You call them freebies and giveaways! Truth is, they are not wholly free. At least, somebody has to account for them…
Businesses, every now and then offer different types of incentives in a bid to woo customers, retain their loyalty or continued patronage. Some of these incentives come in the form of Sales Discounts, Giveaways, Bonuses, Reward points etc. The customers who benefit from these incentives may not have much to worry about, but the same cannot be said of the entities that dole out the largesse.
While it is so easy for the benefiting customers (both private and corporate) to see these as freebies and ignore their accounting implications, it cannot (and should not) be business as usual in the Accounts departments of benefactors—proper entries must be made to balance the books. The truth is, there is no such thing as “freebies” when it comes to accounting—everything that has (or once had) value must be accounted for. Even a company’s car that is wrecked must still be accounted for by debiting an expense account to get the wrecked car out of the books; goods that are damaged, expired or stolen must be accounted for, otherwise accounts will not balance, or the financial position will not be fairly stated.
You might find it convenient to overlook the free lunch you offered your uncle in your restaurant, the free accommodation you normally provide your friends who stay in your hotel, or the complimentary drinks you give to your guests. If you continue to ignore them, you will be making accounting mistakes that could hurt your business. Nothing is free—as long as a value is attached to it. Sometimes, the problem is with our inability to determine the value. Think of that make-up you did free of charge or the dress you designed for your friend. How much would they have cost? You must find a way to attach values to these things.
The aim of this post is to present the standard framework on how to account for customers’ incentives, which I classify into the following categories: Sales Discount, Promotional and Complimentary Sales, Customer Loyalty Programme.
This is the oldest form of customers’ loyalty incentive. It involves reducing the marked price on goods or services by a certain percentage (or amount). The selling price of the item does not change, but what the customer pays is less the discount. The Discount is recognized as cost. Some companies issue their customers Instant Discount Card, which entitles the customers to a fixed discount for every purchase they make. There are those who offer discount only for purchases in excess of a fixed amount.
The figure below summarizes the standard accounting entries that go with Sales without a Discount, and Sales with a Discount.
Take note of the following:
- Sales Discount is an expense classified as Cost of Sales (or Direct Cost).
- Your Income Statement will show that you incurred additional cost on the goods or services as a result of the discount
Promotional and Complimentary Sales
These are what might be referred to as “giveaways.” The customer or the beneficiary does not pay anything for the goods or services provided. The value associated with the goods or services are either written off as overhead expense (not cost, as was the case with Discount) or debited to a clearing account for further action. Note that the goods and services given out this way also attract applicable taxes, such as Sales Tax or Valued-Added Tax (VAT).
The figure below provides summary of accounting entries for Promotional and Complimentary Sales. In this illustration, we have to assume that the goods or services provided are written off as overhead expense. Your Income Statement should show that you incurred a loss on those goods or services.
One question a customer once asked me was “why are these complimentary sales appearing in my Income Statement as Revenue when we did not sell the items?” The answer is: they are sales—the only difference being that they are not paid for in cash. You do not earn cash from such transactions, but you might earn customers loyalty, or what is called “goodwill”—which is an asset.
Another question I had to answer in the past had to do with the reason one cannot omit the sale part of the transaction and go ahead to record only the cost of goods. The simple answer to that is: it is fraudulent, as it might also result in not accounting for applicable taxes.
Customer Loyalty Programme
Now, let us consider another customer loyalty incentive, which involves awarding credit points to customers for purchases or under defined criteria. The award credits are redeemable in the future by using the credits to offset future purchases based on the fair value of the credits.
The International Financial Reporting Interpretations Committee’s Accounting for Customer Loyalty Program (IFRIC 13) was issued in order to have a uniform accounting treatment for a practice which is becoming widespread. Under IFRIC 13, the award credits have expiry date, and all unredeemed credits should be discharged on expiration.
Prior to the issuance of IFRC 13, most entities treated the loyalty award credits as marketing expense, but IFRIC 13 stipulates that the fair value of the award credits should be treated as a separate component of the sale transaction, by allocating it between:
- The good or service provided
- The award credits (as Deferred Revenue) to be redeem in future
Consequently, the following accounting entries become applicable for a Purchase (P) which results in a Loyalty Credit with Fair Value (X):
- Dr. Cash P
- Cr. Sales Revenue P-X
- Cr. Deferred Revenue (Customer Loyalty) X
This is similar to the following entries:
- Dr. Cash P
- Cr. Sales Revenue P
- Dr. Customer Loyalty Component of Sales X
- Cr. Deferred Revenue (Customer Loyalty) X
On redeeming the loyalty credits:
- Dr. Deferred Revenue (Customer Loyalty) X
- Cr. Sales Revenue X
On expiration, all expired unredeemed credits should be released:
- Dr. Deferred Revenue (Customer Loyalty)
- Cr. Sales Revenue
If you want to account for Customer Loyalty make sure you include the relevant accounts in your Chart of Accounts.
Accounting for giveaways and discounts can serve, at least, one practical purpose: letting you know just how much you are giving away and how it affects your bottom-line. So when next you gleefully dole out those freebies or discounts, don’t just shake hands and walk away—go and complete the books and make sure everything is properly accounted for and your account is balanced.
ABC Toolkit financial and business solution for Small and Medium Enterprises (SMEs) has provided simple tools that automate the task of accounting for these transactions with ease.