Explained by a Certified Accountant [with examples]
|WHAT are trade and cash discounts based on?|
|Discount Type||Calculation Basis||Payment Method|
|Trade Discount||Original catalogue list price||All (cash and credit)|
|Cash Discount||Invoice price||Cash only|
|WHEN are trade and cash discounts used?|
|Discount Type||Timing||Accounting Recognition|
|Trade Discount||At the time of purchase||Not separately recognized|
|Cash Discount||At the time of payment||Separately recognized|
|WHY are trade and cash discounts used?|
|Trade Discount||Increase a seller’s revenue||Large and frequent purchases from buyers|
|Cash Discount||Accelerate a seller’s cash inflows||Prompt payment from buyers|
Here is a step-by-step example of how to calculate trade and cash discounts and enter them into the accounting books:
Manufacturer M sells 1,000 units of product on credit to a Wholesaler W at a list price of $10 per unit, with a 5% trade discount granted by the seller as a reward for their good business relationship where the buyer places bulk orders on a regular basis.
The invoice payment terms that the buyer and seller previously agreed on are 5%/30 Net 60, which means that the payment is due in 60 days, but Wholesaler W will receive a further 5% discount if the invoice is paid within 30 days. The reason why Manufacturer M offers this cash discount is to encourage the buyer to pay the invoice early.
Manufacturer M decides to take an advantage of the prompt payment discount and pays the invoice within 30 days.
In summary, the formula for calculating trade and cash discounts is as follows:
|Trade vs. Cash Discount: Calculation Formula + Example|
|Discount Type||Calculation Formula||Calculation Example|
|Trade Discount||List Price||$1,000 x $10||$10,000|
|Cash Discount||= Invoice Price||$10,000 – ($10,000 x 5%)||$9,500|
|Final Amount Due||= Net Invoice Amount Paid||$9,500 – ($9,500 x 5%)||$9,025|
1. Total list price = 1,000 units x $10 per unit = $10,000
2. Trade discount = $10,000 total list price x 5% trade discount = $500
The list price ($10,000) and the trade discount ($500) are not separately entered into the accounting general ledger because Manufacturer M deducts the trade discount from the original catalogue price before any exchange transaction with Wholesaler W occurs.
Instead, the trade discount journal entry is posted for the net amount ($9,500) at which the exchange between the buyer and seller actually takes place, which is after the trade discount is subtracted from the list price.
|Trade Discount: Accounting Journal Entry + Example|
|Seller (Manufacturer M)||$9,500||Accounts Receivable (Wholesaler W)||Sales Revenue|
|Buyer (Wholesaler W)||$9,500||Purchase Expenses||Accounts Payable (Manufacturer M)|
3. Net amount after trade discount to be recorded when an invoice is issued = $10,000 list price – $500 trade discount = $9,500
4. Cash discount = $9,500 price after trade discount x 5% early-payment cash discount = $475
The cash discount is based on the invoiced price of $9,500 (after the trade discount) and not on the original list price of $10,000 (before the trade discount).
5. Net amount after cash discount to be recorded if an invoice is paid within 30 days = $9,500 price after trade discount – $475 cash discount = $9,025
Unlike a trade discount, a cash discount is shown separately in a company’s accounting records because it is deducted at the time of an early invoice settlement, meaning after an exchange transaction between a buyer and seller takes place.
|Cash Discount: Accounting Journal Entry + Example|
|Seller (Manufacturer M)|
|Accounts Receivable (Wholesaler W)||$9,500|
|Buyer (Wholesaler W)|
|Accounts Payable (Manufacturer M)||$9,500|
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