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On invoice discount example for Inventory

in this video i'm going to discuss how we account for purchase discounts related to inventory items now even though i'm choosing inventory as the setting to discuss purchase discounts the items that i'm going to discuss here can apply in other scenarios as well not just regarding uh inventory but let's go ahead and look at it from this perspective so the main thing is we have two main approaches people can use to account for these purchase discounts and it really makes no difference what method you use because ultimately we end up with the same things and i'm gonna explain how that's the case here so if you use the gross method what ends up happening is that you record everything at the full amount and if later on you take purchase discounts then we adjust for that whereas if we use the net method we record the purchase at the amount assuming that the discount will be taken so we net out the discount up front okay so let's look at the example here for the gross method assume we buy inventory for a hundred dollars and uh we include that as part of our inventory and then accounts payable goes up by that same amount the seller since we're buying this this inventory the seller that sold us the inventory is offering us a five dollar discount if we pay within the discount period so let's assume two possible scenarios here one of them is we pay with no discount in other words we do not take advantage of the discount and if that's the case when we pay the hundred dollars it would just be a reversal of the accounts payable here and then we credit cash for a hundred dollars straightforward and under this particular scenario overall we are going to reflect that the fact that the inventory cost us a hundred dollars now alternatively and this is this is one or the other okay it's you know obviously it's you either pay with no discount or you pay with a discount so the alternative is maybe we paid on time early not on time but early in order to take advantage of the discount in which case we get a five dollar discount now if we get a five dollar discount we got to keep in mind that this inventory item that we initially recorded at a hundred dollars will be overstated because the fact that because of the fact that we got a five dollar discount so the mechanism that we're going to use to reduce this overstatement of inventory is through the use of the purchase discount account now notice how i i say here that it reduces the inventory account so if this account called purchase discount reduces the inventory account then we would call it a contra asset or contra inventory account so the way i would do that is reduce the accounts payable the liability for the full amount i'm going to send the check for 95 dollars so the difference is going to be recorded as purchase discounts or an indirect reduction of inventory okay and by doing so i'm reflecting the fact that overall this inventory cost me 95 dollars i'm taking care of the potential overstatement in inventory that would have occurred if i would not have used this purchase discount account now that's using the gross method right if we use the net method without going into the details yet notice how i make i emphasize here that the cost reflected over the whole transaction is the same as if we would have used the gross method so it doesn't matter whether you use the net or gross method overall you're going to reflect the true cost of the inventory item and that's what's important so you know why would some companies prefer the girls method over the net method it's it's really just a company choice maybe you have a company that is is normally taking advantage of the discounts in general takes advantage of the discount so for that kind of company it might be more efficient to just record things at the net amount and or if you have a company that doesn't necessarily have that approach they might want to use the gross method and sometimes companies want to use the gross method even if they take advantage of a lot of discounts for the simple reason that having this extra account here allows them to do analysis of how often they're taking advantage of the discounts in other words if if we have the net method where we record things at the net amount the 95 inventory goes up ap goes up goes up then later on when we pay it all we got to do is reverse the ap and credit cash this here while efficient may not allow us to later on do analysis of how much in discounts we're taking advantage of whereas this having this account is information for that purpose because you might be doing this for the analysis based on each vendor or in examining the performance of the accounts payable department or many other reasons so it just provides additional information but for a company that just wants to use the net method it's the same they could look at it from the other side so if you use the net method you'll use this account called purchase discounts lost if you do not take advantage of the discounts so if that's the case you would classify this as an expense as a finance charge so notice what happens here we buy the inventory at an id uh and we record it at 95 even though the invoice is for 100. so when we later pay with no discount we debit ap we reduce the liability we got to send a check for the full amount of 100 so we debit this purchase discounts lost now at the end it's as if our inventory cost a hundred dollars because when you sell this inventory item it's going to go to cost of goods sold for 95 and then the additional five dollars will be considered a finance charge for that inventory which is an expense so you have cost of goods sold being an expense of 95 and then the finance charge being five dollars so that's a total of a hundred so it's it's as if our inventory cost us a hundred dollars you're expensing 100 for that inventory related transaction all right and then here on the other hand uh oh before i go there so by using this purchase discount account we can also analyze our efficiency or how well we're doing in terms of taking advantage of discounts if you're using this account to do that analysis then you want to maximize you want to see the maximum usage through the purchase discount if you're using this account to see how well you're taking advantage of discounts then you want to see the minimum amount in this account right if you're doing a report so you might do it on a percentage basis you know what is pdl over ap that gives you a ratio of how large or how often you're using this or if you're using this angle then you go purchase discounts p purchase discounts over ap and you want this ratio to be larger whereas you want this ratio to be slower lower sorry so it just depends on your preference but at the end of the day the key thing here is this when you go out to a client they're not necessarily going to call the gross method or the net method you would just pick up on what they're doing based on the accounts that they're using right if they're using purchase discounts then you're you can see that for those type of transactions are using gross method or if they're using something similar to this then you can pick up on the fact that they're using the method most likely all right this concludes the video on purchase discounts