Cash Discounts Allowed and Provision for Discounts Allowed

Cash Discounts Allowed – Definition:

Some firms allow cash discounts to their customers for prompt payment. In that case at year end, the outstanding trade receivables may include an amount to be allowed to them in the following year on account of discounts. The actual cash discounts allowed to customers are initially recorded in the cash book and then posted on the debit side of discounts allowed account in the general ledger.

Provision for Discounts Allowed – Definition:

Not all of the trade receivables will take advantage of discount terms. Moreover, no one exactly knows that how many trade receivables will take the opportunity of getting discounts. Therefore, a rough estimate for discount is made, based on a percentage of outstanding trade receivables. Such estimation is known as provision for discount allowed.

Calculation and Recording the Journal Entries of Provision for Discounts Allowed:

The recording of provision for discount allowed is very much similar to provision for doubtful debts. The only difference is that the provision for discounts is calculated on the trade receivables’ balance after deducting all bad and doubtful debts. It is a contra asset account and is shown as a deduction from trade receivables in the balance sheet to determine their net realizable value. The provision for discounts allowed help us to “match” the discount to the period in which sales were made to the customers to whom discount is to be provided for.

provision for discount allowed formula

Provision for doubtful debts is recorded in the following way:

Journal Entry 1 – To record creation of provision:

Debit (Dr) Income statement

Credit (Cr) Provision for discounts allowed

In order to maintain realistic company profits, there is need to consistently update the provisions for discounts allowed. Businesses therefore, review and restate the provision for discounts allowed at the end of each financial year.

Journal Entry 2 – To record increase in provision:

Debit (Dr) Income statement

Credit (Cr) Provision for discounts allowed

Entry 3 – To record decrease in provision:

Debit (Dr) Provision for discounts allowed

Credit (Cr) Income statement