A purchase discount reduces the purchase price of certain inventories, fixed assets supplies, or any goods or products if the buying party can settle the amount in a given time period.
The purchase discount is also referred to as cash discounts. This is mainly an incentive to the purchasing party to settle the bill earlier than the prescribed date. This has advantages for both the seller, as well as the buyer.
From the sellers’ perspective, it can be seen that he is able to recover the amount in a quicker time frame.
This helps keep their cash conversion cycle in check, and therefore, this is greatly helpful, essentially because it keeps their liquidity under check.
On the other hand, as far as the buyer is concerned, it can be seen that they can avail of a certain discount on their purchase and the trade discount. This helps to lower their purchase cost, and therefore, this can impact their profitability.
Purchase discounts are mainly treated as a general ledger account. It is mainly maintained by a company that uses a periodic inventory system.
Purchase discounts are mainly explained using terminology a/b net c. In this, a is the percentage discount offered if the payment is made within ‘b’ days, and if the payment is not made in ‘b’ days, then the remaining amount is due in ‘c’ days. For example,
3/15 net 30 would mean that the company will get a 3% trade discount if the payment is settled within 15 days. However, if the payment is not settled within 15 days, the full amount will be due at the end of 30 days.
From an accounting perspective, it can be seen that when the purchase is made (and the invoice is generated), the journal entry to record this transaction is Debit – Purchases, and Credit – Accounts Payable.
If the company does not avail of a trade discount, the subsequent journal entry would be to Debit – Accounts Payable and Credit – Cash/Bank.
However, in the case where a trade discount is availed, it can be seen that the journal entry would be to Debit – Accounts Payable (with the actual and full amount), and Credit – Trade Discount, Credit – Cash/Bank. The journal entry is shown as follows:
Debit – Account Payables
Credit – Cash / Bank
Credit – Discount
The difference in both the accounts is subsequently shown as a trade discount, and the remainder is subsequently credited from the bank (the amount actually paid).
In case of Cash Purchases, the journal entry is shown as follows:
Debit – Purchases
Credit – Cash / Bank
Credit – Discount
Is the purchase discount a revenue or expense?
Purchase discount is neither the revenues nor the expenses. However, the company could benefit by paying less to its suppliers for the same products or services that it purchases.
It reduces the expenses or cash outflow of the company, but it could not be considered the revenues under the accounting principle.
The key advantages of purchase discount for the company:
- Paying less to the supplier for the same amounts or services that the company purchased. These will reduce the expenses or cash-out flow of the company. The company will have the remaining cash or budget the remaining for purchase.
- Have a better relationship with a supplier or having better credit with the supplier since the company could impress supplier that it does not have the cash flow problem. The company might receive a better discount for the next purchase.
The key advantages of the purchase discount for the company:
- A large amount of cash will have to outflow early than it should be if the company decides to pay its supplier to get the cash discount. This could lead to a shortage of cash for purchase or operating expenses.
- The company will have to give up the interest on the deposit from the saving that it has with the bank.
The main premise used when creating Trade Payables mainly vests on the grounds of ensuring that the company has been able to incorporate the time value of money into their calculations when calculating the trade discount percentage.
With every day that the payment is not received, the seller or receivable has an opportunity cost– in terms of the financial return he could have otherwise generated.
On the contrary, the debtor, who has purchased the goods, has a chance to earn more as a result of the amount that is being withheld.
Therefore, to set that off, trade discounts are offered which incentivizes buyers of a certain product to pay early, at a cheaper cost.