When a business purchases goods on credit from a supplier the terms will stipulate the date on which the amount outstanding is to be paid. In addition the terms will often allow a purchase discount to be taken if the invoice is settled at an earlier date.
The purchase discount is based on the purchase price of the goods and is sometimes referred to as a cash discount on purchases, settlement discount, or discount received.
Purchase Discount Example
For example, if a business purchases goods to the value of 1,500 on 2/10, n/30 terms, it means that the full amount is due within 30 days but a 2% purchases discount can be taken if payment is made within 10 days.
The purchase discount in this example is calculated as follows.
Purchase price = 1,500 Purchase discount % = 2% Purchase discount = Purchase price x Discount % Purchase discount = 1,500 x 2% = 30 Amount to pay = Purchase price - Purchase discounts Amount to pay = 1,500 - 30 = 1,470
If the business pays within 10 days then a 2% purchase discount amounting to 30 can be deducted from the purchase invoice, and the business will pay only 1,470 to settle the supplier account.
Purchase Discount Journal Entry
Accounting for purchase discounts requires two journal entries.
Purchase Invoice Posted
At the date of purchase the business does not know whether they will settle the outstanding amount early and take the purchases discount or simply pay the full amount on the due date. In these circumstances the business needs to record the full amount of the purchase when invoiced and ignore any discount offered in the supplier terms.
The journal to record the purchase is as follows.
The full amount owed to the supplier is shown as a balance sheet liability (accounts payable) and included as purchases or expenses in the income statement. This transaction is more fully explained in our purchases on account example.
Purchase Discount Taken
If the business pays the supplier within the 10 days and takes the purchases discount of 30, then the business will only pay cash of 1,470 and accounts for the difference with the following purchases discounts journal entry.
The business pays cash of 1,470 and records a purchase discount of 30 to clear the customers accounts payable account of 1,500.
The purchases discounts normal balance is a credit, a reduction in costs for the business. The discount is recorded in a contra expense account which is offset against the appropriate purchases or expense account in the income statement.
|Purchase discounts||– 30|
Purchase Discount Not Taken
If the business does not pay within the discount period and does not take the purchase discount it will pay the full invoice amount of 1,500 to the supplier and the discount is ignored.
In this instance the accounts payable balance is cleared by the cash payment and no purchase discount is recorded.
Advantages and Disadvantages
The purpose of a business taking purchase discounts is to reduce its costs. The downside of course is that the business must make payment earlier (10 days instead of 30 days in the above example) and will lose the use of the cash for an extra 20 days.
If we use the example above, the gain to the business of paying 1,470 20 days earlier than expected was the purchase discount of 30. The ‘interest rate’ for the 20 days is calculated as follows.
Interest rate for 20 days = Interest / Principal Principal = 1,470 (amount paid to the supplier) Interest = 30 (discount taken) Term = 20 days (normal terms - discount terms) Interest rate for 20 days = 30 / 1,470 = 2.04%
This is the rate for the use of the funds for 20 days, to convert this to an annual percentage rate (APR) we simply divide by 20 to convert it to a daily rate, and then multiply by 365.
Interest rate for 20 days = 2.04% Daily interest rate = 2.04% / 20 Annual interest rate = (2.04% / 20) x 365 Annual interest rate = 37.23%
By paying early and taking the payment discount the business effectively earns 37.23% on the funds it uses. Providing they have the funds or can borrow at a rate cheaper than 37.23% (in the above example), the business is better off borrowing and taking the discount.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.