Calculation of Trade and Cash Discounts
A trade discount is based on the list price of the goods.
The use of trade discounts allows a seller to have one single list price for its products but different invoice prices for different customers.
The trade discount rate will vary dependent on the quantity or monetary amount of goods purchased. The higher the quantity the higher the discount.
The customer invoice price is calculated by deducting the trade discount from the list price.
A cash discount is based on the invoice price of the goods.
The amount paid is the invoice price less the discount.
To encourage early payment the buyer will offer a higher cash discount rate for earlier settlement. For example, 1% for settlement within 10 days.
Point at Which Discount is Given
A trade discount is given at the point of sale and is deducted from the list price before any exchange of goods takes place.
A cash discount is given when invoice payment has been made within the early settlement terms.
Variability of Discount
A trade discount is given at the same rate to all customers and depends on the quantity/amount purchased.
A cash discount is based on payment terms which vary from customer to customer.
Difference Between Trade Discount and Cash Discount Example
A trade discount is deducted from the list price before any exchange of goods takes place to arrive at the invoice price.
For example, suppose a business sells a product with a list price of 900 and offers a trade discount rate to a customer of 25%, then the customers price is calculated using the trade discount formula as follows:
List price = 900 Trade discount = 25% Invoice price = List price x (1 - Trade discount %) Invoice price = 900 x (1 - 25%) = 675
The exchange will now take place at the invoice price of 675 and bookkeeping entry would be as follows:
The only bookkeeping entry relates to the invoice price (675) given to the customer. The list price of 900 and the trade discount of 225 (900 x 25%) are not entered into the accounting records. No ledger account is opened for trade discounts.
A cash discount is not deducted until after the original invoice has been posted and payment has been made and therefore does form part of an accounting transaction and is entered the accounting records.
If in the example above a 4% cash discount was given for payment within 10 days. Assuming the customer decides to pay within the 10 day terms, they would deduct 27 (4% x 675) from the invoice price and pay only 648.
In the accounting records of the seller the bookkeeping entry to record the cash discount would then be as follows.
It should be noted that a ledger account has been opened for cash discounts, in this case it is referred to as discounts allowed and is an expense to the business.
Discount Information Shown on the Invoice
A trade discount is often shown on the invoice as a deduction from the list price for information purposes. The invoice price after deducting the trade discount is the starting point of the accounting transaction.
The cash discount is only calculated after payment has been made and is therefore the amount is not shown on the invoice. If should be noted that the invoice will specify the terms of the transaction and will therefore show the rate of cash discount available should prompt payment be made.
Difference Between Trade Discount and Cash Discount Summary
The differences between trade discounts and cash discounts discussed above are summarized in the following table.
|Trade Discount||Cash Discount|
|Use||Increase sales||Prompt payment|
|Calculation||List price x rate||Invoice price x rate|
|Rate basis||Quantity||Payment terms|
|Discount point||Purchase of goods||Payment of invoice|
|Variability||Same for all customers||Varies by customer|
|Transaction||None||Cash discount account|
|Invoice||Amount shown||Amount not shown|
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.