How to Calculate Settlement Discount

Posted by: Patricia Barlow Post Date: 10th December 2014

As an accounts tutor, the one question I get asked more than any other is how to calculate settlement discount. Let’s take a look at how to work it out from the surrounding context.

What is settlement discount?

This type of discount is used as an incentive to encourage customers to pay early. This means that, while we are allowing our customers to take, say, 30 days to pay, if they pay sooner than this they will be given a discount.

How to Calculate Settlement Discount

How do I calculate it?

Let’s say the invoice is £100 plus VAT at 20%, and we’re offering a 2% settlement discount. The first thing to do is take the discount off the net (find out how to work out discounts here). £100 x 0.02 is £2, so this is the amount that will be discounted. 100 – 2 = 98, so this is now our net amount.

What is the total value of the invoice?

The VAT is always calculated on the discounted net, so we would work it out as £98 x 20% = £19.60. Regardless of when payment is made, the VAT is always £19.60.

If they settlement discount offer is not taken up, the VAT is added to the original net of £100. This means the total amount payable is £119.60.

If they pay early, the discounted net of £98 plus the VAT of £19.60 is payable (£117.60).

Why is the VAT always discounted?

Many people ask why the discounted VAT amount is offered, even when the customer does not pay early. The answer is that HMRC is trying to avoid scenarios in which companies pretend that their customer has taken the discount. For example, a crafty company could say that a customer took the settlement discount, and only paid £19.60 in VAT, when really they paid later and were charged £20 in VAT. Keeping the 40p each time adds up, so a rule of discounted VAT is there to prevent this scenario from happening.

How to calculate settlement discount is covered in more depth within the AAT Level 2 Foundation Certificate Processing Bookkeeping Transactions unit.

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