Purchase Discount: Definition, Accounting, Journal Entry, Example, Formula

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Most companies acquire goods and sell them at a profit. During this process, they may also process those goods or convert them to another form. However, purchases are crucial to the operations of these companies. Usually, companies acquire goods for credit and pay for them at a later date. During this process, they may also receive a purchase discount.

What is a Purchase Discount?

A purchase discount reduces the amount owed and repaid to a supplier. This discount is available to companies that acquire goods for credit. However, it does not apply to every transaction. Purchase discounts are only applicable if the supplier allows them. This discount requires a company to settle its obligation before a specific date or time.

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A purchase discount is an income for companies in accounting. Usually, it relates to the purchase price of the goods. In accounting, it is known as cash or early settlement discount. Since it involves paying for those goods earlier, it entails an accounting treatment. Most suppliers offer purchase discounts on a per-invoice basis.

How does a Purchase Discount work?

When a company purchases goods on credit, it discusses the repayment terms with the supplier. Usually, suppliers allow a 30-60 days period by which the company must settle its obligations. However, some suppliers may also offer a purchase discount if the company repays its debt before that period. This feature allows the company to pay lesser for the goods purchased.

The purchase discount relates to the price of the goods agreed upon by both parties. Usually, suppliers offer a percentage of the total amount as a purchase discount. On top of the discount rate, they will also specify the number of days by which the company must settle the obligation. If the company fails to pay the owed amount by that period, it cannot avail of the purchase discount.

What is the accounting treatment for a Purchase Discount?

A purchase discount requires an accounting treatment since it depends on an earlier settlement by the company. It differs from a trade discount which does not entail an accounting treatment. However, this treatment only applies if the company meets the supplier’s criteria to avail it. It is also crucial to understand the accounting treatment for credit purchases beforehand.

When a company acquires goods on credit, it records the transaction as follows.

Dr Purchases
Cr Trade payable

If the company does not apply for the purchase discount, it uses the following journal entry to record the settlement.

Dr Trade payable
Cr Cash or bank

However, if it avails the purchase discount, the journal entries will be as follows.

Dr Trade payable
Cr Purchase discount
Cr Cash or bank

Example

A company, Red Co., purchases goods worth $10,000 from a supplier. The supplier allows the company to settle the amount within 60 days. However, the supplier also offers a purchase discount of 5% on the transaction if Red Co. pays the amount in 10 days. Red Co. repays its supplier in 8 days, availing of the purchase discount.

The journal entry to record the settlement, including the purchase discount for Red Co., is below.

Dr Trade payable $10,000
Cr Purchase discount ($10,000 x 5%) $500
Cr Cash or bank $9,500

Conclusion

A purchase discount is a reduction in the amount repayable to a supplier. However, this discount only becomes available if a company repays the supplier within a specific period. This discount applies to credit purchases only. The accounting for purchase discounts is straightforward. However, the company must ensure it meets the criteria to avail of that discount.

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