Accounts Payable: Gross vs. Net Method Explained | Purchase Discounts & Journal Entries | CPA FAR

Hello and welcome to the session in which we will discuss how to accounts for trade accounts payable or simply put accounts payable. Now, why do we call it trade accounts payable? Most likely in your textbook you will see it as accounts payable. And usually that's the first liability you would learn about in your accounting 101. It's called trade payable because it's the result of buying goods or services on credit. Buying goods or services as part of your business, as part of the trade. So, that's why we call it trade accounts payable. But, what is it? Just in case you don't know what an accounts payable is, accounts payable is when you purchase something on credit. What does that mean? It means you buy the material, you buy the goods, you buy the services today and you will pay for that later. We We say it's purchasing on credit. So, you buy now and you pay for it later. When you do that you have what we call the accounts payable for short. The technical word is trade. Now, this purchase, this transaction is not supported by a promissory note. In other words, you don't sign a note. You don't sign a note to pay. Basically, they trust you. They trust your credit. And usually when you sign a note, we will see later, they charge you interest. It becomes a notes payable. Which is sounds like accounts payable, but but a little bit different. It's a notes. We'll We'll have its own separate recording about that. But, this is what a what an accounts payable is. And accounts payable 100% 100% of the time is a short-term because short-term liability because whoever's sell you something on credit, they might give you 30, 60, 90 days if they are desperate, but they will not give you longer than than a year to pay. Now, if they do give you longer than a year, this is where they make you sign a promissory note and finance the transaction for you. It becomes a note. But, we could always assume accounts payable is a short-term liability, and we know the amount and when we're going to be paying it back. Again, usually 30-60 days, those are very very common in the real world. The only thing we are going to be adding to notes payable today from an accounting perspective is the discount. So, some suppliers, what they do, they allow you to buy on credit, and they would say, "If you pay within a period of time." So, let's assume they give you a period of time, 45 days. This is we call this the credit period. We gave you 45 days to pay. So, this 45 days, we call it the Let me write this properly. Credit It's very hard to write on the screen. Credit period. What they would say, you would say, "You have 45 days to pay. However, if you pay within the first 10 days, we'll give you a discount." What is a discount? A discount is a reduction in your cost. Whatever you Whatever you're supposed to pay us, we'll give you a little bit of a discount. So, we're going to see how we read this on the second the slide, but basically some supplier offer cash discount. And why would they do that? Clearly, they want you to pay early. Why? Because cash is king. The the the vendor, the merchant, they want their cash as soon as possible. They want to entice you to buy. So, we have You have 45 days. You know, pay us in 45 days. They want you to buy. They want you to commit. But, they also want their money. They will turn around. They would say, "Look, we gave you 45 days and if you can pay within 10 days, we'll give you 2%." Now, we need to learn how to read this discount and how do we integrate this information within an accounts payable transaction? Let's go ahead and get started. >> Before we proceed any further, I have a public announcement about my company, farhatlectures.com. My AI turns any lecture into a complete study system. You can create summary table, formulas, and example from each lecture. Flashcard builds from the lesson itself. A quiz built on the lesson. And as a bonus, convert any lecture into a portable short audio on the go. So, it helps you with the retention. No noise, no generic responses, just clarity based on that specific lecture. Don't just watch, interact, test yourself, and retain the material using Farhat AI. Now, go to farhatlectures.com now and see how the AI can help you understand, practice, and retain the material. >> So, the first thing we need to explain is the discount term. So, if if it reads something like this, 2/10 and 45, it means you have 45 days to pay. We call this the I just mentioned it, the credit period. However, 2/10 means if you pay within 10 days, you get 2%. This is called the discount period. So, within 10 days, otherwise, you pay any anytime you pay more than on the 11th day, you pay the full amount. So, if you buy something for 10,000 under these terms, you pay within 10 days, you get 2% off. Now, how do you determine the 9,800? There's two ways to do it. Just kind of show you the math. You'd say, "If I'm getting 2% off, it means I'm paying 98% of the bill. It means I have to pay 9,800." Or you would say, "10,000, I'm going to take out 2%, which is .02, which is $200. 10,000 200 I will end up paying 9,800. So, notice it's you could do it one shot. You see, you know, 2% means I'm going to have to pay three meaning 98%. If you pay any time after the 10th day, you have to pay the full amount. This is how we read the discount from a mechanical perspective. Now, from an accounting perspective, they give you two different method to record your purchases. When you buy something, you you can record the transaction using either the gross method or the net method. So, we're going to look at the gross method first. So, you purchase something and you record it at you guessed it, the gross, the full amount, the full invoice price. Now, if the company pay later within the discount period, it would say, "Well, we got a discount when the payment is made." Now, when do companies use this method? This method is used for simplicity and when management don't expect to take many discounts. So, why would they use the gross method? Because they don't think they're going to take the discount. Why not? Because they rather wait for the full credit period, especially when they give them 60 days or a longer time, because they want to keep the cash. They think they are they are better off with the cash. This is This is when the gross method is used. So, I'm not going to I'm going to assume I'm going to pay the full amount. So, the best way to illustrate this is to take a look at an example. ABC purchases 5,000 of raw material, 2/10 n 45. ABC pay within 10 days and take the discount. So, let's take a look at the journal entries. At the purchase, they debit inventory or purchases, depending which invent which inventory method we are using, whether we are using the perpetual or the periodic. If we're using the periodic, we use the purchases. The perpetual, we use inventory. Therefore, we debit I'm going to be using uh the uh perpetual. So, I'm going to say I'm going to debit my inventory, which is keeping track of the cost of the inventory. Again, this could be also purchases 5,000. Credit [snorts] accounts payable 5,000. I'm going to Now, I'm going to owe 5,000 as a liability. Now, if I pay within the discount period, I'm going to pay I'm going to pay 98%. So, I'm going to take 9,000 * 0.98. I'm going to pay 4,900. So, if I pay within the discount period, within the 10 days, I am going to pay only 4,900. I will debit my payable for the full amount cuz I paid the whole thing. Therefore, my liability goes down to zero. Notice I debited payable for the full amount. And what I do, you have to be you have to be careful here because um I credit purchase discount if I'm using the periodic method. If I'm using the perpetual method, which I which what I showed you, I credit the inventory. Therefore, I credit inventory 100, and now I'm keeping track of my inventory cost at 4,900. So, notice again, the inventory could be purchases, and if I'm using the inventory account as my initial purchase, when I take the discount, I credit the inventory account. So, I will credit the inventory. If If using the periodic, I would have credited the an account called purchase discount and we'll talk about the periodic method in a separate recording. Now, if ABC uses perpetual, the 100 discount would reduce inventory, which means would reduce the cost of the inventory, which is I This is what I have on the screen. Now, if the payment is made after 10 days, nothing to nothing to do. If the payment made after after 10 days, what would happen is is this. If the payment is made after 10 days, you will credit accounts you will debit accounts payable 5,000, you will credit cash 5,000, and you pay off your liability, and the cost of the inventory is 5,000. You debit account accounts payable, credit cash, and that's that if no discount is taken. So, this is the gross method. And usually this is the method that you would learn in your financial accounting 101. In intermediate accounting, they show you the net method. The net method is is what? The net method on the other end on the other hand assumes that you are going to take the discount. You are going to take advantage of the discount. Therefore, what you should do, record the discount right from the get-go. Why? Because why record it at gross then take the discount if you're going to take the discount already? Because that's going to give you the true cost of the item. So, if the payment is made within the discount period, no adjustment is needed because you already assumed the net amount will be paid. So, if the payment is late, the lost discount is recorded as an expense usually called purchase discount lost purchase discount forfeited, some sort of a an expense account. Now, when do we use the net method? Again, when management consistently expect to take advantage of the discount. And the discount are worth a lot for for some companies. If you have the cash and you can pay it, you can really you can really save yourself over the period of over over 1 year a lot of money. But, you have to kind of do the math to determine whether that's the right thing for you to do. So, this method better reflect the company's intent and recognize the penalty if discounts are taken. So, this is when what companies will which companies will do it. Now, the best way to illustrate this is to work an example. Assume XYZ purchases 10,000 of supplies on credit 2/10 and 30. And XYZ pays after the discount period. At purchase, we debit inventory, credit accounts payable. Now, why do we Again, I'm going to use inventory rather than purchases. So, we're going to debit inventory. We're going to assume it's going to cost us 9,800. Hold on a second. We paid We We purchased 10,000 worth. Well, we we we we put it on the account for 10,000 uh 9,800 because we assume we are going to take the 2% discount. This is the assumption. If the payment has been made within 10 days, there'll be no further entry and all will be good. So, if we pay within the discount period, we pay 9,800, we credit cash 9,800, we debit payable 9,800. The payable is zero and inventory indeed cost us 9,800 if that's what happened. If we did not make the payment until 10 days later, I mean, it means we miss the we miss the period, we miss the discount period. Here's what's going to happen. We are going to pay 10,000 of which we debit accounts payable. We need to reduce accounts payable by 9,800. We need to reduce accounts payable by zero. Now, we debit an account called purchase discount lost or purchase discount, you know, forfeited, you know, discount lost 200. Also, what you can do is basically this purchase discount lost would increase the inventory by 200. You could debit the inventory directly by 200. It does not matter. The point is this purchase discount lost, you lost 200. They They gave you an advantage. They They gave you the opportunity to take an advantage of a 200 dollar, and you did not. Uh It will uh It It will uh you lose it. Therefore, it is It is lost. It means you kind of your inventory went up in cost, you know, because now your inventory is back to, you guessed it, 10,000. You did not take advantage of the 200. This is a comparison between the gross and the net method. Uh it's it's a good uh it's a good summary of what we just did. I would print it out and, you know, study with it. Let's take a look at this multiple-choice question from farhatlectures.com. Omega frequently misses the two two {slash} 10 and 30 discount offer by their supplier. It uses the net method for purchases. Why do that, right? If you're going to be constantly missing. Which of the following best describe the effect on Omega's financial statement? Now, if you're taking this question on farhatlectures, and you want to kind of get a refresher what's the net method, you could ask AI to explain farhat that AI to explain the topic. Otherwise, start to answer the questions. A. Assets are overstated when discounts are missed. Well, does this make sense? If you miss a discount, if you miss something good, would that would that increase your assets? It just doesn't sound right. Uh it it because increasing your asset is good and missing a discount something it's not good. No, that's not going to be the answer. Expenses increase through purchase discount lost. Yes, if you keep recording the amount initially at the discount, then you missed the discount, you're going to have a purchase discount lost, which would increase your expenses, not your asset. So, between A and B, I'm going to keep B. C, liabilities are understated at purchases. No, liabilities are recorded at the net amount. Uh they're not understated. They're not understated, they're recorded at the net amount. D, there's no effect since the method assumes discounts are not taken. No, the net method assumes that the discount is taken. Therefore, the best answer choice is B as in boy. Now, if you want to, you could ask AI to explain the correct and incorrect answers. And if you like this question or you want to practice more about this topic, you can ask AI to create a similar MCQ. What should you do now? 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