Credit Purchases Vs. Cash Purchases: All you need to know!

What are purchases?

Purchases are categorized as expenses that are incurred by organizations when they procure goods and services, for purpose of reselling, or value-addition followed by reselling. Purchases are categorized as costs incurred by the company to bring goods and services to a sellable condition.

Technically, purchases are defined as the act of a company to take possession of a given asset, by paying a predetermined amount of money for the transaction to be completed successfully. In simpler terms, this is the amount that is paid for an exchange of money for particular goods and services.

Types of Purchases

Purchases can be broadly categorized into two categories:

  • Credit Purchases
  • Cash Purchases

When are purchases recognized?

There is often confusion regarding the recognition of purchases. In the case of the purchase of goods and services, the purchase is said to be made when the risks and awards associated with the underlying goods are transferred to the buyer of the asset. In most cases, this occurs when the buyer has received the asset. The payment against the asset is not relevant to when the purchase is actually recognized, since expenses are mostly recorded under the accrual basis of accounting.

Therefore, purchase recognition, just like sales recognition, only takes place when the risks and rewards and transferred from the seller of the asset to the buyer of the asset.

What are credit purchases?

Credit Purchases are defined as purchases that involve procuring a certain good at an earlier date, and paying for that particular amount at a later date. This implies that organizations do not pay for these goods and services upfront, but pay at a date later than when the goods were actually delivered.

Credit Purchases are payables that are owed by the company to another party. This amount mostly needs to be settled within a timeline of one year. Therefore, it is regarded as a Current Liability of the company.

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However, under the accrual concept, it can be seen that regardless of payment terms decided between the buyer and the seller, credit purchases are supposed to be recorded in the financial statements as long as they are relevant and pertinent to the current fiscal year.

Accounting Treatment of Credit Purchases

Credit Purchases are regarded as purchases that are made on credit by one party to another party. Factually, it can be seen that credit purchases have the following journal entries:

ParticularAmount
Purchasesxxx
  Creditors – Current Liability  xxx

Purchases are considered an expense for the Income Statement. Therefore, they are debited in the Income Statement. The contra entry is a credit to the Creditors account, which is a current liability from the perspective of the company.

Example of Credit Purchases

The concept of credit purchases is illustrated in the following example:

Jaybees Co. procured goods on credit from Hico Ltd. On 15th November 2020. This amount was supposed to be settled by 10th June 2021. The total amount of goods procured was equivalent to $5000.

In the example above, it can be seen that Jaybees Co. purchases goods on credit. Hence, this implies that the purchases were credit purchases. The journal entries used to reflect this was as follows:

ParticularAmount
Purchases$5,000
  Creditors – Current Liability  $5,000

The journal entries above show a debit to the purchases account and a subsequent credit to the Creditors Account (for Current Liabilities).

What are cash purchases?

Cash Purchases can be defined as purchases that are incurred by businesses when they make their transactions on cash. This implies that the company pays upfront for all the resources that they procure from their suppliers.

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Cash Purchases are settled there and then, and therefore, they are not declared as Current Liabilities on the Balance Sheet of the company.

Accounting Treatment of Cash Purchases

Cash Purchases are regarded as purchases that are made in cash by one party to another party. Factually, it can be seen that credit purchases have the following journal entries:

ParticularAmount
Purchasesxxx
  Bank (Cash)  xxx

Purchases are considered an expense for the Income Statement. Therefore, they are debited in the Income Statement. The contra entry is a credit to the cash account. This reflects the decrease in cash as an offset of payment to the given supplier.

Example of Cash Purchases

The concept of cash purchases is illustrated in the following example:

Pringles Co. procured goods on cash from Giggly Ltd. On 10th October 2020. This amount was supposed to be settled by 10th March 2021. The total amount of goods procured was equivalent to $15000.

In the example above, it can be seen that Jaybees Co. purchases goods in cash. Hence, this implies that the purchases were cash purchases. The journal entries used to reflect this was as follows:

ParticularAmount
Purchases$15,000
  Bank  $15,000

The journal entries above show a debit to the purchases account and a subsequent credit to the Creditors Account (for Current Liabilities).

Accounting Treatment for Purchase Returns

Purchase returns are defined as goods initially procured, returned back to the sellers. This might be because of faulty goods delivered, or any other reason because of which the company no longer requires the goods and services.

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In order to reflect purchase returns, the following transactions are made:

ParticularAmount
Bankxxx
  Inventory   xxx

The aforementioned transactions reflect that inventory needs to be reduced, whereas the bank needs to be debited again in order to showcase the increment in the bank account.

Differences between Cash Purchases and Credit Purchases:

Despite the fact that cash purchases and credit purchases both reflect procuring goods and services from one supplier to another, there are differences between both of them. These differences are as follows:

  • Credit Purchases involve delayed payments. On the other hand, cash purchases involve upfront payments made to the suppliers.
  • Credit Purchases require a credit to the creditors account, whereas cash purchases require a credit to the bank account of the company.
  • Cash purchases are normally undertaken by companies that are relatively new, or do not have a good credit rating. Credit purchases, on the other hand, are done by companies that are relatively older, and have a solid credit rating.
  • Credit Purchases impact the balance sheet, in the form of Current Liabilities. On the other hand, Cash Purchases are not declared in the balance sheet directly. They do, however, impact the balance sheet in the form of deducted cash.
  • Credit purchases are relevant for companies that work on credit with their suppliers. Cash purchases, on the other hand, are mostly followed by companies that mostly have their transactions in cash. For example, an automotive supplier might find it reasonable to work on credit. On the other hand, the restaurant industry might find it more appropriate to work on cash, since most business dealings are undertaken in cash only.
  • Cash purchases often prove to be more cost effective from the perspective of buyers. This is because it entitles the buyers to avail cash purchase discount. There is a finance cost associated with credit purchases, because of which credit purchases often tend to be more expensive and costly.
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