Many service providers and distributors give a certain percentage of price reduction in the invoice amount as an incentive. This is called a cash discount. In simple terms, a cash discount is an incentive offered by a seller to a buyer in exchange for paying a bill before the due date.
Types
It is critical to deduct trade discounts before computing the cash discount to calculate the amount to be paid or expected to be received. There are two sorts of cash discounts:
(i) Discount Allowed: This is a cash discount given to clients who pay their bills on time. It is reported as an expense since it represents the cost of rapidly collecting debts.
(ii) Discount Received: Suppliers’ cash discount for paying early. It is shown as a source of income since it represents the benefit of paying off obligations ahead of schedule.
Calculation
The cash discount is typically expressed as a percentage of the entire invoice amount but can also be expressed as a fixed value. The following is a typical format for recording cash discount terms on an invoice:
[Discount percentage]
Net [if paid within x days] [usual amount of days for payment]
If a supplier offers a 2% discount if an invoice is paid within ten days, or normal terms if paid within 30 days, this information would show on the invoice as follows:
2 % 10 % / net 30
These cash discount terms come in various shapes and sizes, but they tend to be standardised within businesses.
Equation
Assets = Liabilities + Owners Equity is an accounting equation that states that the overall assets of a company are always equal to the total liabilities plus the company’s equity at any moment and for any transaction. The accounting equation for this transaction is shown in the table below.
Formula
A cash discount has a straightforward formula. It is as follows:
Purchase price * discount rate Equals cash discount.
The discount rate can be stated as a decimal figure or percentage. The discount rate, for example, can be stated as 2 per cent or.02. The formula is CD = P*R, where CD denotes the cash discount, P denotes the price, and R denotes the discount rate represented as a decimal.
Advantages and disadvantages of cash discount
Advantages
Encourage debtors to pay on time, which reduces the likelihood of bad debts developing
As a result of the shorter time frame, cash will be available sooner in the trade cycle
Cash discounts may enhance sales because new clients will be attracted to the firm’s cash discount programme.
Disadvantages
As a result of the cash discounts granted, debtors’ cash inflows are reduced.
Discount expenses are charged to profits, affecting net profits.
Cash discount- Methods
Ordinary dating
A credit term of [2/10, n/30] suggests that if you settle your account within ten days, you will receive a 2% discount. In other words, if you pay within ten days of the invoice date, you will receive a 2% discount. It also means that you must pay the bill within 30 days of receiving it to avoid incurring interest costs.
Taking a cash account
A buyer will accept a cash discount if the indicated interest rate is larger than what the buyer would receive on typical investments and provided the buyer has sufficient cash on hand. Because the normal terms of cash discounts imply a relatively high-interest rate, a cash discount favours the buyer over the seller. This interest rate on a cash discount is calculated using the following formula:
Discount % ÷ (100-Discount %) x (360 ÷ (Full Allowed Payment Days – Discount Days)
ABC International, for example, offers a cash discount under 1 per cent 10 / Net 30 terms, which means that purchasers can get a 1% discount provided they pay within ten days; otherwise, ABC expects them to pay the full price.
It is a rather high-interest rate, even if the discount terms aren’t particularly favourable. As a result, unless the seller needs cash, offering a cash discount is not usually a wise option. To make matters worse, some purchasers pay late but still accept the discount, causing the seller to give a higher implied interest rate.
If the seller claims that the buyer did not accept the reduction under the terms stated on the invoice, this might lead to a lot of back-and-forth between the parties. As a result, disputed invoices may be on the seller’s books for an extended period. It is an additional expense of doing business with a customer that should be considered before deciding.
Conclusion
A supplier may offer a cash discount to encourage clients to pay within a specified time frame. Customers can choose whether to take advantage of the cash discount by paying promptly or to pay later without the cash discount. When products are traded with the possibility of a cash discount, the buy or sales price is always recorded net of the trade discount, but at a pre-cash discount.
