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The Gross and net Method

# The Gross and net Method - The Gross Method This...

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The Gross Method This illustration assumes a gross purchase price of \$1,000 and typical discount terms of 2/10, n/30. [The appendix demonstrates that this is more than a 37% rate of interest.] As suggested by the name, the Purchases and Accounts Payable are recorded at the gross amount: Dr: Purchases \$1,000 Cr: Accounts Payable \$1,000 If payment is made within the ten-day discount period, the payment would be recorded: Dr: Accounts Payable \$1,000 Cr: Cash \$ 980 Purchase Discounts (taken) \$ 20 If payment is NOT made within the ten-day discount period, the payment would be recorded: Dr: Accounts Payable \$1,000 Cr: Cash \$1,000 The \$20 discount equals 2% of the \$1,000 purchase price and is a reduction awarded for early payment. Whether or not the account is paid within the discount period is a financing decision, not an asset acquisition decision. In essence, the discount is actually an interest charge for not paying within 10 days. However, note that if the discount is not taken this “interest expense” is left in the Purchases account, where it eventually becomes part of cost of goods sold. For all other purchased assets, it is generally recognized that interest charges are NOT appropriate to include as a part of the cost of the asset. Thus, the gross method is inappropriate, from a theoretical point of view. The Net Method Assuming the same typical discount terms of 2/10, net/30, described above, and the same purchase price of \$1,000, under the net method both parts of the transaction are initially recorded at the net amount: Dr: Purchases \$ 980 Cr: Accounts Payable \$ 980 If payment is made within the ten-day discount period, the payment would be recorded: Dr: Accounts Payable \$ 980 Cr: Cash \$ 980 If payment in the above example is NOT made within the ten-day discount period, the payment would be recorded: Dr: Accounts Payable \$ 980 Purchase Discounts Lost 20 Cr: Cash \$1,000 The net method has the advantage of recording Purchases at the correct amount, but the explicit recognition of the Purchase Discounts Lost is not popular. The difference between the methods falls within the realm of materiality which “justifies” use of the gross method. However, from the informational point of view both methods are deficient.

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