This outcome tests whether you can tell a trade discount from a settlement discount and record discounts received correctly. The examiner likes it because the numbers are simple but the wrong base or wrong treatment is easy to pick.
The rule
A trade discount is deducted from the list price before anything is recorded, so purchases and payables are shown net and no discount appears in the ledger. A settlement discount is for early payment and is calculated on the net invoice amount after the trade discount. When it is taken, debit payables for the full invoice, credit cash for the amount paid, and credit discounts received for the difference. Discounts received is income in the statement of profit or loss.
Worked example
Style Co receives an invoice with a list price of $5,000. The supplier gives a 20% trade discount and a further 2.5% settlement discount for payment within 10 days. Style Co pays within 10 days.
Step 1: Trade discount. $5,000 x 80% = $4,000. Purchases and payables are recorded at $4,000.
Step 2: Settlement discount. $4,000 x 2.5% = $100.
Step 3: Cash paid = $4,000 - $100 = $3,900.
Journal on payment:
Dr Payables $4,000
Cr Cash $3,900
Cr Discounts received $100
The $1,000 trade discount never appears in the ledger.
Remember: only the settlement discount is credited to discounts received, and it is worked out on the invoice value after the trade discount, not on the list price.
Where candidates lose marks
Applying the settlement percentage to the $5,000 list price instead of the $4,000 net amount, giving $125 and $3,875.
Adding the trade discount to the settlement discount and recording both in discounts received.
Treating discounts received as an expense in the profit calculation, or adding discounts allowed as income, so both discounts are on the wrong side.
Try it: 4 questions
Style Co, a fashion retailer, receives a supplier invoice with a list price of $5,000. The supplier allows a 20% trade discount. It also offers a further 2.5% settlement discount if the invoice is paid within 10 days. Style Co pays within 10 days. Which TWO of the following statements are correct?
Select the two that apply (each shows on its own).
Answer: A, C. A trade discount is deducted from the invoice before it is recorded, so the invoice is recorded at $5,000 x 80% = $4,000. The settlement discount is calculated on this net amount: $4,000 x 2.5% = $100. Cash paid = $4,000 - $100 = $3,900. Only the $100 is credited to discounts received (income). Wrong options: $3,875 and $125 apply the 2.5% to the $5,000 list price instead of the $4,000 net amount. $1,100 wrongly adds the $1,000 trade discount to the settlement discount, but a trade discount is never recorded in the ledger accounts.
Bean Roast Co, a coffee roaster, orders 500 units from a supplier. The supplier gives a 15% reduction for buying 500 units. It also offers 3% off if the invoice is paid within 7 days. Bean Roast Co intends to take both. Which of the following correctly describes the accounting treatment?
Answer: A. The 15% is a trade discount for bulk buying. It is deducted from the invoice, so purchases and payables are recorded net and no separate entry is made. The 3% is a settlement discount for early payment. It is recorded when the payment is made, by crediting discounts received (income). Option B reverses the two treatments. Option C wrongly records the trade discount as income. Option D ignores that a settlement discount is a separate item in the ledger.
Kiln Co, a cement plant, has the following trial balance extracts for the year: revenue $250,000; cost of sales $160,000; discounts allowed $3,200; discounts received $2,100; other expenses $48,000. What is the profit for the year?
Answer: A. Gross profit = $250,000 - $160,000 = $90,000. Discounts received are income and are added: $2,100. Discounts allowed are an expense and are deducted: $3,200. Profit = $90,000 + $2,100 - $3,200 - $48,000 = $40,900. $36,700 deducts discounts received as an expense. $47,300 adds both discounts as income. $43,100 deducts discounts received and adds discounts allowed, so both are on the wrong side.
Cloudsoft Ltd, a software subscription firm, owes a supplier $1,500. It pays $1,470 by cheque, and the supplier accepts this in full settlement under an agreed settlement discount. Which of the following is the correct double entry?
Answer: A. The whole $1,500 debt is cleared, so payables are debited with $1,500. Bank is credited with the $1,470 paid. The $30 difference is income for Cloudsoft Ltd and is credited to discounts received. Option B puts the discount on the debit side and credits bank with more than was paid. Option C treats the $30 as discounts allowed, which relates to customers, and the entry does not balance. Option D clears only $1,470 of the debt and leaves $30 owing.
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What is the difference between a trade discount and a settlement discount?
A trade discount is a reduction in price, for example for bulk buying, and is deducted from the invoice before recording. A settlement discount is a reduction for paying early and is recorded in the ledger when payment is made.
Is discounts received income or an expense?
Discounts received is income. It is added in the statement of profit or loss. Discounts allowed, by contrast, is an expense.
How do you calculate a settlement discount when there is also a trade discount?
Deduct the trade discount first to get the net invoice amount. Then apply the settlement discount percentage to that net amount. For example, 2.5% of $4,000 is $100.