Businesses all over the world use a tried and tested process of increasing sales of the products by offering discounts. Discount results in the reduction of the selling price of the product, which makes it more attractive for the customer.
Reduction in price makes a psychological impact on the customer which results in the purchase. The two types of discount offered are trade discount and cash discount.
In the world of accounting and finance, you’ll often come across the terms “cash discount” and “trade discount.” While they sound similar, these two types of discounts are very different Understanding the distinction is important for recording transactions properly
In this comprehensive guide, I’ll explain what cash discounts and trade discounts are, their key differences, and provide examples of how each works. By the end, you’ll have a clear understanding of when to apply each discount type in accounting and bookkeeping tasks.
What is a Cash Discount?
A cash discount, sometimes called a discount for prompt payment, is an incentive offered by a seller to encourage timely payment from a buyer. It allows the buyer to deduct a small percentage from the total amount owed if they pay their bill early within a set discount period.
For example, payment terms of 2/10 net 30 mean:
- A 2% discount can be taken if paid within 10 days
- The full amount is due within 30 days.
If no discount is taken the full invoice total is owed by the final due date.
Cash discounts are usually only offered on credit sales, where the buyer is not required to pay immediately. They motivate early payment which improves the seller’s cash flow.
Some key attributes of cash discounts:
- Offered as a percentage reduction off the total invoice or bill amount (e.g. 2%)
- Only available if payment is made by the specified discount date
- Recorded as an expense in accounting books when allowed
- Journal entry is made when the discount is utilized
Overall, the terms and use of a cash discount are very specific. It is not automatic and only applies when payment timing conditions are met.
What is a Trade Discount?
A trade discount is a percentage reduction off the list price or manufacturer’s suggested retail price (MSRP) of an item. It’s a discounted price offered to specific buyers within a particular industry or trade.
For example, a wholesaler may offer a 40% trade discount off the MSRP on large orders placed by retailers. This reduces the cost for the retailer so they can mark up and resell at MSRP.
Unlike cash discounts, trade discounts:
- Are not dependent on timing of payment
- Given based on industry, quantities purchased, or negotiated rates
- Deducted before setting the final invoice total
- Not recorded separately in accounting books
Trade discounts adjust the starting price point down for select buyers. The reduced price after the trade discount is used for all accounting purposes.
The Key Differences Between Cash and Trade Discounts
While both refer to percentage reductions off an amount owed, there are several key ways cash and trade discounts differ:
| Factor | Cash Discount | Trade Discount |
|---|---|---|
| Timing | Offered for early payment by discount date | Not tied to timing of payment |
| Availability | Offered selectively | Given based on industry, quantities, etc. |
| Final Amount | Deducted from invoice total if used | Deducted upfront before invoice created |
| Accounting | Recorded separately as an expense | Already reflected in invoice amount |
To summarize:
- Cash discounts incentivize fast payment. Trade discounts adjust base prices.
- Cash discounts are conditional. Trade discounts apply by default.
- Cash discounts are recorded separately. Trade discounts are not.
Understanding these core differences is crucial for accurate accounting treatment.
Cash Discount Example
Let’s look at an example of a cash discount:
- ABC Company invoices XYZ Store $10,000 on March 1st
- Payment terms are 2/10 net 30
- This means a 2% discount can be taken if paid within 10 days
In this case:
- The full $10,000 is due on March 31st (30 days after invoice date)
- But XYZ Store can take a 2% discount by paying $9,800 by March 11th
If XYZ pays the $9,800 by March 11th, ABC Company’s accounting entry would be:
Debit: Cash $9,800
Credit: Accounts Receivable $10,000
Credit: Sales Discounts $200
The cash discount of $200 is recorded separately as a contra revenue account.
But if XYZ waits until March 31st to pay the full $10,000, there is no discount or contra account needed.
Trade Discount Example
Now let’s see a trade discount example:
- ABC Company (the manufacturer) sets a list price of $100 for a product
- They offer a 40% trade discount to wholesale distributors
This means distributors can purchase the product from ABC Company for $60 ($100 x (1 – 0.4)).
The $60 discounted price would be reflected on the sales invoice to the distributor. There is no separate accounting entry or expense recorded for the trade discount.
If the distributor sells the product for the original $100 MSRP, their gross profit would be the $100 sales price less the $60 cost after the trade discount.
Key Takeaways
- Cash discounts incentivize timely payment, trade discounts adjust base prices
- Cash discounts are specifically recorded, trade discounts are not
- Cash discounts are conditional, trade discounts are standard
- Understand when each applies for proper accounting treatment
The bottom line is cash and trade discounts are fundamentally different. Always assess transactions carefully to determine if either type of discount applies. Proper classification is important for recording sales, revenues, and expenses accurately in your books.
Meaning of Trade Discount
Trade discount is referred to as the discount that is offered by a seller to the buyer of the product in the form of reduction in the price of the item.
Trade discounts are offered to increase the sales of the product and make the customers feel that they are getting the best offer. No accounts are maintained for keeping track of the discounts that are offered.
Cash Discount vs Trade Discount
What is the formula for trade discount?
•Discount rate- a percent of the list price. 7. TRADE DISCOUNT FORMULA Trade Discount (TD) =List Price (LP) x Trade Discount Rate (R) or TD= LP x R Net Price (NP) = List Price (LP) – Trade Discount (TD) or NP= LP – TD 8. LET’S HAVE AN EXAMPLE Dominador will buy a box of canned tuna that lists for P680 and has a trade discount of 25%.
Do you offer a trade discount?
Trade discount is offered when goods are purchased in bulk by retailers and wholesalers from manufacturers. However, cash discount is offered by retailers to the ultimate consumer of goods in the form of various payment plans. Example of trade discount are given below:
Should you be offering trade discounts?
There are both advantages and disadvantages to consider. On the positive side, offering a trade discount gets you paid earlier, plain and simple. As every good business owner knows, cash flow is important. Getting paid earlier also is important if your clients have cash flow problems of their own.
