On the face of it the question about the meaning of Discount received in accounting seems a little silly, but it is not. The area of discounts does cause some confusion for some accounting students as they are coming to terms with all those debits and credits. So in today’s article, part of our accounting tutorial series, we are going to be looking at the two different types of discount a business can receive and then look at the journal entries involved.
Types of Discounts
When we are talking 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 starting off looking at the difference between these two categories of discounts.
In respect to discounts the confusion often comes about because of the difference between trade discounts and cash discounts. In regards to trade discounts these are generally not recognised in accounting systems, ie there is no journal entry to make, because the “transaction” does not meet the definition of an expense or revenue. We have a whole tutorial on this and the reason why, so its worth checking out if you would like to know some more.
So we aren’t dealing with trade discounts. What we are dealing with when we use the term “discount received” is a discount often offered for early repayment of a liability – referred to as a cash discount. 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 payment each time they order.
You can see how this is a little confusing because here are are talking about discounts received in the normal course of trade, but not “trade discounts” in how we use the term in accounting. So let’s look at an example below to help clarify when to make a journal entry and when one isn’t required.
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 settle their account within seven days of invoice date (rather than waiting until the end of the month). 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.
So for April ended ABC received an account statment of $5,540 for its purchases during the month. The journal entry to recognise this would be:
|April 30||Machinery Spares Expense||5,540|||
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.
ABC Ltd likes to take advantage of the five per cent discount and 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
|May 6||Accounts Payable||5,540|||
The debit to accounts payable reduces the balance to $0. While the credit to bank of $5,263 reflects the net amount XYZ Ltd would accept 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 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 statment 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 tests enjoy trying to trip students up on.
And that brings us to the end of this tutorial looking at what the meaning in accounting is when we use the term discount received. For the accounting student it is important to know when you are dealing with a trade discount, ie a discount already applied before payment or invoice, and a cash discount, a discount applied after an invoice or account has been issued.
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