A cash discount is a reduction in the amount of an invoice that the seller allows the buyer. This discount is given in exchange for paying the invoice earlier than the normal payment date of the invoice. There are two reasons why the seller might make this offer:
- To obtain earlier use of cash, which may be necessary if the seller is short of cash; or
- To offer a discount for an immediate cash payment in order to entirely avoid the effort of billing the customer.
The amount of the cash discount is usually a percentage of the total amount of the invoice, but it is sometimes stated as a fixed amount.
The typical format in which cash discount terms are recorded on a invoice is:
[Percentage discount][If paid within xx days] / Net [normal number of payment days]
Thus, if the seller is offering a reduction of 2% of the amount of an invoice if it is paid within 10 days, or normal terms if paid within 30 days, this information would appear on the invoice in the following format:
2% 10 / Net 30
There are many variations on these cash discount terms, which tend to be standardized within industries.
To record a payment from the buyer to the seller that involves a cash discount, debit the cash account for the amount paid, debit a sales discounts expense account for the amount of the discount, and credit the account receivable for the full amount of the invoice being paid. For example, if the buyer is paying $980 on a $1,000 invoice, with the $20 difference being a cash discount for early payment, record a debit of $980 to the cash account, $20 to the sales discounts expense account, and a credit of $1,000 to the accounts receivable account.
A seller uses cash discounts if he wants faster access to cash from buyers, which may be critical if the seller has little cash on hand, or is simply trying to reduce his working capital investment in accounts receivable.
A buyer accepts a cash discount if doing so carries an implied interest rate that is higher than the buyer would otherwise earn on normal investments, and if there is sufficient cash available to do so.
A cash discount tends to be more favorable to the buyer than the seller, since the customary terms of cash discounts imply a very high interest rate. The formula for calculating this interest rate on a cash discount is:
Discount %/(100-Discount %) x (360/(Full Allowed Payment Days – Discount Days))
For example, ABC International is offering a cash discount under 1% 10 / Net 30 terms, which means that it allows its buyers to take a 1% discount if they pay within 10 days; otherwise, ABC expects them to pay the full amount of the invoice in 30 days. The calculation of the implied interest rate to ABC in this deal is:
(1%/99%) x (360/(30 Normal payment days - 10 Discount days) = 18.2% interest rate
This is a fairly high interest rate, and on discount terms that are not especially high. Consequently, offering a cash discount is not always a good idea for the seller, unless it is severely short of cash.
To make matters worse, some buyers pay late and still take the discount, so that the seller ends up offering an even higher implied interest rate. This can cause continual dickering between the parties, if the seller takes the position that the buyer did not take the discount under the terms offered on the invoice. The result may be disputed invoices that remain on the seller's books for quite some time.