accruals
Liabilities for services received
for which payment has yet to be
made.
640 PART 5 Short-Term Financial Decisions
stretching accounts payable
Paying bills as late as possible
without damaging the firm’s
credit rating.
Effects of Stretching Accounts Payable
A strategy that is often employed by a firm is stretching accounts payable—that
is, paying bills as late as possible without damaging its credit rating. Such a strat-
egy can reduce the cost of giving up a cash discount.EXAMPLE Lawrence Industries was extended credit terms of 2/10 net 30 EOM. The cost of
giving up the cash discount, assuming payment on the last day of the credit
period, was found to be approximately 36% [2%(36020)]. If the firm were
able to stretch its account payable to 70 days without damaging its credit rating,
the cost of giving up the cash discount would be only 12% [2%(36060)].
Stretching accounts payable reduces the implicit cost of giving up a cash discount.Although stretching accounts payable may be financially attractive, it raises
an important ethical issue: It may cause the firm to violate the agreement it
entered into with its supplier when it purchased merchandise. Clearly, a supplier
would not look kindly on a customer who regularly and purposely postponed
paying for purchases.Accruals
The second spontaneous source of short-term business financing is accruals.
Accrualsare liabilities for services received for which payment has yet to be
made. The most common items accrued by a firm are wages and taxes. Because
taxes are payments to the government, their accrual cannot be manipulated by
the firm. However, the accrual of wages can be manipulated to some extent. This
is accomplished by delaying payment of wages, thereby receiving an interest-free
loan from employees who are paid sometime after they have performed the work.
The pay period for employees who earn an hourly rate is often governed by union
regulations or by state or federal law. However, in other cases, the frequency of
payment is at the discretion of the company’s management.EXAMPLE Tenney Company, a large janitorial service company, currently pays its employ-
ees at the end of each work week. The weekly payroll totals $400,000. If the firm
were to extend the pay period so as to pay its employees 1 week later throughout
an entire year, the employees would in effect be lending the firm $400,000 for a
year. If the firm could earn 10% annually on invested funds, such a strategy
would be worth $40,000 per year (0.10$400,000).Review Questions
15–1 What are the two major sources of spontaneous short-term financing for a
firm? How do their balances behave relative to the firm’s sales?
15–2 Is there a cost associated with taking a cash discount?Is there any cost
associated with giving up a cash discount?How do short-term borrowing
costs affect the cash discount decision?
15–3 What is “stretching accounts payable”? What effect does this action have
on the cost of giving up a cash discount?