What Is a Discount?
We all love discounts, but why would a business offer offer a discount on their products? Typically, a business might offer a discount to increase sales, make an unhappy customer happy or incentivize a customer to pay quickly.
Understanding Payment Terms
Typically when customers purchase inventory, they are not expected to pay cash. The seller extends credit to the buyer, but extending credit comes at a cost for the seller. The seller does not have the cash and therefore must pay its bills from other sources, either cash reserves or borrowing. The seller may lose out on interest earned on cash reserves or possibly even pay interest on loans or lines of credit. In order to decrease the time a receivable is outstanding, a company may offer a discount for fast payment. When a company offers this type of discount, it is listed in the payment terms on the bill:
Payment terms: 2/10, n/30
What does this mean? Well, first notice the comma. That means there are two parts to the payment terms. So let’s look at each part, starting with 2/10. This does not mean that the bill is due on February 10. It means “2% discount if paid in 10 days”. Therefore, if the date of the bill is February 15 and you pay the bill on or before February 25, you get a 2% discount off the balance due. What happens if you don’t pay in the first 10 days? For that, we have to look at the statement after the comma: n/30. The “n” in the statement stands for net. So the statement tells us that the net, or entire, amount is due in 30 days. Taking it all together, the statement is as follows:
Payment terms: If paid within 10 days, we will give you a 2% discount, or you can pay the full balance within 30 days.
Can you see why businesses prefer 2/10, n/30? Takes up a lot less space on a bill. What happens if you don’t pay with bill within 30 days? After 30 days, your payment is now late and the seller can add on late charges or interest, depending on state law.
Let’s look at some examples using payment discounts.
Medici Music purchased instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 with terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Medici Music.
The first step is to break down the information. Medici purchased inventory for $5,000 on August 13 and paid the bill on August 20. Looks like we have two transactions. Wait! We are dealing with inventory. Have you realized we are missing something? If not, take a second to see if you can figure it out. <Insert Jeopardy theme here> Is Medici using periodic or perpetual inventory? Remember, we are about to record an entry dealing with the movement or change in value of inventory! I know we are talking about payments here but we are still talking about inventory. That trumps the payment discussion!
We will look at this transaction under both methods so you can see the difference. Before we start looking at each method, let’s start by discussing what is the same under each of the methods. We have two transactions. The first transaction deals with the purchase of the inventory. The second transaction deals with the payment for the instruments already received.
When working with discounts, we generally calculate the discount and record it at the time of payment. Some textbooks may show you two different methods for recording the discount, one in which the discount is recorded at the time of the purchase and one where the discount is recorded at the time of the payment. I prefer the second method. When you record the discount at the time of the purchase and the discount is not taken because the buyer does not pay within the discount window, we must alter the payment entry to undo the discount taken in the first entry. By recording the discount at the time of the payment, we are only recording a discount that has actually been taken and we never need to undo something from the first entry.
First, we need to record the entry to show the purchase of the inventory.
Notice that we used Inventory, because under the perpetual method, whenever the value of inventory is changing, we must show that change in the account.
Now let’s look at the second transaction. We are paying off what is owed but we are receiving a discount. We must show the accounts payable fully paid off, so we must debit Accounts Payable for $5,000. How are we paying the balance? With cash, so we must credit Cash for the amount of cash being paid. Because of the discount, the amount will be less than $5,000. If we take 3% of $5,000, we calculate the discount as $150. Therefore, the amount of cash needed to fulfill the obligation is $4,850.
What do we do with the $150? Remember the rules for perpetual inventory. If the value of the inventory is changing, we need to target the inventory account. Is the value of the inventory changing? Currently, we have $5,000 in the Inventory account for this purchase. Did we actually pay $5,000 for the inventory? Well, no, we didn’t. We actually paid $4,850 for the inventory. Therefore, the value of the inventory is not $5,000 but $4,850. We need to reduce the value of the inventory by $150 to reflect the discount received. Now, we have all the information we need to complete the second entry.
Now the process is complete. The Accounts Payable balance is now zero and the Inventory balance is $4,850 which matches what we actually paid for the inventory.
Under the periodic method, we do not update the value in the inventory account until we do the adjusting entries at the end of the period. Therefore, we should never use the inventory account in purchase transactions for companies that use the periodic method. Instead, we use the purchases account.
Let’s look at the first entry.
Pretty similar to the perpetual method, except for the use of the purchases account. The second entry will also be similar to the perpetual method, except for one difference. Can you figure out what that difference would be?
We will not be using the Inventory account. Instead we will use an account related to the Purchases account. We do not use the Purchases account because we want to preserve the balance in that account, in case we need to match it up with purchase documents. In order to preserve the original balance in the Purchases account, we will use a contra account. A contra account is an account that is linked to an account but acts in the opposite way. It acts contrary to the account it is linked to. Since Purchases has a normal debit balance, the contra account will have a normal credit balance because it will be used to decrease the value in the Purchases account. The account we will use is called Purchase Discounts (very tricky, huh?). Here is the entry:
The Sales Side
So far, we have looked at the purchase side of the transaction. What about the sales side? Let’s look at our original example again. This time, we will look at it from the seller’s perspective.
Medici Music purchases instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 (with a cost of $3,000), terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Whistling Flutes, LLC.
When recording sales transactions, we still must be concerned with whether the company uses perpetual or periodic inventory. We will review perpetual inventory first.
Under the perpetual method, when inventory changes or the value changes, we must record that change. When a business sells merchandise, inventory is leaving the building, therefore the amount and value of the inventory left is changing. There will be two parts to the August 13 entry. The first part will record the sale and increase in an asset (Accounts Receivable). The second part will record the change in Inventory and the cost of the sale. Let’s look at the entry:
The value of Inventory dropped $3,000, which moves to the income statement as an expense.
Now let’s look at the entry on August 20. This is the date that Whistling Flutes, LLC gets paid in full. However, because of the discount, the Company will not receive the full $5,000. Therefore, we must show the obligation fully paid even though the amount received is less than the amount in Accounts Receivable. The amount of the discount is 3% of $5,000 or $150. The amount of cash received is $4,850. Is Inventory changing? No, the payment on August 20 has no effect on Inventory. We will use a contra account, Sales Discounts, to record the discount amount.
By using a contra account, the company knows how much its sales were over the course of the year and how much was lost because of discounts and other items. This is good information for managers to have in order to make decisions about the effectiveness of company policy.
How would the entry be different under a periodic system? On the sales side, the only difference is the fact that we would not track the change in inventory at the time of the sale. The rest of the entry is exactly the same. Let’s look at both entries together, since we already discussed the methodology. Again, the only difference is that we do not track the changes in inventory under the periodic system.
Read Transactions Slowly!
The biggest problem students have with this topic is confusing purchase and sale transactions. I have had students do the problem perfectly, except they give me the journal entries for the purchase when I ask for the sale or vice versa. Spend extra time if needed to make sure that you understand what the transaction actually means. Do not jump right into the entries until you know what is happening in the transaction. Typically, a problem will state which company you should do the entries for. Go back through the transactions to see if the company is the buyer or seller. Sometimes, I will even note that when I am reading the problem. Read the transactions carefully or you may lose a lot of points on a problem you know how to do.
Sales Entries: Periodic and Perpetual Methods
Purchasing Inventory: Periodic and Perpetual Journal Entries