Chapter 7, Problem 9E

Discounts Nelson Company bought inventory for $50,000 on terms of 2/15, n/60. It pays for the first $37,500 of inventory purchased within the discount period and pays for the remaining $12,500 two months later.

Required:

1. 1. Prepare the journal entries to record the purchase and the payment under both the (a) gross price and (b) net price methods. Assume that Nelson uses the periodic inventory system.
2. 2. Next Level Which of the two methods yields a conceptually preferable valuation of inventory?

To determine

Journalize the transactions of Company N under gross price method, assuming Company N uses periodic inventory system.

Explanation of Solution

Periodic inventory system: The method or system of recording the transactions related to inventory occasionally or periodically is referred as periodic inventory system.

Gross price method: Under gross price method, sales and purchases of inventory are recorded at the full invoice price (gross amount) without the deduction of discounts.

Journalize the transactions of Company N:

Date	Account title and Explanation	Post ref.	Amount
			Debit	Credit
	Purchases		$50,000
	Accounts payable			$50,000
	(To record the purchase of inventory of $50,000 on account, credit terms of $2/15,\text{n}/60$)
	Accounts payable		$37,500
	Purchases discounts (1)			$750
	Cash (2)			$36,750
	(To record the payment for  inventory  within the discount period)
	Accounts payable		$12,500
	Cash			$12,500
	(To record the payment for  inventory  after the discount period)

Table (1)

To record the purchase of inventory of $50,000 on account, credit terms of$2/15,\text{n}/60$:

Purchases account is an expense and it is decreased the equity value by $50,000. Therefore, debit purchase account with $50,000.

Accounts payable is a liability and it is increased by $50,000. Therefore, credit accounts payable account with $50,000.

To record the payment for inventory within the discount period:

Accounts Payable is a liability and it is decreased because the company has paid the amount for the credit purchases. Therefore, debit Accounts Payable account with $37,500.

Purchases discount is a contra expense account to Purchase account and will have a normal credit balance. Therefore, Purchase discount account is credited with $750.

Cash is an asset and it is decreased because cash is paid for credit purchases. Therefore, credit Cash account with $36,750.

To record the payment for inventory after the discount period:

Accounts Payable is a liability and is decreased because the company has paid the amount for the credit purchases. Therefore, debit Accounts Payable account with $12,500.

Cash is an asset and it is reduced because cash is paid for credit purchases. Therefore, credit Cash account with $12,500.

Working Note 1: Compute the discount on purchases.

Credit terms: The credit terms are $2/15,\text{n}/60$. Company N makes payment for the inventory purchased within the discount period. Hence, the Company N is entitled to discount of 2%.

$\begin{array}{c}\text{Discount on purchases}=\text{Purchases}\times \text{Discount rate}\\ =\$37,500\times \frac{2}{100}\\ =\$37,500\times \frac{2}{100}\\ =\$750\end{array}$

Working Note 2: Compute the cash paid to accounts payable (suppliers).

$\begin{array}{c}\text{Cash paid to accounts payable}=\text{Purchases}-\text{Discount onpurchases}\\ =\$37,500-\$750\left(1\right)\\ =\$36,750\end{array}$

To determine

Journalize the transactions of Company N under net price method, assuming Company N uses periodic inventory system.

Explanation of Solution

Periodic inventory system: The method or system of recording the transactions related to inventory occasionally or periodically is referred as periodic inventory system.

Net price method: Under net price method, sales and purchases of inventory are recorded at the net invoice price which means the discounts are deducted from the gross invoice price.

Date	Account title and Explanation	Post ref.	Amount
			Debit	Credit
	Purchases  (4)		$49,000
	Accounts payable			$49,000
	(To record the purchase of inventory of $50,000 on account, credit terms of $2/15,\text{n}/60$ )
	Accounts payable  (5)		$36,750
	Inventory			$36,750
	(To record the payment for Inventory within the discount period)
	Accounts payable		$12,250
	Purchase discount lost		$250
	Cash (6)			$12,500
	(To record the payment for Inventory after the discount period)

Table (2)

To record the purchase of inventory of $50,000 on account, credit terms of$2/15,\text{n}/60$:

Purchases account is an expense and it is decreased the equity value by $49,000. Therefore, debit purchase account with $49,000.

Accounts payable is a liability and it is increased by $49,000. Therefore, credit accounts payable account with $49,000.

To record the payment for Inventory within the discount period:

Accounts Payable is a liability and is decreased because the company has paid the amount for the credit purchases. Therefore, debit Accounts Payable account with $36,750.

Cash is an asset and it is reduced because amount is paid for credit purchases. Therefore, credit Cash account with $36,750.

To record the payment for Inventory after the discount period:

Accounts Payable is a liability and is decreased because the cash has paid the amount for the credit purchases. Therefore, debit Accounts Payable account with $12,250.

Purchases discount lost is a component of retained earnings and it decreases the retained earnings.  Therefore, Purchase discount lost account is debited with $250.

Cash is an asset and it is reduced because amount is paid for credit purchases. Therefore, credit Cash account with $12,500.

Working Note 3: Compute the net invoice on purchases.

Credit terms: The terms are $2/15,\text{n}/60$. The merchandising company makes payment for the Inventory purchased within the discount period. Hence, the merchandising company is entitled to discount of 2%.

$\begin{array}{c}\text{Net invoice price}=\text{Gross Invoice price}-\left(\text{Invoice price}\times \text{Discount rate}\right)\\ =\$50,000-\left(\$50,000\times \frac{2}{100}\right)\\ =\$50,000-\$1,000\\ =\$49,000\end{array}$

Working Note 4: Compute the net invoice price of cash paid within the discount period.

$\begin{array}{c}\text{Net invoice price}=\text{Gross Invoice price}-\left(\text{Invoice price}\times \text{Discount rate}\right)\\ =\$37,500-\left(\$37,500\times \frac{2}{100}\right)\\ =\$37,500-\$750\\ =\$36,750\end{array}$

Working Note 5: Compute the net invoice price of cash paid after the discount period.

$\begin{array}{c}\text{Net invoice price}=\text{Gross Invoice price}-\left(\text{Invoice price}\times \text{Discount rate}\right)\\ =\$12,500-\left(\$12,500\times \frac{2}{100}\right)\\ =\$12,500-\$250\\ =\$12,250\end{array}$

To determine

Identify among the two methods that yields a conceptually desirable valuation of inventory.

Explanation of Solution

Gross price method: Under gross price method, sales and purchases of inventory are recorded at the full invoice price (gross amount) without the deduction of discounts.

Net price method: Under net price method, sales and purchases of inventory are recorded at the net invoice price which means the discounts are deducted from the gross invoice price.

Under net price method, discount is not considered as a reduction in the inventory cost because losing the discount would not increase the amount derived from the inventory. But, in gross price method, includes the discount not taken as a part of inventory.

Hence, net price method yields a conceptually desirable valuation of inventory.