Explained by a Certified Accountant [with examples]

Explanation: What is trade discount and cash discount?

When do you give and take trade and cash discounts?

A trade discount is a deduction granted by a seller to a buyer on the original catalogue list price of goods and services to encourage large and frequent purchases, whereas cash discount is subtracted from the invoiced amount a to encourage early and prompt payment.

Alternative terms:

  • Cash discount is also known as an early settlement discount or a prompt payment discount.
  • Trade discount is also referred to as a functional discount.

Recognition: How are trade and cash discounts recognized?

Where do you show trade and cash discounts?

A cash discount is recognized in the accounting records of a seller and buyer, whereas a trade discount is not separately shown in their general ledgers because the deduction is based on the original catalogue list price of goods and services before any exchange transaction takes place.

Comparison: What is the difference between trade and cash discounts?

How do you distinguish a trade discount from a cash discount?

Although trade and cash discounts are both a type of a sales discount, there are 5 key distinctions between the two: 1. Calculation Basis; 2. Payment Method; 3. Timing; 4. Accounting Recognition; 5. Amount Changes.

Top 5 differences between a cash discount and a trade discount:

Difference #1: Basis of Calculation

Trade discounts are based on an original catalogue list price of goods and services, whereas cash discounts are based on an invoice price.

Difference #2: Method of Payment

While a trade discount is suitable for all methods of payment, a cash discount is only available to buyers who settle their payments in cash.

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

Difference #3: Timing of Transaction

Trade discount is granted at the time of purchase and a cash discount is deducted later when an invoice payment is being settled.

Difference #4: Accounting Treatment

  • There is no separate entry made into accounting records for a trade discount because it is deducted from a list price at the time of purchase, before any exchange between a seller and a buyer occurs that would give rise to an accounting transaction.
  • In comparison, a cash discount is separately recognized in books of accounts because it is subtracted from an invoice price at the time of payment.
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

Difference #5: Determination of Amount

  • As the purpose of a trade discount is to increase a seller’s revenue, the amount of a trade discount depends on the size and frequency of a buyer’s purchases.
  • In contrast, as the purpose of a cash discount is to accelerate a seller’s cash inflows, the amount of a cash discount depends on how promptly a buyer pays an invoice.
WHY are trade and cash discounts used?
Discount Type Purpose Effect
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

Example: How to calculate and record trade and cash discounts?

Here is a step-by-step example of how to calculate trade and cash discounts and enter them into the accounting books:

Question:

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.

Solution:

1. Formula: How do you calculate trade and cash discounts?

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
(Trade Discount) (5%) ($500)
Cash Discount = Invoice Price $10,000 – ($10,000 x 5%) $9,500
(Cash Discount) (5%) ($475)
Final Amount Due = Net Invoice Amount Paid $9,500 – ($9,500 x 5%) $9,025

2. Journal Entry: How do you record trade and cash discounts?

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
Entity Amount Debit Credit
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
Amount Debit Credit
Seller (Manufacturer M)
Bank $9,025
Discount Granted $475
Accounts Receivable (Wholesaler W) $9,500
Buyer (Wholesaler W)
Accounts Payable (Manufacturer M) $9,500
Discount Received $475
Bank $9,025

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