Treatment of Cash discounts

Practice and theory are both unsettled with respect to the treatment of cash discounts. These reductions can be taken by the customer if the account balance is paid within a relatively short period. Cash discounts might be viewed first of all as rewards offered for prompt payment. Alternatively, cash discounts missed by customers may be treated as penalties for late payment.

That is, the real price is viewed as the invoice amount less the discount, and failure to pay promptly results in the customer’s having to pay the full amount. The interpretation that is chosen affects how receivables and sales are measured and how the discount is reported. The possibilities are summarized in this table:

Cash discount example

These interpretations are reflected in the method of recording the sale and the subsequent collection.

Journal Entry

For example, assume that two $1,000 sales are made to different customers on May 10, 20×1, under terms of “2/10, n/ 30” (which means that 2 percent can be deducted by the customer if they make payment within 10 days; otherwise, the full amount is due in 30 days). These journal entries could be made to record the sale and subsequent collections if one customer takes the discount and the other does not:

Cash discounts journal entry

Under the reward interpretation, the discount taken by the customer is treated as a cost of obtaining the cash earlier. The missed discount does nothing to alter the situation. Under the penalty interpretation, the missed discount is treated as an additional revenue.

Making the choice. The selection between the reward and the penalty interpretations can be made on either a conceptual or practical basis. Conceptually, we could compare the discount rate expressed in annual terms with the rate that is paid for borrowed funds.

For example, “2/10, n/ 30” indicates that the seller is willing to pay 2 percent to receive the cash 20 days early. On an annual basis, that arrangement is equivalent to 36.5 percent (2% X 365 / 20). If the firm can borrow elsewhere at a significantly lower rate, it is unlikely that it would pay such a high reward to get the cash sooner. Further, we might observe that a firm would be quite willing to impose a penalty of this size in order to encourage prompt payment.

Pragmatically, we can simply set up our system to accommodate the typical result. That is, if most customers take the discount, we might choose to record sales and receivables at net. If few take them, we can most easily work with the gross amounts. While making the choice on this practical basis may produce imprecise information, it results in simpler entries.

Disclosure problems. Although sales discounts recorded under the reward interpretation are more in the nature of an expense, common practice treats them as reductions of revenue. While the net income is the same regardless of which approach is used, there may be a distortion of gross profit on sales and financing expenses. Discounts missed should be reported as additional revenue under the reward approach; insufficient evidence exists to support a description of common practice under this approach.

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