Definition and Kinds.—A discount is a deduction from a listed or named figure. The manufacturer or wholesaler in making up his catalogue for the trade usually enters his products at certain prices—called “list prices”—which are not selling prices but only nominal amounts on which the actual sale prices are based. For reasons to be explained later, he offers buyers a deduction from list prices which is called “trade discount.” The usual quotation of sale prices is at so many per cent below the list prices.

Among practically all merchants it is a very common practice to bill goods to customers with settlement allowed on an optional basis. The goods may be billed “net,” i.e., the full amount shown in the invoice must be paid. Since there is a relationship between the time allowed for payment and the amount to be paid, most concerns have an established credit term, at the end of which they expect full settlement of the account, but, as an inducement for earlier payment, they offer a reduction in the amount to be paid. This is stated usually at so much per cent below the billed price, and is generally called “cash discount.” The practice had its origin in conditions prevailing at the close of the Civil War when business failures were numerous and the risk on open accounts even for short credit terms was very great.

Bankers when making loans usually deduct from the face of the loan the interest charge for the use of the money. This deduction is called “bank discount.”

Merchants usually allow a deduction for the prepayment of a customer’s note, and this is called “commercial discount,” to distinguish it from bank discount, although the two kinds of discount are essentially identical; the only difference being that in the one case a bank buys a merchant’s note, while in the other case it is a transaction between two commercial houses, the one buying back its own note before it is legally due.

Trade discounts are very seldom recorded on the books, the actual selling price and not the list price being entered. Cash discounts are invariably recorded. If the merchant knew at the time of the sale which optional basis of settlement the buyer would choose, he could record the transaction at a net figure on that basis without entering the discount portion. This would, of course, result in a varying figure at which sales were booked. Accordingly, the almost invariable practice is to record sales at the gross amount and show by means of the Sales Discount account the acceptance of any lesser sum in settlement in accordance with the sales contract. Bank discount has to be booked in order to show the cost of the loan which is the difference between the asset received, cash, and the asset parted with, notes. The matter of bank discount has been treated in some detail in Chapter XLII.

The Method and Purpose of Trade Discount.—Trade discounts are so universally met with in business that an extended discussion of them will be of value to the student. As has been stated, a trade discount is a deduction from the list price and it serves two purposes. It is apparent that the prices listed in the catalogue cannot be changed until a new catalogue is printed and that it would not be practicable to print a new catalogue to make a change in selling prices. Therefore, instead of reprinting the catalogue whenever market prices fluctuate and a change in the list prices must be made, sheets containing the discounts allowed from list prices are published, the expense of which is much less than that of a new catalogue.

The other purpose served by the trade discount is in partly concealing the real quotation. Without the rate of discount allowed from that list, the catalogue tells nothing of the real price. In this way a concern in publishing its catalogue does not lay itself open to the risk of being underbid by competitors publishing later catalogues.

Prices may be quoted at a single discount or by means of a series of discounts, each taking as its base the net amount left after deducting the next preceding discount. Examples will illustrate:

It is apparent that the list prices without the trade discounts tell nothing as to the real prices.

Methods of Calculation.—Short methods for calculating trade discounts when given in a series are often employed. For a series of only two discounts, a single rate equivalent to the two may be found by subtracting their product from their sum—always treating them as decimals. Thus a series of 20 and 20 is equivalent to a single rate of 36,

(.20 + .20 = .40; .20 × .20 = .04; .40 - .04 = .36).

Another method of calculating trade discounts, and one applicable to a series of any number of discounts, is to treat the discount off as equivalent to one-minus-the-discount on. Thus a discount of 15% is equivalent to 85% of the list. An additional discount of 10% is equivalent to 90% of the new base, or 90% of 85% of the original list, or 76.5%. Thus a continued multiplication of the “percentages on” gives the single sale price multiplier to be applied to the list price. If the single discount rate is desired, it is secured by subtracting the multiplier from 1, or 100%. Take the series 60, 20, 10, and 10 off. This is equivalent to 40, 80, 90, and 90 on, or 25.92% on

(.40 × .80 × .90 ×. 90 = .2592).

The single discount rate equivalent to the series is, therefore, 74.08% (100%-25.92% = 74.08%).

The order in which the discounts of a series are used is immaterial, as the order of the factors does not affect the product.

The method just illustrated develops the reason for the first special rule given above for a series of two discounts. Let the discounts be “a”% and “b”%. The “percentages on” are, therefore, (1 -a)% and (1-b)% whose product, algebraically, is 1- [(a + b)-ab], which is the single “percentage on”; from which it is readily seen that the single rate discount is a + b-ab, i.e., the sum of the two rates minus their product. Similar rules can be developed for longer series, but they are too complicated for easy application.

There is now available a “discolog” table, an ingenious reference table, which is operated somewhat like a logarithmic table. It gives quickly and easily the single discount rate equivalent to any series of discounts.

The chief value of the single rate equivalent to the discount series is in its use for comparative purposes, as it indicates which of two discount series is the more favorable. When a large number of selling prices must be computed, all having the same discount series, the single rate method of calculation also has a great advantage over the long method, which makes use of the series. This is true especially when the work is done with the use of a calculating machine.

The Nature of Cash Discount—Its Basic Elements.—Where goods are sold on credit with a cash discount offering, four main factors of cost, not incurred when goods are sold for cash, must be provided for. These are:

• 1. Credit investigation and collection expense.
• 2. Bookkeeping and billing expense.
• 3. Loss from uncollectible accounts.
• 4. Interest for the use of the money—credit.

The cash discount is offered to free the vendor especially from costs (3) and (4), which are the heaviest of the four.

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.

2. Entry is made as in method 1 above, but the discount column is used in finding the cash balance. Where, as sometimes happens, the net cash column is omitted, the true receipts can be found only by subtracting the amount of the discount from the other column totals.

The closing summary for the columnar cash book, explained in Chapter XIX, shows one method of handling the discount column total. While all other summary entries for the cash receipts are credits, the discount summary is a debit. Because of this fact, the discount total is sometimes shown on the disbursements side of the cash book among the summary entries of the other columns, in which case the word “contra” is written after the words “Sales Discount,” showing that the amount has come from the discount column on the opposite page. Similarly for the Purchases Discount.

The only advantage of this method is to bring all summary debit postings on one side of the cash book and all credits on the other. Where the cash book is operated according to method 2, the closing summaries are made as shown in Form 42, using columns on the debit side for Customers, Sales Discount, and Sundry; and on the credit side for Creditors, Purchases Discount, and Sundry. As there is no net cash column, the totals for Customers and Creditors are not all cash. To clear them of their non-cash elements, the discounts can be subtracted from their respective Customers’ and Creditors’ totals, and only the net brought over into the Sundry columns; or the subtraction can be effected by adding the discounts to the opposite side. The use of a Net Cash column simplifies the summarization of the cash book and should always be employed. Treatment 2 is shown only because it is sometimes met with in practice.

Securing Information as to Neglected Discounts.—Some accountants have pointed out the desirability of bringing before a manager or proprietor the cost of his failure to take advantage of discounts offered him. To show this cost the following method of entering a purchase has been suggested:

The net amount of the bill is thus charged to Purchases, the discount offered to Purchases Discount, and the Vendor is credited with the billed amount. When payment is made on any of the optional bases offered, entry is made as follows:

In the case of entry (1), the net result of the whole purchase transaction is a loss or expense of the amount in Purchases Discount, because of failure to take the discount. In entry (2), if the best option is taken, viz., the entire 5%, Purchases Discount shows no balance; any less favorable option, say 2%, results in a debit balance in Purchases Discount of 3%, measuring the expense incurred through failure to take the best option. Unquestionably, the information given a manager by this Purchases Discount debit balance will claim his notice and immediate attention.

A sales transaction handled on a similar basis results in a Sales Discount credit balance representing the excess of the offering of discounts over the amount taken by customers and has to be treated as income additional to the booked sales income.

Inasmuch as the sale or purchase, under this method, must be booked on a cash option basis, this treatment seems to result in a departure from true cost or in the mistake of booking only some of the elements which enter into the cost of merchandise. The price at which a merchant can sell his product must include all direct and indirect costs and provide a margin for profit. The sales discount offered is simply one of these indirect costs. It cannot be more accurately estimated than can the salesman’s salary which is a part of the sale price. It is inconsistent practice to separate the invoice price into two elements and term one real selling price and the other sales discount cost when the real selling price is still a composite item. Rather, the sale should be booked at its full invoiced price and actual costs recorded as they accrue, to be closed out against Sales Income at the end of the fiscal period.

After all, the sales policy of each concern enters largely into the determination of its normal selling price. A concern with a normal credit term of 30 days fixes its sale price on that basis; one with a 60-day credit term will, in determining its sale price, take into account the risk and interest costs of the longer credit period; and one doing a cash business will determine its sale price accordingly. However, as a means of furnishing the information necessary for guidance under a particular sales policy, sales should be recorded on the basis of the normal credit term.

To secure the information sought as to neglected discounts, it is suggested that memorandum accounts be opened for that purpose and entry be made of the expense only when incurred. Thus failure to take a purchase discount would be recorded under these or similar captions:

• Neglected Purchase Discounts
• Reserve for Neglected Purchase Discounts

At the time the books are closed these memorandum accounts would be closed against each other, having served their purpose of giving the desired information through their inclusion in the trial balance submitted to the manager or owner.

Trade Acceptances and Cash Discounts.—Brief mention should perhaps be made of some recent discussions of the probable effect of the extended use of trade acceptances on the practice of allowing cash discounts. Some sellers, to whom the cash discount practice is troublesome and unsatisfactory, welcome the use of trade acceptances as an avenue of escape from the practice. Others have gone so far as to say that the trade acceptance will eventually do away with cash discounts. It should be said that the use of trade acceptances, while attractive from the seller’s standpoint, has not as yet made a strong appeal to buyers, largely because of the fact that it offers little that the open account method does not secure for them and it may, on the other hand, interfere somewhat with the taking of cash discounts.