## **Learning Outcomes**

After reading this article, you will be able to explain the purpose of credit policies in managing receivables and payables, describe how credit terms are set and their implications for cash flow, distinguish between trade and settlement discounts, and account correctly for early payment incentives. You will also be able to assess the costs and benefits of offering or taking credit and settlement discounts for both buyers and sellers.

## **ACCA Foundations in Financial Management (FFM) Syllabus**

For ACCA Foundations in Financial Management (FFM), you are required to understand the principles and accounting for managing trade receivables and payables, especially relating to credit control and discounts. Revision focus for this topic includes:

- The objectives and structure of a credit policy for receivables and payables
- The commercial and financial implications of different credit terms
- The recognition, calculation, and accounting for trade and early settlement (cash) discounts
- Evaluating the cost and benefit of offering or using early settlement discounts from both supplier and customer standpoints
- The impact of credit management practices on cash flow and profitability
- Basic journal entries and ledger movements for recording discounts and payments

## **Test Your Knowledge**

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision._

1. What is the main financial advantage for a seller in offering a cash (early settlement) discount to customers?
   a) Increases reported sales
   b) Improves liquidity through quicker cash receipts
   c) Reduces administrative workload
   d) Avoids the need for credit checks

2. Zeke Ltd trades on credit and offers customers terms of "2/10, net 30". How much should a customer expect to pay on a \$1,000 invoice if they settle in 8 days?
   a) \$1,000
   b) \$980
   c) \$1,020
   d) \$990

3. True or false? A trade discount is typically recorded separately in the accounting ledgers.

4. Briefly explain when an early settlement discount is recognized by the seller in the financial statements.

5. What is the accounting entry for a supplier when a customer pays early and claims a settlement discount?

## **Introduction**

Efficient management of receivables and payables is critical for sustaining good cash flow and controlling credit risk. Central to this are the credit policies adopted by a business and the terms set for payment. Both trade discounts and early settlement discounts can influence customer and supplier behavior. Understanding these mechanisms—and accounting for them correctly—is essential for sound financial management and for assessment in the ACCA FFM exam.

> **Key Term: credit policy**
> The documented approach and rules a business follows for granting credit to customers or obtaining credit from suppliers, including limits, terms, and collection procedures.
>
> **Key Term: credit terms**
> The specific details governing when payment for a sale or purchase is due, including the length of the credit period and any incentives such as discounts for early settlement.
>
> **Key Term: trade discount**
> A reduction from the list price given at the point of sale, typically for bulk purchasing or preferred customers, deducted before invoicing and not shown separately in the accounting records.
>
> **Key Term: settlement discount**
> A percentage reduction allowed by the seller if the buyer pays within a specified shorter period, commonly known as an early payment or cash discount, recognized when taken up.

## **Receivables and Payables: Managing Credit**

Both selling on credit and buying on credit are standard business practices, but they require careful management to control risk and support cash flow.

### Receivables–Credit to Customers

Granting credit allows customers to pay after delivery of goods or services. A formal credit policy sets out:

- The maximum credit period (e.g., 30 days, 60 days)
- Credit limits for each customer
- Procedures for assessing creditworthiness
- Actions for overdue accounts

Delaying cash collection ties up working capital and increases the risk of bad debts. However, offering longer credit may attract more customers.

### Payables–Credit from Suppliers

Obtaining credit from suppliers enables a business to delay outflows of cash without immediate payment. The supplier’s credit terms typically specify when payment is due and whether early payment will result in a reduction.

### The Importance of Credit Terms

Credit terms are normally expressed as, for example, "30 days net" or "2/10, net 30", the latter meaning a 2% discount is available if payment is made within 10 days; otherwise, payment is due in 30 days. Both parties must evaluate the financial impact of the terms.

> **Key Term: accounts receivable (trade receivables)**
> Balances owed to the business by customers who have taken goods or services on agreed credit terms.
>
> **Key Term: accounts payable (trade payables)**
> Amounts owed by the business to suppliers for purchases made on credit.

### **Worked Example 1.1**

Shares Ltd sells goods worth \$5,000 to Alpha Co on 1 May. The invoice terms are "2/10, net 30". Alpha pays the invoice on 7 May.

**What amount will Alpha Co pay, and how does Shares Ltd record the early settlement?**

> **Answer:**
> Alpha pays within 10 days and is entitled to a 2% discount:
>
> \$5,000 × 2% = \$100 discount
> Amount paid = \$5,000 – \$100 = \$4,900.
>
> Shares Ltd’s journal on receipt:
>
> Dr Bank \$4,900  
> Dr Settlement discount allowed \$100  
> Cr Accounts receivable \$5,000

## **Trade and Settlement Discounts**

### Trade Discounts

A trade discount is typically given to certain customers, such as bulk buyers or loyal clients. It is deducted at the point of sale and does not appear separately in the accounting ledgers—the invoice is raised for the net amount.

### Settlement (Early Payment) Discounts

Settlement discounts encourage customers to pay sooner. The advantage for the seller is earlier receipt of cash and reduced risk of non-payment. For the buyer, it offers a cost saving, though it may affect their cash flow.

#### Accounting for Settlement Discounts

Settlement discounts (unlike trade discounts) are not certain at the time of sale. Revenue is recognized for the amount expected to be received. When the customer pays within the discount period, the discount allowed is recognized by the seller.

> **Key Term: discount allowed**
> An expense for the seller, representing reduction in receivables when a customer pays early under settlement discount terms.
>
> **Key Term: discount received**
> Income for the purchaser, reflecting the reduction in the amount paid to suppliers when early payment terms are met.

### **Worked Example 1.2**

Bella Enterprises receives an invoice for \$2,000 from a supplier with terms "3/15, net 45". Bella pays on day 12.

**How should Bella record the payment and discount received?**

> **Answer:**
> 3% discount = \$60.
> Payment = \$2,000 – \$60 = \$1,940.
>
> Journal entry:
>
> Dr Accounts payable \$2,000  
> Cr Bank \$1,940  
> Cr Discount received (income) \$60

### **Exam Warning**

> Settlement (early payment) discounts are only entered in the accounts _when actually taken up_. Do not recognize them at the time of sale unless payment is certain within the period.

## **Evaluating Credit and Settlement Discounts**

A business needs to weigh:

- The potential sales increase from longer credit or offering settlement discounts
- The risk of cash flow shortages if too much credit is extended
- The likely improvement in liquidity from encouraging faster payment

For the customer, deciding whether to pay early depends on the effective annual rate of return from taking up a settlement discount—a significant financial consideration.

### **Worked Example 1.3**

Delta Ltd offers "1.5/10, net 30" to its customers. A client can borrow at 12% annual interest if needed. Should the client take up the discount?

> **Answer:**
> Settlement discount over 20 days: 1.5%
> On an annualized basis: (1.5% / 20) × 365 ≈ 27.4%
> Since the effective interest saved by paying early exceeds the 12% borrowing cost, the client should pay early and take the discount.

### **Revision Tip**

> Always distinguish between trade discounts (deducted before invoicing) and settlement discounts (recorded only if taken).

## **Summary**

Effective credit management balances increased sales and customer loyalty against the need for timely cash inflows and the risk of bad debts. Trade discounts lower prices for select customers, while settlement discounts incentivize rapid payment. Properly accounting for these discounts is essential for accurate financial reporting and analysis.

## **Key Point Checklist**

_This article has covered the following key knowledge points:_

- The role and main features of a credit policy in managing receivables and payables
- How credit terms (including payment periods and discount offers) affect financial performance
- The differences between trade discounts and settlement discounts, and their recognition in accounts
- Appropriate accounting entries for settlement discounts allowed and received
- How to evaluate the cost-benefit of offering or using settlement discounts

## **Key Terms and Concepts**

- credit policy
- credit terms
- trade discount
- settlement discount
- accounts receivable (trade receivables)
- accounts payable (trade payables)
- discount allowed
- discount received

Receivables and payables management - Credit policy, terms, and early settlement discounts