Processing Payables Discounts
Processing payables discounts, also known as purchase discounts or early payment discounts, are reductions in the amount a company owes to its suppliers for goods or services purchased on credit. These discounts are offered as an incentive for the company to pay their invoices before the due date.
Typically, suppliers offer these discounts to improve their own cash flow, as getting paid sooner can help them manage their own finances more effectively. The terms of such discounts are usually expressed in a format like “2/10, net 30”. This means that the buyer can take a 2% discount off the invoice total if they pay within 10 days, otherwise the full (net) amount is due within 30 days.
Processing payables discounts can be a good financial strategy for businesses, as it effectively provides them with a high annual return on the money they use to pay their bills early. However, companies should also consider their own cash flow needs, as the benefit of taking the discount needs to be weighed against the potential cost of having less cash on hand.
In terms of accounting, when a company takes advantage of a payables discount, it will debit (reduce) its accounts payable for the full invoice amount, credit (reduce) its cash for the amount paid, and then credit (increase) its purchase discounts (a contra expense account) for the amount of the discount. This way, the amount of the discount reduces the company’s overall purchase expense, reflecting the fact that they’ve paid less for the goods or services they’ve purchased.
Example of Processing Payables Discounts
Imagine that a business purchases $1,000 worth of inventory from a supplier. The supplier offers terms of “2/10, net 30”, meaning that the business has 30 days to pay the full amount of $1,000, but can take a 2% discount ($20) if they pay within 10 days.
The business decides to take advantage of the discount and pays the invoice on the 7th day. They would pay $980 ($1,000 – $20 discount) to the supplier.
The journal entry for this transaction in the business’s books would be:
- Debit Accounts Payable for $1,000 (to decrease the payable)
- Credit Cash for $980 (to decrease the cash account)
- Credit Purchase Discounts for $20 (to record the discount taken)
This way, the company’s records accurately reflect that it only paid $980 for goods that were originally billed at $1,000, reducing its overall inventory cost by the amount of the discount taken.
It’s important to remember that while taking the discount can be beneficial, the business also needs to manage its cash flow effectively to ensure it can cover other expenses and obligations.
