Question

Shawnee Corp., a household appliances dealer, purchases its inventories from various suppliers. Shawnee has consistently stated its inventories at FIFO cost.

Instructions

Shawnee is considering alternate methods of accounting for the cash discounts it takes when paying its suppliers promptly.From a theoretical standpoint, discuss the acceptability of each of the following methods.

(a) Financial income when payments are made.

(b) Reduction of cost of goods sold for the period when payments are made.

(c) Direct reduction of the purchase cost.

Short answer

a) Acceptable

b) Not acceptable

c) Note acceptable

Step-by-step solution

Step1: Financial income when payments are made

A cash discount is like an income for the business. It is earned when obligations are paid off. So this is an acceptable way of recording the cash discount received.

Step 2: Reduction of cost of goods sold for the period when payments are made.

This is not an acceptable way of recognizing the cash discount. A cash discount is received on the selling price and is earned when the obligation is paid. On the other hand cost of goods sold is based on inventory acquisition costs. So this is not a GAAP-acceptable practice.

Step 3: Direct reduction of the purchase cost.

This is also not an acceptable method. Cash discounts are received on the selling price. In contrast, the purchase cost is incurred at the time of purchasing goods. So the income earned is not matched with the expense incurred.