The issue of trade discount and cash discount (received and allowed) can cause some confusion in accounting, in particular with what journal entry to apply. Today’s short accounting tutorial will look at trade discounts, with cash discounts allowed covered here, and discounts received covered off here – if you would like to read further on these specific areas.
The short answer, if one is busy, is there is no journal entry to record. Yip, we don’t generally recognise trade discounts, so no journal entry is made. If you would like to know why, please read on.
What is a Trade Discount?
Trade discounts reduce the listed selling price of goods and services applied to a particular customer or group of customers. These discounts are more common in the wholesale and the business-2-business markets. In these markets, customers are often regular purchasers and buy larger quantities.
Trade discounts are also often applied for customers to ensure their continued repeat business or future loyalty. Price is not the only factor in repeat business for a firm, but where customers feel they have been well looked after (price and service), this makes a real difference. I remember when my wife was an account manager for a beauty therapy firm. And her comment about the value of her regular customers was to achieving the monthly budget targets. And I know for my current employer, a major airline, their frequent fliers are critical to the airlines’ financial survival.
Why is There No Journal Entry for Trade Discounts?
The most common and obvious question is why aren’t these discounts recognised in the ledger system? Why is no journal entry raised to record a trade discount? The main reason being around economic benefits and obligations. The conceptual accounting frameworks over the years have moved away from an income statement (statement of financial performance) focus on income and expenses to a balance sheet (statement of financial position) focus on assets and liabilities. Therefore for a trade discount to be accounted for, it would need to impact the firm’s asset or liability position – so let’s look at that next.
What is an Asset?
From the business offering the trade discount, at first blush, you would think this would be an expense to the business; like advertising, it is part of the cost of doing business in that market. But to be recognised as an expense, it would need to meet the definition of one. The International Financial Reporting Standards (IFRS) Conceptual Framework defines expenses as “… decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims” (para 4.69).
So does a trade discount decrease the firm’s assets or increase its liabilities? Well, now we have to look at what assets and liabilities are. Para 4.3 from the same standard defines an asset as “… a present economic resource controlled by the entity due to past events”. And an economic resource as a “… right that has the potential to produce economic benefits” (para 4.4). It defines liabilities as those events that create an obligation on the firm that will decrease its economic benefits.
So a trade discount neither decreases a present economic benefit nor increases a present obligation to the firm. It is an internal transaction, which we apply to an external transaction with the customer. In our articles referenced above regarding cash discounts, this is quite different when dealing with invoices already issued or received and the value changing a current economic asset or obligation.
Notwithstanding, businesses will often record trade discount data in sales and purchase systems as folio information. By recording on a separate system, a business can use this discount data within its management reporting.
I know that is a lot of words to say that a trade discount does not have a journal entry. But the accounting student needs to understand why and not to accept no transaction is recorded blindly. In researching this article and reviewing other websites, not one of them covered why the discount was not recognised.