There is a direct relation between the credit period and the loss from bad debts. Thus, if a credit period of 30 days results in a given volume of such losses an extension of the credit term to 60 days would undoubtedly result in increased losses, assuming that all factors, such as investigation of the risk, credit supervision, collection effort, etc., remain the same. Inasmuch as the sale price must be sufficiently high to provide for loss from bad debts, the credit term enters into the determination of the price.
The other of the two main factors of cost, the interest charge on the cash sale price, represents the cost of being deprived of the use of the capital tied up in outstanding accounts.
Thus, when a discount is offered for early settlement, under normal conditions the controlling factors are the risk or cost of insurance against loss from bad debts and the interest cost. Special circumstances, however, may make it expedient to offer more or less favorable terms of settlement. Normally, terms of 2% off if paid within 10 days, the billed price being on a 30-day credit period (2/10, n/30), measures two things: (1) the saving secured by receipt of the money 20 days earlier; and (2) the saving in the item of bad debts expense brought about by shortening the term for which credit is extended from 30 to 10 days. How much of the cash discount is for interest and how much for bad debts can be seen by comparing the current interest rate, say 6%, with the discount rate reduced to a yearly basis. A discount of 2% which effects the collection of a debt at the end of 10 days, when the net credit term is 30 days, secures the use of the money by the vendor 20 days earlier than the full credit term would effect. 2% for 20 days is equivalent to 36% on a yearly basis.
Showing Cash Discount in the Trading Section.—Opinions differ among accountants as to the proper treatment of cash discounts in the profit and loss summary at the close of a period. Some maintain that the discount is a trading or selling item, and show it, therefore, in the trading section of the statement. Their theory is that discounts on sales partake somewhat of the nature of trade discounts, that the real selling price is, after all, what is received for a particular bill of goods. According to this theory, if goods are billed at $1,000, and $980 is accepted as full settlement, the sale should be shown only at $980 on the books. At the time of offering an optional basis for settlement, however, the merchant does not know which basis the customer will accept, and he therefore enters the sale on his books at the highest offer. Later, if the customer settles on the more favorable option, the discount he takes is logically a deduction from sales.
On the other hand, if the discount is explained as a bait offered to secure customers, it should be treated as a selling cost. Consequently, on either of these two theories, cash discount would have to be shown in the trading section of the profit and loss statement, in the one case as a direct deduction from sales, in the other as a selling cost.
Correct Method of Showing Cash Discount.—Other accountants maintain that cash discount is a financial management item; that a manager, in order to secure ready funds with which to take advantage of the discounts offered him on his own purchases, extends to his customers sufficient inducement to secure the early and prompt payment of their bills. The difference between the saving on purchases payments and the cost of securing early payment on sales, is the measure of the efficiency of such financial policy.
While this explanation of cash discount on sales as a cost of securing funds may have some foundation, it does not give a fully satisfactory explanation of the practice. If cash discount has been correctly analyzed as being composed of the two factors, interest and bad debts expense, there can be no question as to the place of its showing. Both factors are financial items and they should therefore be placed in that section of the profit and loss statement. In this work cash discounts will be treated as a financial management item.
Account Titles for Cash Discounts.—In booking cash discounts, two accounts are used—one for the discounts on sales, and the other for the discounts on purchases. Self-descriptive titles are Sales Discount and Purchases Discount, which seem better than Discounts Allowed and Discounts Received and other similar titles sometimes met with.
Methods of Booking Cash Discount.—In booking cash discounts, any one of four methods may be used. In [Chapter XIX], “The Cash Journals,” two of these methods were shown and the explanations will not be repeated here. Explanations of the other two methods follow.
1. Entry is made only in the cash book through the use of a non-cash-discount column on the receipts side. This was also fully explained and illustrated in [Chapter XIX]. In the illustration given there, this discount column was not used in finding the cash balance, because net cash columns were employed, thus making unnecessary the use of any other column to find the cash balance.