Cash discounts are sometimes called purchase discounts from the purchaser's perspective. Discounts are designed to encourage early payment and usually represent substantial savings. If a purchase was made on April 1, terms 2/10, n/30, the discount can be taken if payment is made between April 1 and April 10 - 10 days between these two dates. The discount cannot be taken from April 11 up to April 30, a time frame of 20 days. The invoice will become past due after April 30. Waiving a discount means ignoring savings for your company. For example, if a company is earning a 2% return by paying 20 days early, the annual interest is actually 36%, established by determining the number of twenty-day periods in a year (365/20 = 18 periods x 2% = 36%).
Discounts are offered in different terms, for example:
- 1/15, n/30 -- 1% if paid within 15 days, net in
- 1/10, n/eom -- 1% if paid within 10 days, net
end of month
- .5/10, n/60 -- ½% if paid within 10 days, net
in 60 days
This example illustrates the calculation of the allowance for cash discounts. If a company, LifeSavers, LLC sells to wholesalers on terms of 2/15, net 30, it means that a 2% would be earned if paid within 15 days, net in 30 days. LifeSavers LLC, has no cash sales but 50% of LifeSavers take advantage of this discount. LifeSavers, LLC analyzed its account receivables balances at December 31, 2009, which revealed the following information:
- Between 0 - 15 days $100,000 of which 100% were collectible
- Between 16 - 30 days $ 70,000, 95% collectible
- Between 31 - 60 days $ 6,000, 90% collectible
- Over60 days $3,500, collectible $500.
LifeSavers, LLC should report in its December 31, 2009 Balance Sheet $1,000 for allowance for discounts. The reason is that only the receivables that have aged 0 - 15 days were eligible for the discount. The discount is computed using 50% of the dollar amount eligible , not 50% of the discount, because only 50% of the customers take advantage of the discount. The $1,000 allowance for discount is computed as follows:
Amount eligible for discount: $100,000 x 50% of customers that take discount = Amount of eligible amount taken $50,000 x 2% discount allowed = $1,000 Allowance for discount.
Payment systems will incorporate procedures that take advantage of cash discounts as a matter of routine and eliminate any need for special handling. All discount payments should be scheduled for issuance as close as possible to, but no later than, the last day of the discount period.