Accounting Course - Purchase Discounts

One of the accounting course topics is learning of purchase discounts concept, essence and practical application. It is important to understand this concept and know how to account for discounts when certain purchases are being made. Also this topic covers calculation of discounts and their application conditions.

Essence

Purchase discounts concept is closely related to the accrual accounting principle and accounts payable. Accounts payable are accounted for when business makes purchases on credit, i.e. goods or services are acquired with the postponed cash payment. Supplier and customer agree sales conditions of transaction and payment terms. Payment terms usually determine period within whic
h customer must pay for the goods or services acquired. Such period is called normal payment period. Worth to mention that it is a usual practice to postpone payment fro the goods or services, i.e. make sale on credit.

Referring to the time value of money concept, the important aspect is that money we have today on hand have higher value than money we will receive in the future. Therefore seller always would like to get payment for the sale quicker, since such money can be invested back into the business to make additional profit.

Customer in its turn wants to postpone payment as long as possible and use the money in the business, instead of earlier payment to the supplier.

In order to speed up the payment, suppliers propose certain incentive to the customers in the form of purchase discount. This means that in case customer pays for the goods or services quicker, it will receive certain percentage discount and will be able to pay less for the purchase.

The following example demonstrates how purchase discount terms are being determined:

3/15, n/35, where
3 - percentage of discount
15 - number of days within which payment must be made to utilize discount
n/35 - normal payment period within which payments for the purchase must be made.

Practical Example

The following practical example will show how to account for discounts from the perspective of buyer. We will use the same terms, i.e. 3/15, n/35 for the purchase value of $1,000, let us assume that inventory was purchased.

1. On acquisition date the following entry is made in the books of the buyer:

D Inventory $1,000

C Accounts Payable $1,000

2. In case payment is made within 15 days, buyer will get 3% discount amounting to $1,000*0.03=$30. The following entry is made in the books of buyer:

D Accounts Payable $1,000

C Cash $1,000-$30=$970

C Purchase Discounts $30

After this payment the buyer will not be liable any more for the purchase made despite the lower amount was paid, since the buyer utilized a right to get purchase discount.

3. In case payment is made after 15 days, no discount will be provided. The following entry will be done in the books of the buyer:

D Accounts Payable $1,000

C Cash $1,000