7.4 Purchase Discounts: Gross Method vs Net Method

Purchase Discounts: Buyer's Perspective

Methods for Recording Purchase Discounts

• Two main methods:
  • Gross Method
  • Net Method

Gross Method

• Record purchases at the gross amount (without upfront discount inclusion).
• If the discount is taken, it's recorded in a "Purchase Discounts" account.
• The "Purchase Discounts" account is a contra account to "Purchases" on the income statement.

Net Method

• Record purchases net of the discount (assuming the discount will be taken).
• If the discount isn't taken, it's recorded in a "Purchase Discounts Lost" account.
• The "Purchase Discounts Lost" account is classified as an other expense or loss on the income statement.

Example: DESIR Company (Periodic Inventory, Gross Method)

• Uses a periodic inventory system.
• Uses the gross method for recording purchase discounts.
• All purchases are made on account.
• Terms: 2/10, net 30 (2% discount if paid within 10 days, total due in 30 days).

Scenario 1: June 1 - Purchase

• Purchases $1,000$ of inventory from Beach Company.
• Debit Purchases: $1,000$
• Credit Accounts Payable: $1,000$

Scenario 2: June 8 - Payment within Discount Window

• Pays Beach in full on June 8 (within the 10-day discount window).
• Earns a 2% discount on $1,000$, which is $20$. The amount to pay would then be $980$.
• Debit Accounts Payable: $1,000$
• Credit Cash: $980$
• Credit Purchase Discounts: $20$

Scenario 3: June 20 - Payment Outside Discount Window

• Pays Beach in full on June 20 (outside the 10-day discount window).
• No discount is earned; pays the full $1,000$.
• Debit Accounts Payable: $1,000$
• Credit Cash: $1,000$

Scenario 4: June 5 - Partial Payment within Discount Window, June 28 - Remaining Balance

• June 5: Pays $200$ (20% of what is owed) within the 10-day discount window.
• Earns a discount on the $200$ payment, which is 2% of $200$, or $4$.
  • Debit Accounts Payable: $200$
  • Credit Cash: $196$
  • Credit Purchase Discounts: $4$
• June 28: Pays the remaining balance ($800$) outside the discount window.
  • Debit Accounts Payable: $800$
  • Credit Cash: $800$

Example: DESIR Company (Periodic Inventory, Net Method)

• Uses a periodic inventory system.
• Uses the net method for recording purchase discounts.
• Terms: 2/10, net 30.

Scenario 1: June 1 - Purchase Recorded Net of Discount

• Purchase of $1,000$ of inventory with a 2% discount (2% of $1,000$ is $20$).
• Records the purchase net of the discount: $1,000 - 20 = 980$.
  • Debit Purchases: $980$
  • Credit Accounts Payable: $980$

Scenario 2: June 8 - Payment within Discount Window

• Pays Beach in full on June 8 (within the 10-day discount window).
• Since the discount was already accounted for, the journal entry is simplified.
  • Debit Accounts Payable: $980$
  • Credit Cash: $980$

Scenario 3: June 20 - Payment Outside Discount Window

• Pays Beach on June 20 (outside the 10-day discount window).
• Does not earn the 2% discount which needs to be recorded in a purchase discounts lost account.
  • Credit Cash: $1,000$ (full payment)
  • Debit Accounts Payable: $980$ (to close out the balance)
  • Debit Purchase Discounts Lost: $20$ (amount of the lost discount)

Scenario 4: June 5 - Partial Payment within Discount Window, June 28 - Remaining Balance

• June 5: Pays 20% ($200$) within the discount period and earns that discount (2% of $200$ is $4$).
  • Credit Cash: $196$
  • Debit Accounts Payable: 196
• June 28: Pays off the remainder of the $980$ accounts payable. Since the first payment of $200$ less the discount of $4$ leaves a balance of $784$
• The remaining $800$ must be paid which is recorded into a purchase discounts lost account. The amount of the discount lost on this is ($16$).
  • Debit Accounts Payable: $784$
  • Credit Cash: $800$
  • Debit Purchase Discounts Lost: $16$

Gross Method vs. Net Method

• Benefits of Net Method: Some benefits exist, but…
• Why Most Firms Use Gross Method: Cost constraint.
  • Net method is more complicated and costly to implement.
  • Gross method is more straightforward and saves recording time.
  • Especially relevant with many purchases, suppliers, and varied discounts.