Discounts are probably the most popular selling tool in business. Without a doubt, many companies discount the price for their products or services in various forms, for example:
- Buy 1, get 1 free (and modifications),
- Get 10% off for purchases over CU 100 (and modifications),
- Gift vouchers,
- Settlement discounts (bonus for early payment or for cash payment),
and many others.
What do discounts really mean for us, accountants?
In most cases, troubles.
The reason is that discounts directly affect measurement of various items in the financial statements and potentially the accounting treatment (timing and journal entries).
In this article, I explain how you should treat the discounts from the point of view of both seller and buyer.
My good friend, Prof. Robin Joyce added a bonus to this article.
We try to explain why discounting is not always that great and how you should decide on the amount of your discount based on your own margins and sales.
Maybe you’ll be surprised to find out that not every single business can afford discounting. Yes, it’s an expensive selling tool!
Sellers provide discounts
When a seller provides a discount, it directly affect the amount of his revenue.
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Therefore logically, we should look to the standard IAS 18 Revenue or IFRS 15 Revenue from Contract with Customers for guidance.
Both standards specify that you should present the revenue net of discounts. Just refer to IAS 18.7 or IFRS 15.47 and following).
In other words, discounts reduce the amount of your revenue and do not represent cost of sales (or cost of promotion etc.).
For example, when you sell a machine for CU 100 and you decide to provide a discount of 3%, then you present a revenue of CU 97, and NOT the revenue of CU 100 and cost (of sales, marketing, whatever) of 3.
This rule seems very basic and very simple, yet its practical application can be challenging at some circ*mstances.
Let me give you 2 examples.
Example 1: Discount coupons
Imagine you run an e-shop with books. To support your sales, you send a discount coupon for CU 5 that your customers can use with every purchase over CU 100.
How should you account for the discount coupon?
In this particular example, you don’t recognize a provision in your financial statements for a discount at the time of distributing a coupon.
Why?
Because there’s no past event.
Remember, a customer would have to make a purchase over 100 and only then you have a liability to provide a discount of CU 5.
Instead, you simply recognize revenue net of CU 5 discount when a coupon is redeemed.
Example 2: Buy 1, get 1 free (or any free items)
Instead of giving discount coupons, you promise to deliver a book “Thai cuisine” for free with every purchase of “Thailand travel guide” for CU 50.
You normally sell Thai cuisine for CU 10, its cost in your inventory is CU 6 and the cost of Thailand travel guide is CU 35.
What do to now?
Under IAS 18, you simply recognize revenue for both books of CU 50 and cost of sales of CU 41 (35+6).
Cost of free item is not a marketing or promotion cost in this case, because a free item increases revenues (supports spending).
Under IFRS 15, the accounting treatment is the same if both books are delivered at the same time.
However, if you deliver Thailand travel guide in September and Thai cuisine in October due to low stock, then you would need to split the transaction price of CU 50 based on the relative stand-alone selling prices and recognize revenue accordingly.
More specifically:
- Total stand-alone selling prices: CU 50+CU 10 = CU 60
- Revenue allocated to Thailand travel guide: CU 50/CU 60*CU 50= CU 42 to be recognized in September.
- Revenue allocated to Thai cuisine: CU 10/CU 60*CU 50 = CU 8 to be recognized in October.
Costs of sales are recognized accordingly.
Buyers get discounts
When buyers get discounts, it’s a totally different story.
We need to look at IAS 2 Inventories, IAS 16 Property, plant and equipment or other similar standards for guidance.
Both IAS 2 and IAS 16 prescribe that we should initially measure an item of PPE or inventories at its cost including purchase price. And, it’s net of discounts.
However, let me stop here.
You should examine the reason for getting a discount.
If you receive a discount as a reduction in the purchase price of inventories, then you should deduct it from their costs.
When discounts refund some selling expenses, then these discounts are not deducted from the costs of inventories, but treated as income.
Another consideration might relate to settlement discounts, i.e. discounts received from quick payment. They should not be treated as finance income, but again, they reduce the cost of inventories.
Example 3 Rebates on inventories
Supermarket wants to purchase 1 000 Chocobars. What is their cost, based on the following information:
- Sales price per unit: CU 5
- Volume discount per 1000 units: 10%
- Settlement discount: 2% when paid within 30 days
- Contribution for leaflet printing costs: 1%
If the supermarket intends to pay within 30 days, then it should reduce costs of inventories by settlement discount, too.
Contribution for leaflet printing costs is clearly refunding some selling expenses and therefore it should be treated as income, not as cost of inventories.
The costs of inventories is: CU 5*1 000 – CU 5*1 000*(10%+2%) = CU 4 400.
What about inventories received for free?
Well, it depends.
If a government (including governmental agencies) donated you some inventories, then you should apply the standard IAS 20 Accounting for Government grants and Disclosure of government assistance.
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If you received some units of inventories for free as a “gift” with your purchase, then you should apply the standard IAS 2 – i.e. measure inventories at cost.
For example, you purchased 1 000 units at CU 2/unit and received 50 units for free, then you record 1 050 units at CU 2 000, i.e. CU 1,90/unit.
I have also seen that some companies record free items at their fair value while a credit entry goes in profit or loss (as an income). However, this approach is not supported by IFRS.
In any case, you should always seek the substance of a transaction and then make appropriate decision.
When you should NOT discount your goods or services
Let’s take a different angle of looking at discounts. My friend, Prof. Robin Joyce helped me with that.
Discounts represent a very powerful selling tool, but at the same time, they are like marketing’s nuclear weapon.
Why?
The reason is that discounts can lower price perception permanently or make your product a commodity.
It means that clients will see no difference between your product and other products – they will just buy the cheapest (not necessarily the best).
What do discounts do to your profit? Do you really need to discount your products or services in order to increase your profits?
If you sell some tangible products, then you need to know the exact financial impact of your planned discounts on sales and the net profit.
The following table sums it up (read the explanation below the table):
This table shows you how many additional items you should sell at your present profit margins, if you want to keep the same profit.
For example, if you are making 80% margin (top row), and you provide a discount of 20% (side column), you need to sell 33% more units to get the same financial result as without giving a discount.
Putting some numbers to it:
Let’s say you sell a product for CU 100 with 80% margin, therefore its cost of sale is CU 20. You sell normally 100 units, therefore your gross profit is CU 80*100 units = 8 000.
You’d like to give a discount of 20%. Looking at a table above, you need to sell 33% more units than before to have the same effect.
For verification, your new discounted sales price is CU 80, therefore your gross profit with 33% more units sold is CU 60 (80-20) * 133 units = 7 980 (Cu 20 is a rounding difference).
This table assumes that you provide discounts for all your units sold, not just some of them (in this case, you would need to adjust the calculation).
What are the conclusions?
- You need to know your gross margin before considering a discount.
- You need to know how many additional units you need to sell after discount to keep the profit. And, are you able to do so? Will your customers really buy 33% more with 20% discount?
- If you operate with low margins, you cannot afford any discount. For example, if you operate at 10% margin, you cannot give away any discount without hurting your gross profit. You simply cannot sell enough items to pay for it.
It’s your turn now! If you have any questions or concerns with regards to discounts and their accounting, please let me know in the comments below this article. Thank you!
