A note on the calculation of the effective annual rate for cash discounts

Abstract

This note describes an inconsistency, which has gone unnoticed for a number of years, between theoretical discussions of effective interest and the nature of cash discounts and the typical calculation of the effective annual rate for cash discounts presented in intermediate accounting textbooks. These calculations understate the effective rate because the amount presumed “borrowed” is the gross purchase price rather than the theoretically correct net purchase price. As educators, our arguments and problem solutions should be logically consistent and should convey a thorough understanding of the underlying theoretical constructs and their applications.