Final answer:
Cash discounts in a periodic inventory system should be recorded as a reduction in the cost of inventory. These discounts are taken to reduce purchase price when payment is made promptly, benefitting both the buyer and the seller by improving cash flow and reducing costs.
Step-by-step explanation:
In theory, the cash discounts allowed on purchased merchandise, also known as purchase discounts, in a periodic inventory system should be recorded as a reduction in the cost of inventory acquired. When a company takes advantage of a purchase discount, it is essentially reducing the purchase price of goods on the basis that payment is made within a specified discount period. This discount period is typically outlined by credit terms such as 2/10, n/30, where '2' represents a 2% discount if payment is made within 10 days, and 'n/30' signifies that the net amount is due within 30 days if the discount is not taken.
The discounted amount is accounted for by crediting the accounts payable and debiting the inventory for the discount taken. The main purpose of offering a cash discount is to incentivize prompt payment, thus improving cash flow for the seller and reducing inventory acquisition costs for the buyer. If the discount is not taken, the full price is recorded, and no changes are made to the inventory costs. It is crucial for businesses to track these discounts effectively as it impacts both the financial statements and inventory valuation in a periodic inventory system.