Financial Memos – The Accounting and Finance Community

On its face, the question about the meaning of discount received in accounting seems a little silly, but it is not. The area of discounts can cause some confusion for some accounting students. So in today's article, part of our accounting tutorial series, we will be looking at the two different types of discounts a business can receive and then look at the journal entries involved. Types of Discounts When we talk about discounts received in accounting, they generally fall into two categories; trade discounts and cash discounts. The terms can be a little misleading, and hence they do cause some confusion for those new to how to account for them. But not to fear, we'll go through it all below, first by looking at the difference between these two categories of discounts. Trade Discounts Regarding discounts, confusion often comes about because of the difference between trade discounts and cash discounts. Regarding trade discounts, these are generally not recognised in accounting systems, i.e. there is no journal entry. The reason being the "transaction" does not meet the definition of an expense or revenue. We have a whole tutorial looking at these discounts if you would like to know more. Cash Discounts So we aren't dealing with trade discounts. What we are dealing with, when we use the term "discount received", is a discount offered for early repayment. Firms, in particular when dealing business-to-business, will buy and sell on credit. Rather than making payment at the time of purchase. A business will often have a trade account with a supplier, enabling them to settle the account, say monthly, rather than making a payment each time they order. You can see how this is a little confusing. On the one hand, we refer to discounts received in the normal course of trade, but not "trade discounts" as an accounting term. So let's look at an example below to help clarify when to make a journal entry. Example of a Discount Received Journal Entry ABC Ltd buys its machinery spare parts from a local supplier on credit. Parts are ordered and delivered with payment due by the end of the month following. However, the supplier, XYZ Ltd, offers its customers a five per cent discount if they pay within seven days of the invoice date. Because we are looking at the meaning of discount received, the accounting entries below will be from ABC's point of view, rather than the supplier's. Expense Incurred So for April ended, ABC received an account worth $5,540 for its purchases during the month. The journal entry to recognise this would be: DateAccount NameDebitCreditApril 30Machinery Spares Expense5,540Accounts Payable5,540 The debit recognises the expenses incurred by ABC Ltd for machinery spare purchases, while the credit reflects the obligation it now has to pay for these purchases from XYZ Ltd. Payment Made and Discount Used ABC Ltd likes to take advantage of the five per cent discount, so on May 6, makes payment to XYZ Ltd for the net amount. To do this, they make the following calculation and journal entry: $5,540 x 5% = $277 $5,540 - $277 = $5,263 DateAccount NameDebitCreditMay 6Accounts Payable5,540Discount Received277Bank5,263 The debit to accounts payable reduces the balance to $0. While the credit to the bank account of $5,263 reflects the net amount, XYZ Ltd would accept it if paid within seven days. So the difference is the discount received of $277. This is an income to ABC Ltd and would be reflected in their statement of financial performance (profit and loss statement). If we were to look at this example but let's say ABC Ltd received a trade discount (of five per cent) at the time of purchase of the spares each month, the monthly statement of account from XYZ Ltd wouldn't be for $5,540 but rather $5,263. Because the obligation is created when the monthly statement turns up for ABC Ltd, $277 of the obligation has already been removed - so there is no entry to account for. Of course, as we can see, the net effect of all of this is zero. But the distinction is important and something accounting exams enjoy testing students on. Conclusion And that brings us to the end of this accounting tutorial reviewing the meaning of discount received. For the accounting student, it is important to know the difference between trade discounts and cash discounts. The former involves a discount already applied before payment or invoice. While the latter is a discount applied after an invoice or account has been issued. As always, we welcome your comments and questions. Please use the comments section below, our "ask a question" section or the contact us form.

Blog

Tutorials

Questions

Recent Posts