What is a trade discount and how to record it?

A trade discount is an immediate reduction in the list price of goods granted by a manufacturer or wholesaler to a buyer, typically for bulk purchases or as part of a B2B relationship. Unlike cash discounts, trade discounts are not recorded in the accounting books of either the seller or the buyer because the transaction is recognised at the net price.

This article provides a comprehensive guide on the mechanics of trade discounts, the specific accounting entries required to maintain clean financial records, and the distinction between trade and settlement discounts.

By understanding these principles, businesses can ensure accurate revenue recognition and inventory valuation in accordance with standard accounting frameworks.

Key Takeaways

• Trade discounts reduce the list price immediately and are never recorded as separate ledger entries in the accounts.
• The seller records revenue and the buyer records purchases at the final net price after the discount.
• Trade discounts are distinct from cash discounts which incentivize early payment and require separate contra-revenue accounts.
• Applying trade discounts at the point of sale keeps the general ledger reflective of actual agreed revenue.
• Inventory must be valued at the net cost of purchase including all trade-related deductions to remain compliant.

A trade discount is a reduction of the list price of products from a seller to a buyer as an incentive for future business. The trade discount is given as a percentage to deduct from the list price which is the normal selling price. In order for a buyer to receive a trade discount from a seller, there are a few conditions that must be met.

Conditions of a trade discount

It is given to businesses not individuals

Only businesses can receive a trade discount, not individuals. This is because businesses are involved in daily transactions and need to purchase goods regularly.

This is beneficial to a seller because business is ongoing with the buyer. Individuals however usually make one-time purchases to satisfy an immediate need which is of no benefit to a seller.

Businesses must be engaged in the same line of activity

A trade discount is offered to a buyer who is engaged in the same line of activity as the seller. Since the trade discount is an incentive to encourage the buyer to come back, then a buyer in the same line of business ensures that business will continue.

A business that is not in the same line of business however might be making a one-time purchase from the seller to fulfil a particular need at that point. This buyer may not return to do any further business and is of no benefit to the seller.

Order must be large

A bulk purchase is another condition for a business to receive a trade discount. Volume discount is an economic incentive given to businesses to encourage them to buy in large quantities.

The more goods are sold at a cheaper price, the faster stock can reach the consumers. Since retailers purchased the goods at a discounted price, they too may pass on the reduced price to the consumers at stores.

How to record a trade discount

Recording a trade discount is very simple. When you are given a list price of a product and a trade discount percentage, calculate the deduction first. Only record the net amount due in the journal.

Example:

On June 1, ABC Ltd purchased goods at list price $2,000 less 25% trade discount.

Calculate 25% of $2,000 = $500

Deduct $500 from $2,000 = $1,500

Record amount due in journal as $1,500

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Understanding trade discounts

A trade discount is a reduction from the catalogue or list price of a product. It is often used to differentiate pricing between wholesalers and retailers or to encourage high-volume orders. Because the discount is agreed upon before or at the time of the sale, it is considered a price adjustment rather than a financial transaction.

Accounting for the seller

When a seller provides a trade discount, they do not create a “Discount Allowed” entry. Instead, the invoice is issued at the net amount.

Example:

If a wholesaler sells goods with a list price of US$1,000 and offers a 20% trade discount, the net price is US$800.

Journal entry:

• Debit: Accounts Receivable US$800
• Credit: Sales Revenue US$800

Accounting for the buyer

Similarly, the buyer records the purchase at the net amount paid. The “list price” is irrelevant for the purposes of the general ledger and the balance sheet.

Example:

Using the same US$800 transaction:

Journal entry:

• Debit: Purchases (or Inventory) US$800
• Credit: Accounts Payable US$800

Trade discount vs cash discount

It is critical to distinguish between these two types of deductions:

1. Trade discount: Given at the time of purchase. Not recorded in books.
2. Cash discount (settlement discount): Given for prompt payment (e.g., 2/10, n/30). These are recorded using accounts like “Sales Discounts” or “Purchase Discounts” because they occur after the initial sale is recorded.

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See also:

ALICE: Assets, Liabilities, Income, Capital, Expenses

Assets: Owned fixed and liquid items with a debit balance

Liabilities: Owed long and short-term items with a credit balance

Income: Earned, unearned and contributed money

Capital: Invested assets and the liquidity of a business

Expenses: Spending that’s direct, indirect, operating and non-operating

Debit and Credit: Simple view of in and out

Increase and decrease of ALICE accounts

Accruals: How to record owed expenses and revenues in the Accounting Cycle

Accounting Cycle: Complete basic accounting in 8 steps

Journals: Complete 7 Day Books with 4 types of transactions

Ledger accounts: Simple breakdown of Types, Format, Double Entry, Balance

Trial Balance: 6 important things to know

Income Statement: 6 key points for reporting profitability

Balance Sheet: 10 key parts of the statement of financial position

Cash Book: How to record cash, bank and discounts

7 Key financial ratios students should know in basic accounting