Selling inventory on credit or account is a standard business practice for merchandisers and retailers. By granting short-term credit to customers, sellers can boost sales and inventory turnover and build good customer relationships.
In this guide, we’ll discuss what “Inventory sold on credit/account” is and share two journal entry examples. Please note this post is using the basis of perpetual inventory system (FIFO/LIFO), which doesn’t apply to the periodic inventory system.
What is Inventory Sold on Credit/Account?
Inventory sold on credit/account is sales made to customers for which payment will be collected later.
When inventory is sold on credit/account, the sellers are expected to specify the payment term.
A payment term sets the due date of the credit sale. For example, the payment term “Net 30” means the due date is 30 days from the purchase date. However, some sellers grant cash discounts to entice customers to pay early. The discount is set as a percentage and is valid only for a short period.
An example of a payment term with a cash discount is 2/10, Net 30, which reads as “2% discount if paid within 10 days. Otherwise, pay the full amount within 30 days.” The length of the payment term depends on the seller’s leniency and judgment. A longer payment term (usually >30 days) is riskier from a collection perspective. In comparison, a shorter term (usually <10 days) may seem unappealing for some customers.
Let’s also go over the accounting for early payment discounts. There are two ways to account for cash discounts: 1) gross method and 2) net method. The accounting method is a matter of choice; either way is acceptable.
Under the gross method, the sale is recorded without the cash discount; it will only be deducted when the customer takes the discount. On the flip side, the net method accounts for the cash discount on the date of the sale as if the customer already took the discount. However, if the customer skips the discount opportunity, an additional journal entry is required to adjust the accounting impact.
Journal Entry Examples of Inventory Sold on Credit/Account
Without Early Payment Discount
When there’s no early payment discount, the seller records sales and receivables as is. For example, let’s assume Company A sold inventory on account to Company B for $5,000 at a cost of $4,000. Company A then gave a payment term of Net 30 without the early payment discount.
In the books of Company A (Seller), the journal entries look like these on the day of the sale:
- The $5,000 debit to accounts receivable indicates that Company A (Seller) expects to collect the payment from Company B (Buyer). This amount is expected to be received on or before the 30th day from the date of the purchase.
- The $5,000 credit to Sales Revenue is Company A’s revenue booking from the transaction.
Company A then needs to record the inventory and Cost of Goods Sold impact in its books.
- The $4,000 debit to Cost of Goods Sold is the expense incurred to build the inventory.
- The $4,000 credit to Inventory reduces the inventory account balance due to the sale.
- This entry is necessary to match the $4,000 cost with the previously recorded $5,000 revenue, adhering to the matching principle in GAAP.
Assuming Company B paid within 30 days, Company A must make the following journal entry when the payment is collected:
- The $5,000 debit to Cash is the amount Company A (Seller) received from Company B (Buyer).
- The $5,000 credit to Accounts Receivable removes Company B’s indebtedness to Company A.
When a company doesn’t give out early payment discounts, journal entry recording is straightforward. The first step is to recognize the revenue, record a receivable, and account for the impact of the cost of goods sold/inventory. The next step is to remove the receivable when the payment is collected.
In the next section, we’ll discuss how things can get a bit complicated if there is an early payment discount.
With Early Payment Discount
Using the same example, let’s assume Company A (Seller) gave Company B (Buyer) a payment term of 5/15, Net 30, for its purchases of inventory totaling $5,000. This term means that Company B gets a 5% discount if it pays within 15 days from the purchase date.
In the books of Company A (Seller), the journal entries using the (1) gross method and (2) net method are as follows. We will also explain both collection scenarios (paid within 15 days or after 15 days) in detail.
Gross Method
Sale of Inventory on credit/account:
- Under the gross method, the discount is first excluded.
- The $5,000 debit to Accounts Receivable represents the amount due from Company B for the inventory sold on credit or on account.
- The $5,000 credit to Sales Revenue is the revenue recognized at the time of the sale.
Collection with discount taken (customers paid within 15 days):
- Under the gross method, the discount is deducted when taken.
- The $4,750 debit to Cash is the net amount Company A received from Company B. The discount is 5%*$5,000 = $250, hence the cash receipt after discount is $5,000 – $250 = $4,750.
- The $250 debit to Sales Discount (a contra-revenue account) indicates the 5% discount has been granted because Company B paid early.
- The $5,000 credit to Accounts Receivable removes the indebtedness of Company B.
Collection with discount forfeited (customers paid after 15 days)
- Under the gross method:
- The $5,000 debit to Cash indicates the cash receipt.
- The $5,000 credit to Accounts Receivable removes Company B’s indebtedness.
- The receivable was recorded without the discount on the day of sale, thus making this payment collection journal entry straightforward.
Net Method
Sale of Inventory on credit/account:
- Under the net method, the discount is applied as if Company B has already taken it.
- The $4,750 debit to accounts receivable is the net amount Company A expects to receive from Company B. The discount is 5%*$5,000 = $250, hence the net receivable is $5,000 – $250 = $4,750.
- The $4,750 credit to Sales Revenue reports the sale at its net amount. Hence, there will be no additional sales discounts recorded in the books.
Collection with discount taken (customers paid within 15 days):
- Under the net method, no further adjustments are needed when customers paid within the discount period
- The $4,750 debit to Cash records the cash receipt
- The $4,750 credit to Accounts Receivable removes Company B’s outstanding balances.
- The receivable was already recorded net of the discount; therefore, the journal entry is straightforward.
Collection with discount forfeited (customers paid after 15 days):
- Under the net method, we need to adjust sales by adding back the discount deducted previously.
- The $5,000 debit to Cash is the cash receipt.
- The $4,750 credit to Accounts Receivable removes Company B’s indebtedness. Under the net method, the receivable was recorded assuming a discount would be taken ($4,750). In other words, there was only $4,750 AR on the balance sheet.
- The $250 credit to Sales Discount Forfeited adds back the discount that was initially deducted, as the customer did not take advantage of the early payment discount. This Sales Discount Forfeited account is a revenue/other income account.
Cost of Inventory Sold
Company A also needs to make an entry for the inventory sold. This entry is the same regardless of whether a customer discount is granted.
- The $4,000 debit to Cost of Goods Sold represents the expense of producing the inventory.
- The $4,000 credit to Inventory decreases the account balance due to the sale.
- This entry is essential to align the $4,000 cost with the $5,000 revenue recorded previously. This alignment follows the matching principle, a key concept in GAAP.
Both the Gross and Net methods lead to the same financial outcome. The choice between them depends on the business owner’s preference and whether they expect buyers to take advantage of the discount.
Key Takeaways
- Inventory sold on credit or account is a common business practice to boost sales and establish long-term customer relationships.
- When there are no early payment discounts, the journal entry is straightforward.
- Upon sale, we debit AR and credit Sales Revenue.
- Upon collection of the payment, we debit Cash and credit AR.
- When the seller offers early payment discounts, it incentivizes customers to make prompt payments. Early payment discounts are accounted for using either the gross or net method.
- The gross method records AR and Sales Revenue without deducting the discount. If the customer takes the discount, a follow-up debit to Sales Discounts (contra-revenue) is recorded.
- The net method records AR and Sales Revenue net of the discount as if the customer has already taken it. If the customer forfeits the discount, we must record a follow-up credit to Sales Discount Forfeited (Revenue/other income account) to reverse the discount initially assumed.
- Both the net method and the gross method result in the same financial impact. It is a matter of preference.
- Whether or not an early payment discount is offered, we must always record the cost of inventory sold. This involves debiting the Cost of Goods Sold account and crediting the Inventory account.
