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There are some key terms related to accumulated depreciation. But, first, let’s clarify what a useful life, depreciation, straight-line method of depreciation, reducing balance, and accumulated depreciation account are.
Useful life – the period over which one long-term asset is being used in the business. If the useful life of a long-term asset is expected to last 5 years, it would be sensible to reflect the fact that this long-term asset is being used in the business over 5 years by charging an expense each year of $2,000.
Depreciation - charging of the cost of a long-term tangible asset over its useful life. Depreciation applies the matching concept by charging the asset’s cost to the income statement as it is being used up. At the same time, the value of the assets is being reduced with the amount of the cost charged.
Amortization - charging of the cost of a long-term intangible asset over its useful life. Amortization applies the matching concept by charging the asset’s cost to the income statement as it is being used up. At the same time, the value of the assets is being reduced with the amount of the cost charged.
Straight-line method of depreciation/amortization – under this approach, the company charges an equal amount of depreciation each year. Each year’s depreciation charges are calculated by subtracting the residual value from the long-term asset’s original value and dividing the result by the estimated useful life.
Reducing balance method of depreciation/amortization - under this approach the company charges more depreciation in the early years of an asset’s life, with a progressively lower charge in each subsequent year.
An accumulated depreciation/amortization account is a contra account. It is an account that reduces the value of a long-term asset account. This contra account has an opposite to the long-term asset account balance. When a depreciation/amortization expense is recognized, this account is credited. And it is debited when the value of the long-term asset is decreased.
Now we can show what records should be made when depreciation is accumulated.
The first journal entry shows that an expense is recognized. Depreciation/Amortization Expense account is debited, and the Accumulated Depreciation account is credited. The second journal entry shows that this expense decreases the value of the long-term assets. Therefore, the contra Accumulated depreciation/amortization account is debited, and the particular Long-term asset account is credited.
17. Trade discount and cash discount
Discount means deduction from the usual price of a good or service. There are two main types of discount: a trade discount and a cash discount.
Let's begin with a clarification of what a trade account is. A trade discount is a reduction in the regular price given by the seller to the buyer at the time of purchase of goods or services. A trade discount is usually granted in two cases: when a manufacturer sells to wholesalers in high volumes or when wholesalers sell to retailers in high volumes.
When a buyer purchases in larger quantities, the trade discount increases. The trade discount may be calculated as a specific dollar reduction from the regular price or a percentage discount.
Let's illustrate the trade account with the following example:
A manufacturer sells bags at a retail price of $30 per bag. A wholesaler orders 200 bags, for which the manufacturer grants a 20% trade discount. Thus, the total retail price of $6000 is reduced to $4800. And this is the amount that the manufacturer bills to the wholesaler. The trade discount is, therefore, $1200.
A cash discount is a deduction of the invoice price offered by sellers to motivate buyers to pay within a shorter time. This discount reduces the amount of an invoice in return for paying the invoice immediately or earlier than its normal payment date. The amount of the cash discount is, in most cases, a percentage of the total amount of the invoice, but it can be sometimes stated as a fixed amount.
Here is a simple example to illustrate the cash discount.
A seller of bags is offering a reduction of 10% of an invoice if it is paid within 10 days. For example, a buyer makes a purchase of 2 bags at a total price of $300. The total invoice amount is $300, but the buyer pays within the first 10 days and saves $30.
After clarifying what both types of discounts are, we can point out the main differences between them.
1. The first difference is that the trade discount is not included in the invoice amount. And the cash discount is part of the invoice amount.
2. The trade discount motivates the purchase of larger quantities. The cash account motivates earlier payment.
3. The trade discount is usually made by manufacturers or wholesalers. Retailers usually make the cash account.
4. The trade discount doesn't appear in the books of accounts. The cash account should be recorded in the accounting system.
In the next videos we are going to talk about cash discounts from sellers perspective and from buyers perspective.
18. Sales discount/Discount allowed - cash discount from a seller's perspectives
When a seller makes a cash discount to its customers if they pay earlier, we are talking about a discount allowed. It reduces business' revenues. And it appears in the account of books as a contra revenue account called Sales discount.
When a business sells a good or a service and offers a cash discount, in the beginning, it does not know whether the customer will take the sales discounts or simply pay on the due date. In this case, the business has to record the total amount of the sale when invoiced. Therefore, it should debit the Accounts receivable account with the gross invoice amount and credit the Sales revenues account with the same amount.
When the customer pays earlier and takes the cash discount, the seller has to:
debit the Bank account for the net price received,
debit the contra Sales discount account for the amount of the discount,
and credit the Accounts receivable account for the whole invoice amount.
After that, the seller has to decrease sales revenue by the amount of the discount. Then, the sales revenue account has to be debited for the discount amount, and the sales discount account has to be credited for the same amount.
Example: Company A sold merchandise to Company B for a total sales price of $100,000. Company B is given 90 days to pay the amount, and it will be granted a 9% discount if it pays within 14 days.
At the date of the sale, Company A doesn't know whether Company B will pay within 14 days or not. Therefore, Company A should make a record that shows an increase in accounts receivable and sales revenue. The following entry has to be made: $100 000 debit to Accounts receivable account, and $100 000 credit to Sales revenue account.
We assume that the customer paid within 14 days. In this case, Company A should make a record that shows an increase in the Bank account with the net price, which is the sales price deducted by the discount, and a decrease in the Accounts receivable account for the gross sale price. Thus, the difference between the amount received and the expected amount is shown in a contra discount amount, decreasing sales revenue.
The following record needs to be made:
$91 000 debit to Bank account
$9 000 debit to Sales discount account
$100 0000 credit to Accounts receivable account.
The seller needs to decrease the sales revenue with the amount of the discount. It should make the following journal entry:
$9 000 debit to Sales revenue account
$9 000 credit to Sales discount account.
19. Purchase discount/Discount received - cash discount from a buyer's perspective
When a buyer takes a discount from its sellers, we are talking about a discount received. The discount received reduces business' expenses. And it appears in the account of books as a contra expense account called Purchases discount.
When a business buys a good or a service and takes a cash discount, at the beginning it does not know whether it will pay earlier or simply pay on the due date. In this case, the business has to record the full amount of the purchase when invoiced. It should debit Inventory account with the gross invoice amount and credit Accounts payable account with the same amount.
When a buyer pays earlier and takes the cash discount, the buyer has to:
debit Accounts payable account for the gross invoice price, credit Bank account for the net price, and credit contra Purchases discount account for the amount of the discount account.
After that a buyer has to decrease business expenses for the amount of the discount. Then, the purchases discount account has to be debited with the amount of the discount and the Expense account has to be credited for the same amount.
Let's use this example:
Company A sold merchandise to Company B for a total sales price of $100,000. Company B is given 90 days to pay the amount, and it will be granted a 9% discount if it pays within 14 days.
At the date of the sale, Company B doesn't know whether it will pay within 14 days or not. Therefore, Company B should make a record that shows an increase in Inventory account and an increase in Accounts payable account. The following has to be made: $100 000 debit to the Inventory account, and $50 000 credit to Accounts payable.
We assume that Company B paid within 14 days. In this case, Company B should make a record that shows a decrease in the bank with the net price, which is the sales price deducted by the discount, and a decrease in the accounts payable for the gross sale price. Thus, the difference between the amount paid and the amount due is shown in a contra discount amount which decreases business' expenses.
The following record needs to be made:
$100 000 debit to Accounts payable
$9 000 credit to Purchases discount account
$91 000 credit to Bank account.
The buyer needs to decrease the business' expenses for the amount of the discount. It has to make the following journal entry:
$9 000 debit to Purchases discount account
$9 000 credit to the Expense account.
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