Sales and Purchases: The Revenue and Cost Cycle

Learning objectives

By the end of this chapter you should be able to:

• Record credit sales and credit purchases using journals and ledgers.
• Account for sales returns and purchase returns using credit notes.
• Calculate trade discounts and settlement discounts and record the correct net amounts.
• Post transactions to receivables, payables, revenue, purchases/expenses, and returns accounts.
• Explain how these transactions affect profit, trade receivables, trade payables, and cash.

Overview & key concepts

Most businesses buy and sell on credit. That means transactions are recorded when they occur (usually when invoices and credit notes are issued), while cash is received or paid later. This time gap creates:

• Trade receivables(amounts owed by customers) and
• Trade payables(amounts owed to suppliers).

The revenue and cost cycle also includes:

• Returns(supported by credit notes), which reduce what is owed and adjust revenue or costs, and
• Discounts, which reduce the amount ultimately received or paid.

A key exam skill is separating:

• Trade discounts(price reductions agreed at the point of sale/purchase) from
• Settlement discounts(reductions for early payment).

Core theory and frameworks

1) The document trail (what happens in practice)

Typical flow in the cycle:

Invoice → Receivable/Payable → Credit note (if any) → Settlement (cash) → Settlement discount (if taken)

• Sales invoicecreates or increases a receivable.
• Purchase invoicecreates or increases a payable.
• Credit notereduces the receivable/payable.
• Settlementclears the balance, sometimes with a settlement discount.

2) Credit sales: double entry and timing

A credit sale increases the customer balance immediately, even though no cash has been received yet.

Journal entry (credit sale):

• DrTrade receivables
• CrRevenue

Accounting equation effect:

• Assets (receivables) increase
• Equity increases through higher profit (via revenue)

Timing point: Record revenue on the invoice date when the sale has taken place under the agreed terms (typically when goods have been delivered or made available to the customer). Cash may be received later, but the entry is based on when the sale occurs, not when payment is collected.

3) Credit purchases: periodic and perpetual approaches

Credit purchases create a supplier balance immediately, even though cash is paid later.

Learners will meet two common approaches:

(A) Periodic approach (common in bookkeeping-style questions)

Purchases of goods for resale are recorded in a Purchases account during the year. Cost of sales is determined later using opening/closing inventory.

• On purchase: DrPurchases/ CrTrade payables
• At period end: calculate cost of sales using opening inventory + purchases − closing inventory.

This approach is used when the question frames inventory adjustments at the end rather than tracking inventory continuously.

(B) Perpetual approach (inventory tracked continuously)

Purchases of goods for resale are recorded directly into Inventory.

• On purchase: DrInventory/ CrTrade payables
• On sale: recordRevenueand separately recordCost of sales(and reduce inventory).

Important: Neither approach is “wrong.” Use the approach signalled by the question (or by the accounts provided).

Operating expenses (same in both approaches)

If the item is an operating cost (e.g., office supplies consumed by the business), record an expense when incurred (or as a prepaid asset if clearly for future periods):

• DrExpense(orPrepayment) / CrTrade payables

4) Returns: credit notes and double entry

Returns reduce the amount owed and adjust revenue/costs. They are normally tracked in separate accounts to keep reporting clear.

Sales returns (customer returns goods)

Journal entry (credit note issued):

• DrSales returns(contra-revenue)
• CrTrade receivables

This reduces the customer balance and reduces net revenue.

Purchase returns (returns to supplier)

Journal entry (credit note received):

• DrTrade payables
• CrPurchase returns(or reduce the related expense/inventory account)

This reduces the supplier balance and reduces the related cost.

Exam note — inventory systems and sales returns (cost side):

• Perpetual approach:a sales return often needs asecondentry to restore inventory and reverse cost of sales (at the goods’ cost).
• Periodic approach:the cost effect is usually captured in the period-end cost of sales calculation (opening/closing inventory), rather than a separate return entry.

5) Trade discounts: record only the net invoice amount

A trade discount is agreed up front and reflected in the invoice price. Record only the net amount in the ledger.

• Donotpost trade discounts as a separate entry.
• Use the amount actually charged on the invoice.

6) Settlement discounts: record on settlement, using the outstanding balance

A settlement discount is offered for early payment and is recorded only when payment occurs and the discount is taken.

• Discount allowed(to a customer): an expense that reduces profit.
• Discount received(from a supplier): commonly shown as income in exam answers, but it may also be presented as a reduction of the related expense or purchase cost.Either approach is acceptable if used consistently.

Customer pays early (discount allowed):

• DrBank(cash received)
• DrDiscount allowed
• CrTrade receivables(full balance cleared)

Business pays early (discount received):

• DrTrade payables(full balance cleared)
• CrBank(cash paid)
• CrDiscount received(or reduce the related expense/inventory)

Important: Calculate the settlement discount on the amount still outstanding, after returns and after trade discounts already reflected in invoices.

7) Overall impact on the financial statements

• Trade receivables/payablesrise on invoices and fall on credit notes and settlement.
• Profitis affected by:
  • Net revenue (revenue less sales returns),
  • Net costs (purchases/expenses less purchase returns),
  • Settlement discounts (allowed reduces profit; received increases profit or reduces costs, depending on presentation).
• Cash flowchanges only when cash is received/paid, not when invoices are posted.

Worked example

Narrative scenario

ABC Ltd enters into the following credit transactions:

• 1 January:Sells goods with a list price of£5,000on credit to XYZ Ltd, offering a10% trade discount.
• 5 January:XYZ Ltd returns goods worth£500(net of trade discount).
• 10 January:Buys office supplies with a list price of£2,000on credit from Supplier A, with a5% trade discount.
• 15 January:Returns supplies worth£200(net of trade discount) to Supplier A.
• 20 January:XYZ Ltd pays the balance and receives a2% settlement discount.
• 25 January:ABC Ltd pays Supplier A and receives a3% settlement discount.

Required

1. Calculate the net amounts for the sale and purchase invoices.
2. Record the journal entries for each transaction.
3. Update the receivables and payables ledgers.
4. Summarise the impact on profit, receivables, payables, and cash.

Solution

Step 1: Net invoice amounts

Sale to XYZ Ltd (1 January):

• List price £5,000
• Less 10% trade discount (£500)
• Net invoice = £4,500

Sales return (5 January):

• Given as£500 net
• Credit note = £500

Purchase from Supplier A (10 January):

• List price £2,000
• Less 5% trade discount (£100)
• Net invoice = £1,900

Purchase return (15 January):

• Given as£200 net
• Credit note = £200

Step 2: Journal entries

(1) Credit sale (1 January)

• DrTrade receivables (XYZ Ltd)£4,500
• CrRevenue£4,500

(2) Sales return (5 January)

• DrSales returns£500
• CrTrade receivables (XYZ Ltd)£500

Outstanding receivable: £4,500 − £500 = £4,000

(3) Credit purchase of office supplies (10 January)

(Office supplies are treated here as an operating expense item.)

• DrOffice supplies expense£1,900
• CrTrade payables (Supplier A)£1,900

(4) Purchase return (15 January)

• DrTrade payables (Supplier A)£200
• CrPurchase returns(or reduce office supplies expense)£200

Outstanding payable: £1,900 − £200 = £1,700

(5) Receipt from XYZ Ltd with settlement discount (20 January)

Settlement discount = 2% × £4,000 = £80
Cash received = £4,000 − £80 = £3,920

• DrBank£3,920
• DrDiscount allowed£80
• CrTrade receivables (XYZ Ltd)£4,000

(6) Payment to Supplier A with settlement discount (25 January)

Settlement discount = 3% × £1,700 = £51
Cash paid = £1,700 − £51 = £1,649

• DrTrade payables (Supplier A)£1,700
• CrBank£1,649
• CrDiscount received£51(or reduce office supplies expense)

Step 3: Ledgers (T-accounts)

Trade receivables — XYZ Ltd

Trade payables — Supplier A

Step 4: Impact summary

Profit impact (net presentation)

• Net revenue:Revenue £4,500 − Sales returns £500 =£4,000
• Settlement discount allowed:£80expense (reduces profit)
• Net office supplies cost:Office supplies £1,900 − Purchase returns £200 =£1,700
• Settlement discount received:£51(either shown as income or as a reduction of office supplies cost)

Receivables and payables

• XYZ Ltd receivable is created at £4,500, reduced by a £500 credit note, then cleared on settlement.
• Supplier A payable is created at £1,900, reduced by a £200 credit note, then cleared on settlement.
• Both balances end at£0.

Cash movement

• Cash received from XYZ Ltd:£3,920
• Cash paid to Supplier A:£1,649

Common pitfalls and misunderstandings

• Recording trade discounts separately:trade discounts are already reflected in the invoice; record only the net amount.
• Calculating settlement discounts on the wrong base:apply settlement discount to the outstanding balance after returns.
• Treating credit notes as cash:credit notes adjust balances; they do not affect the bank.
• Posting returns to the wrong side:
  • Sales return: credit receivables.
  • Purchase return: debit payables.
• Assuming “Purchases” is always wrong:“Purchases” is commonly used under a periodic approach; “Inventory” is used under a perpetual approach. Follow the approach implied by the question.
• Forgetting the cost-side entry on sales returns under perpetual inventory:revenue/receivable reversal is not the whole story if inventory is tracked continuously.
• Mixing presentations for discount received:treat it as income or net it against the related cost—either is acceptable if applied consistently.

Summary and further reading

Credit transactions are recorded when invoices and credit notes are issued, creating trade receivables and trade payables. Returns are processed through credit notes, which reduce balances and adjust revenue or costs. Trade discounts are reflected in invoice net amounts and are not recorded separately. Settlement discounts are recorded when payment is made and the discount is taken, affecting profit.

A strong grasp of the document trail and ledger postings helps prevent common errors in questions involving returns, discounts, and settlement.

FAQ

What is the difference between trade and settlement discounts?

A trade discount is an upfront price reduction reflected in the invoice net amount. A settlement discount is an incentive for early payment and is recorded only when payment is made and the discount is taken.

How do sales and purchase returns affect financial statements?

Sales returns reduce net revenue and reduce the customer balance. Purchase returns reduce the supplier balance and reduce the related cost (by using a returns account or reducing the related expense/inventory).

Why are trade discounts not recorded separately?

Because the invoice is raised at the reduced price, the ledger should record the actual transaction value. Recording list price and discount separately adds entries without improving the accuracy of balances.

How should discount received be presented?

It is often shown as discount received (income). Alternatively, it may be presented as a reduction of the related expense or purchase cost (especially where it relates to inventory purchases). Either treatment is acceptable if applied consistently.

How do credit sales and purchases impact cash flow?

They delay cash movement. Invoices create receivables or payables without affecting cash. Cash changes only when customers pay or suppliers are paid.

Why use separate accounts for returns?

Separate accounts help track return levels, preserve a clear audit trail, and provide clearer reporting of gross amounts and the reductions made.

What is the purpose of a credit note?

A credit note is the document that supports a reduction to a previous invoice. It is used to adjust customer or supplier balances and supports accurate recording of returns and allowances.

Glossary

Credit sale
A sale where the customer is invoiced and will pay later, creating a trade receivable.

Credit purchase
A purchase where the supplier invoices the business and payment is made later, creating a trade payable.

Trade receivable
An amount due from a customer arising from credit sales.

Trade payable
An amount due to a supplier arising from credit purchases.

Sales invoice
A document issued to a customer showing goods/services supplied, the net amount due, and payment terms.

Purchase invoice
A document received from a supplier showing goods/services supplied, the net amount due, and payment terms.

Credit note
A document that reduces a previous invoice amount, commonly issued for returns or allowances.

Sales returns
A contra-revenue account used to record returns and allowances granted to customers.

Purchase returns
An account used to record returns to suppliers and reductions in purchase-related costs.

Trade discount
An upfront price reduction reflected in the invoice net amount and recorded only through that net figure.

Settlement discount
A reduction for early payment, recorded when payment is made and the discount is taken (discount allowed reduces profit; discount received increases profit or reduces costs, depending on presentation).

Net amount
The invoice amount after trade discounts (and before any sales taxes where relevant), which is the figure recorded in the ledgers.