Today’s question is not so much a question, but a nice discussion I had with Mr. David Kolitz, an academic from the University of Exeter in the UK and author of financial accounting textbooks.
However, I do believe that this little discussion can be beneficial for practitioners and accountants, too, because it is so frequent.
So, David asked me about my opinion about accounting for settlement discounts.
Let’s say that an entity that sells goods on credit for 100 and offers 10% settlement discount if the customer pays within 10 days. Otherwise, the full amount is to be paid after 30 days.
How should we account for it?
Should we initially record the revenue net of discount and if the client pays later, then adjust the revenue for the discount?
Or, should we record the deferred interest income at the time of sale amounting to the amount of discount?
What is a settlement discount?
To make it absolutely clear for everyone:
Settlement discount is a discount for prompt payment of invoice by the customer.
Let’s say you sell something for 1 000 on 30-day credit and you offer 3% off if a customer pays within 10 days. Those 3% – or 30 in this case – is a settlement discount.
Settlement discounts: IAS 18 vs. IFRS 15
In my opinion – under older IAS 18 Revenue, income from the sale on credit was recognized in full and the discount (if a customer paid promptly) was recognized as expenses at the time of payment.
However, under IFRS 15 Revenue from Contracts with Customers, it is clear that there is a variability in the transaction price and thus we must apply the provisions of IFRS 15 about variable consideration.
IFRS 15 says that “Where a contract contains elements of variable consideration, the entity should estimate the amount of variable consideration to which it will be entitled under the contract. ” (par. 50)
Also, par. 56 states that “variable consideration is only included in the transaction price if, and to the extent that, it is highly probable that its inclusion will not result in a significant revenue reversal in the future when the uncertainty has been subsequently resolved. ”
Therefore in my opinion, the seller must first assess the probability of customer paying promptly.
Let me illustrate what happens under different scenarios.
Seller assumes that customer WILL pay promptly
If past evidence or other information indicate that yes, a customer will pay promptly, then the seller should recognize the revenue net of settlement discount at the time of sale.
As an example, let’s say you make a sale of 1 000 to customer John on credit for 30 days.
You offer settlement discount of 3% if John pays within 10 days.
From the past experience with John you expect him to pay within a week because John has always paid you within a week.
Therefore, at the time of sale, you adjust the transaction price for variability because you assume that you will have to provide settlement discount.
Your journal entry is therefore:
- Debit Receivables: CU 970 (CU 1 000 after 3% discount);
- Credit Sales: CU 970
You should not recognize any deferred interest income, because we are not talking about the significant financing component here.
When John pays you within 10 days, you simply:
- Debit Cash: CU 970; and
- Credit Receivables: CU 970.
However, if John pays you after 10 days, then he needs to pay the full 1 000 and in this case, you will simply adjust the revenue as:
- Debit Cash: CU 1 000,
- Credit Receivables:CU 970; and
- Credit Sales: CU 30.
Seller assumes that customer WILL NOT pay promptly
In this case, the revenue is recognized in full and if a customer later pays promptly and is entitled to a discount, then the revenue is adjusted.
Let’s say you make the same sale to different customer, George, but George really likes to take him time and pay after 30 days.
You do not expect he would be entitled to a settlement discount, so you book:
- Debit Receivables: CU 1 000; and
- Credit Sales: CU 1 000
And when George makes a payment within 10 days against your expectations, then you simply adjust the revenue.
You book:
- Debit Cash: CU 970;
- Debit Sales: CU 30; and
- Credit Receivables: CU 1 000.
Settlement discounts: Practical point
Companies often assess the clients individually as each client can have slightly different habits of making payments, so it’s not unusual to record sales both ways at the same company for different customers.
However – good documentation is necessary here.
Any comments or questions?
Please let me know below – thank you!