Chapter 4: Appendix P7

Recording and Comparing Merchandising Transactions Using the Gross Method and Net Method When recording merchandising transactions, companies can use either the gross method or the net method to account for purchases and sales. The key difference between the two methods lies in how companies initially record transactions and how they handle cash discounts. 1. Gross Method The gross method records purchases and sales at their full invoice value (gross amount), assuming that no discounts will be taken. If a cash discount is later applied, it is recorded when the payment is made. This is the more traditional and straightforward approach. Purchases under the Gross Method: When merchandise is purchased, it is initially recorded at the full (gross) price. If a discount is taken later, the adjustment is made at the time of payment. • • • Example: A company purchases merchandise for $500 on November 2, with terms 2/10, n/30 (2% discount if paid within 10 days). o Entry on November 2 (Gross Method):  Debit Merchandise Inventory $500  Credit Accounts Payable $500 Payment within Discount Period: If the payment is made within the discount period (e.g., November 12), the company takes the 2% discount. o Entry on November 12 (Payment within Discount Period):  Debit Accounts Payable $500  Credit Cash $490  Credit Merchandise Inventory $10 (reflects the discount) Payment after Discount Period: If the company misses the discount period and pays after it expires, the full amount is paid. o Entry (Payment after Discount Period):  Debit Accounts Payable $500  Credit Cash $500 Sales under the Gross Method: For sales, the gross method records the revenue at the full invoice price. If a discount is given to the customer when they pay within the discount period, it is recorded when payment is received. • • • Example: A company sells merchandise for $500 on November 2, with terms 2/10, n/30. The cost of the goods is $200. o Entry on November 2 (Gross Method):  Debit Accounts Receivable $500  Credit Sales $500  Debit Cost of Goods Sold $200  Credit Merchandise Inventory $200 Payment within Discount Period: If the customer pays within the discount period, the 2% discount is applied. o Entry (Payment within Discount Period):  Debit Cash $490  Debit Sales Discounts $10  Credit Accounts Receivable $500 Payment after Discount Period: If the customer pays after the discount period, no discount is applied. o Entry (Payment after Discount Period):  Debit Cash $500  Credit Accounts Receivable $500 2. Net Method The net method assumes that all cash discounts will be taken and records transactions at the net amount (invoice amount minus the discount). If a discount is missed, it is treated as an expense. Purchases under the Net Method: When merchandise is purchased, it is recorded at the discounted (net) price, assuming the discount will be taken. If the discount is missed, the company records the difference as a Discounts Lost expense. • • Example: A company purchases merchandise for $500 on November 2, with terms 2/10, n/30. o Entry on November 2 (Net Method):  Debit Merchandise Inventory $490 (reflects the 2% discount: $500 × 98%)  Credit Accounts Payable $490 Payment within Discount Period: If the payment is made within the discount period, no additional entry is needed since the discount was already accounted for. o Entry (Payment within Discount Period):  Debit Accounts Payable $490  Credit Cash $490 • Payment after Discount Period: If the payment is made after the discount period, the company recognizes the discount as Discounts Lost. o Entry (Payment after Discount Period):  Debit Accounts Payable $490  Debit Discounts Lost $10  Credit Cash $500 Sales under the Net Method: For sales, the revenue is recorded at the net amount, assuming that the customer will take the discount. If the customer misses the discount period, the company recognizes the difference as Discounts Forfeited (an additional revenue account). • • • Example: A company sells merchandise for $500 on November 2, with terms 2/10, n/30. The cost of the goods is $200. o Entry on November 2 (Net Method):  Debit Accounts Receivable $490 (reflects the 2% discount: $500 × 98%)  Credit Sales $490  Debit Cost of Goods Sold $200  Credit Merchandise Inventory $200 Payment within Discount Period: If the customer pays within the discount period, no further entry is needed since the discount was already applied. o Entry (Payment within Discount Period):  Debit Cash $490  Credit Accounts Receivable $490 Payment after Discount Period: If the customer pays after the discount period, the company recognizes Discounts Forfeited as additional revenue. o Entry (Payment after Discount Period):  Debit Cash $500  Credit Accounts Receivable $490  Credit Discounts Forfeited $10 Comparison of the Gross Method and Net Method Aspect Gross Method Records at the full Initial Recording of (gross) invoice Transactions amount. Discounts are Handling of recorded when taken Discounts (at payment). Net Method Records at the net amount (assuming discounts will be taken). Discounts are assumed to be taken. If missed, the difference is recorded as Discounts Lost. Aspect Gross Method Net Method If discounts are missed, Discounts Lost is No adjustment needed recorded as an expense (for purchases) or Adjustments after if discounts are Discounts Forfeited as additional revenue (for Payment Period missed. sales). Inventory is recorded Inventory is recorded at the net price, assuming Inventory at the gross price. the discount. Recording Which Method to Use? • • The gross method is simpler and more conservative, assuming that discounts may not be taken. The net method is more aggressive in assuming that discounts will always be taken, which may be more accurate if the company frequently takes advantage of discounts. If discounts are missed, the net method requires recording Discounts Lost, which highlights inefficiencies in cash management. Both methods are acceptable under accounting standards, and the choice depends on the company's typical cash management and payment practices.