What is a Purchase Discount?
Purchase Discount is referred to the discount that is availed by the buyer of the goods, as a result of settling a particular debt earlier than the actual settlement date.
During the normal course of the business, it is highly likely that businesses might procure certain goods or services on credit.
However, regardless of the agreed upon credit limit and timeline, the seller of the goods often offers a cash discount to the purchaser of goods and services, in order to motivate him to settle the amount earlier than the agreed upon date.
The incentive to the buyer of purchase discount is the fact that the purchase costs decreases, and the business is able to save a considerable amount on procurement costs.
On the other hand, the incentive to the seller in offering discounts is simply the fact that he is going to receive the total amount much earlier than the requested date.
Purchase Discounts are often described into two broad categories: Trade Purchase Discounts, and Cash Purchase Discounts.
Trade Purchase Discounts include the discounts that are offered to the buyers as a result of their volume, or just to motivate them to make the purchase.
On the other hand, cash purchase discounts are discounts that are offered to buyers contingent on their ability to settle their debt within a stipulated timeline.
Accounting for Purchase Discount
Purchase discount, by nature, are supposed to decrease the purchase costs of the company. Therefore, they can best be described as a contra-purchase account.
In the Profit and Loss Account (also referred to as Income Statement), the Purchase Discount is subtracted from the gross amount of purchases, as shown below:
|Less: Purchase Discounts||7,000|
An aspect that needs to be noted here is the fact that only cash purchase discounts are included as subtractions from gross purchases.
The net amount is not mentioned earlier on in the analysis because it is still not confirmed if the company is going to be able to pay the dues in time to be able to avail the cash discount or not.
Also, trade discounts are included earlier on in the purchase process, before the purchase is made. Therefore, they are already incorporated in the purchase price itself.
In normal course of business, whenever a business purchases goods on credit, the sales agreement includes the following piece of information:
The format that has been mentioned above means that the buyer of goods and services can avail a discount of 5% is he settles the amount within 10 days.
Otherwise the full amount is due on the 20th date from when the invoice has initially been generated.
Journal Entries for Purchase Discount:
Journal Entries for Sales Discounts are posted in the following manner:
When a Purchase is made on credit, the following journal entries are posted:
When the buyer avails the cash discount offered, the following journal entry is posted:
Example and Solution:
In order to further explain how Purchase Discounts work, the following example is given:
On 1st January, Dolphin Inc., purchased goods worth $2000 from Blenda Co. The agreed credit terms for the transaction were 5/10, net/20.
Jayman Co. settled the amount on 8th Jan.
Jayman Co. settled the amount on 11th Jan.
The credit terms that are put forth by Blenda Co. mean that Dolphin Inc. is supposed to settle the amount due before 10th January, in order to avail a cash discount of 5%.
Otherwise, the net amount would be payable in maximum 20 days (i.e. 20th January).
In the case where Dolphin Inc. settles the amount on 8th Jan (or any date before 10th January), the cash discount is availed. So, the following journal entry is going to be made:
In the case where Dolphin Inc. settles the amount on 11th Jan (or any date after 10th January), the cash discount is availed. So, the following journal entry is going to be made:
The following journal entries show the treatment of purchase discounts, depending on whether the discount has been availed or not.
It can be seen that only cash discount is reflected in the journal entries (as well as the financial statements), whereas trade discounts associated with purchases are not recorded.