Purchase discounts, returns and credit notes
Purchase discounts, returns and credit notes
In the previous lesson we saw how a purchase is recorded from the moment it is agreed with the supplier. In real life, however, few purchases stay exactly as planned: the supplier grants a discount, the merchandise arrives damaged and must be returned, or the business takes advantage of the payment terms to pay less. Each of those situations changes what should have been recorded and, if it is not adjusted in time, the inventory, the accounts payable and the results all keep wrong values. This lesson explains what happens in the accounting records when a purchase does not stay as it was agreed: the trade discount already shown on the invoice itself, the early payment discount, the total or partial return of merchandise and the credit note with which the supplier backs the reduction. Everything is shown with journal entries, so you can see exactly which account is affected in each case. Remember that the physical control of the stock —for example with the inventory module of Kardex Tauro— and the accounting record go hand in hand: first you understand the document and then you make the entry.
Before we start, it is worth remembering a general principle: merchandise is recorded at its real value, that is, at what will actually be paid for it after reductions, returns and discounts. Anything that reduces what is paid to the supplier must also end up reducing the value at which the purchase stands in the books. The apparent exception is the early payment discount, which some companies treat as a financial benefit, as we will see later. The important thing is that no reduction or return can be left unrecorded, because each one touches both the inventory and the debt owed to the supplier at the same time.
1. Trade discount included on the invoice itself
A trade discount is the reduction the supplier grants on the list price because of volume, season, loyalty or the terms of the negotiation. When that discount appears on the invoice itself, the accounting does not even see it as a separate event: the purchase is recorded directly at the net value, that is, at the price already reduced. If a product has a list price of $1,000,000 and the supplier grants a trade discount, the invoice arrives for the already reduced value and the journal entry is made for that same value. In practice the discount is subtracted on the invoice itself, before the total is calculated, and that is why no discount account appears in the entry.
The accounting reason is simple: the cost of the inventory must be recorded at what it really cost to acquire it, and the trade discount is part of the price negotiation, not income for the business. Whoever records the purchase at the list price and then books the discount as income is duplicating a transaction that only reduces cost. In the inventory card, that net value is the one divided among the units received to find the unit cost of the receipt; if the gross value were recorded, the unit cost would be overstated and the cost of merchandise sold would be calculated wrongly. That is why, when the discount comes on the invoice, the whole process —invoice, journal entry and inventory card— works with the same net value from the first day.
2. Early payment discount: paying earlier and paying less
The early payment discount is different: it does not reduce the price of the merchandise, but rewards the buyer for paying before the agreed date. The supplier may offer, for example, that if the invoice is paid within the first fifteen days, part of the debt is forgiven. The purchase was recorded in full on the day the merchandise was received, with its account payable for the total amount. Later, when the payment arrives within the term, the business pays less than it owed: the debt was $100 and only $97 are paid. That $3 difference is the benefit of paying early, and the entry must show that the debt is settled for its full amount while the payment leaves for the real amount disbursed.
And where does the difference go? This is where the accounting policy of each company applies. The simplest criterion, and the most common in small businesses, says that the difference reduces the cost of the purchase: it is credited to a purchase discount account that lowers the value at which the merchandise was recorded. The other criterion, used by companies that want to measure the benefit of financing themselves cheaply, recognizes the difference as financial income. Both ways are valid and neither changes the cash that leaves nor the total credited to the supplier. Your accountant defines the policy; here we show the effect of the simple criterion, the one we recommend to start with: the difference is credited to the account that reduces the cost, and the transaction stays consistent with the principle that a purchase is recorded at its real value.
The most common mistake at this point is treating the early payment discount as if it were a trade discount and subtracting it from the value of the inventory on the very first day. That cannot be done: when the merchandise arrives, the business still does not know whether it will pay within the term, so the purchase and the account payable are recorded in full. The benefit of paying early only exists if the payment happens on time, and only at that moment is it booked.
3. Returning merchandise to the supplier
When the merchandise received is not usable —it arrives damaged, with different specifications, in the wrong quantity or expired— the business returns it to the supplier. The return can be total, when the whole purchase is sent back, or partial, when only the part that is not usable is returned. In both cases the accounting reverses what was recorded on the day of the purchase, in the same proportion: inventory goes down by the value of the returned merchandise and the account payable to the supplier goes down by the same value. If the purchase has not been paid yet, the return directly reduces the debt; if it has already been paid, the return cannot touch the account payable, because it is already settled, and instead an account receivable from the supplier is born: the right to receive the money back or to apply it to future purchases.
Suppose merchandise worth $1,000,000 was bought on credit and $200,000 of it is returned. The purchase entry had been a debit to inventory and a credit to accounts payable for $1,000,000. The return entry is its mirror: a debit to accounts payable and a credit to inventory for $200,000. After that, the debt stands at $800,000, which is exactly what must be paid for what was kept. In the inventory card, the return is recorded as an inventory out at the cost at which the merchandise came in, so the unit cost of what remains is not distorted. If the return happens after part of the merchandise has already been sold, the entry is completed by adjusting the cost of merchandise sold, a case covered in more advanced lessons.
There is a detail that is often forgotten: the original purchase also included, besides the value of the merchandise, the tax associated with the transaction, which was recorded in a separate account and formed part of the total account payable. When merchandise is returned, the portion of the tax that corresponds to the return is also reversed, because a value for merchandise that is no longer held cannot keep being claimed as deductible tax. The reduction that the supplier recognizes normally includes that tax, and the return entry must reflect both parts: the merchandise and its tax. Failing to do so is one of the most repeated mistakes in practice.
4. The credit note: the document behind the reduction
Every return or reduction granted by the supplier must be supported by a written document, which in business-to-business operations is called a credit note. The supplier's credit note is the voucher that proves that the buyer's debt is reduced, whether because merchandise was returned, because the supplier granted a discount after the invoice was issued, or because an error in the price or the quantity was corrected. Without that document the reduction has no support, and the entry that records it would have no backing in a review. That is why the practical rule is: first receive the credit note, check that the amounts match the merchandise returned, and only then make the entry. If the supplier acknowledges the return but the note has not arrived yet, the entry is deferred until it is received, or it is recorded with the internal supporting documents and reconciled later, depending on each company's procedure.
Summary: which document moves which accounts
The following table summarizes the four cases in this lesson: which document originates each situation and what effect it has on the accounts. It is a good guide to review before recording any reduction or return.
| Case | Document | Effect on the accounts |
|---|---|---|
| Trade discount on the invoice itself | Supplier invoice with the price already reduced | The purchase is recorded at the net value: the inventory comes in reduced and no income or discount account is created |
| Early payment discount | Invoice and payment receipt issued within the term | The account payable is settled for its total amount; the payment leaves for the real amount and the difference reduces the cost or is recognized as income, according to the policy |
| Partial or total return of merchandise | Supplier credit note backing the return | Inventory and account payable are reversed for the returned value; if the purchase was already paid, an account receivable from the supplier is born |
| Reduction granted after the invoice | Supplier credit note | It decreases the account payable and reduces the value of the inventory, without any movement of cash |
Complete example step by step
To see how these cases chain together, let us follow a real transaction from start to finish. A company buys merchandise on credit for $3,000,000 and receives it in its warehouse; for simplicity, the example works with the value of the merchandise and leaves the tax aside, although you already know that in practice the associated tax is recorded separately and reversed in the same proportion when there is a return. Weeks later, part of the merchandise arrives in bad condition and $500,000 worth is returned, backed by the supplier's credit note. Finally, the company pays the balance within the agreed term and the supplier grants an early payment discount of $30,000. Let us look at the three entries.
| No. | Economic event | Account | Debit | Credit |
|---|---|---|---|---|
| 1 | Purchase of merchandise on credit | Merchandise inventory | $3,000,000 | |
| Accounts payable | $3,000,000 | |||
| 2 | Partial return backed by a credit note | Accounts payable | $500,000 | |
| Merchandise inventory | $500,000 | |||
| 3 | Payment of the balance with early payment discount | Accounts payable | $2,500,000 | |
| Purchase discount for early payment | $30,000 | |||
| Bank (cash) | $2,470,000 |
After entry 2, the accounts payable account stood at $2,500,000, the balance the company really owed: the $3,000,000 of the purchase minus the $500,000 of the return. In entry 3 that debt is settled in full: the $2,500,000 debit leaves it at zero, the credit to the bank for $2,470,000 shows the cash that actually left, and the remaining $30,000 stay in the discount account, which according to the policy reduces the cost of the purchase or is recognized as financial income. At the end, the balance of Accounts Payable is zero and the inventory stands at the net value of what was really kept: $2,500,000. Notice that entry 3 is the only one that touches cash, because the return and the trade discount never involved a movement of money.
Common mistakes when recording reductions and returns
- Recording the trade discount as income: when the reduction comes on the invoice itself it only reduces the cost of the purchase; booking it as income inflates the results and leaves the inventory with a value higher than the real one.
- Recording the purchase at the gross value and waiting to adjust later: until the inventory and the account payable are corrected, the balances do not reflect the true obligation and the unit cost in the inventory card is wrong from the receipt.
- Not reversing the associated tax in the return: the supplier's reduction normally includes the tax of the returned merchandise and that part must also leave the accounts; leaving the full tax inflates the benefit taken and leaves the account payable wrong.
- Not recording the return because "we already deducted it from the payment": paying less without the entry leaves the inventory with merchandise that no longer exists and the account payable with a balance that no longer matches; first record the return and then pay the correct balance.
- Making the entry without the credit note: without the supporting document the reduction has no backing and, if the supplier disagrees, the company has no way to prove why it paid less.
- Confusing the trade discount with the early payment discount: the first reduces the price from the invoice; the second only exists if payment is made before the due date and is recognized at the moment of payment, not before.
Closing
Reductions and returns are not rare events: they are a normal part of the purchasing operation and, when properly recorded, they keep the inventory, the accounts payable and the results at their real value. The key is to always follow the same order: review the document (the reduced invoice or the credit note), check the amounts against the merchandise received or returned, make the entry that reverses or adjusts the affected accounts and update the inventory card with the net value. This manual explains the general criteria and the typical entries, without going into specific tax rates or the particular rules of each country, because those details depend on the local legislation in force and on the accounting policy of each company; to apply them to your own case, consult your accountant, who defines the final criterion and verifies that the records comply with the applicable regulations.