Physical Quantities Included in Inventory
Regardless of the system used, the measurement of inventory and cost of goods sold starts with determining the physical quantities of goods. Typically, determining the physical quantity that should be included in inventory is a simple matter because it consists of items in the possession of the company. However, in some situations the identification of items that should be included in inventory is more difficult. Consider, for example, goods in transit, goods on consignment, and sales returns.
GOODS IN TRANSIT. At the end of a reporting period, it's important to ensure a proper inventory cutoff. This means determining the ownership of goods that are in transit between the company and its customers as well as between the company and its suppliers. For example, in December 2011, the Lothridge Wholesale Beverage Company sold goods to the Jabbar Company. The goods were shipped on December 29, 2011, and arrived at Jabbar's warehouse on January 3, 2012. The fiscal year-end for both companies is December 31.
Should the merchandise shipped to Jabbar be recorded as a sale by Lothridge and a purchase by Jabbar in 2011 and thus included in Jabbar's 2011 ending inventory? Should recording the sale/purchase be delayed until 2012 and the merchandise be included in Lothridge's 2011 ending inventory? The answer depends on who owns the goods at December 31. Ownership depends on the terms of the agreement between the two companies. If the goods are shipped f.o.b. (free on board) shipping point legal title to the goods changes hands at the point of shipment when the seller delivers the goods to the common carrier, and the purchaser is responsible for shipping costs and transit insurance., then legal title to the goods changes hands at the point of shipment when the seller delivers the goods to the common carrier (for example, a trucking company), and the purchaser is responsible for shipping costs and transit insurance. In that case, Lothridge records the sale and inventory reduction in 2011 and Jabbar records a 2011 purchase and includes the goods in 2011 ending inventory even though the company is not in physical possession of the goods on the last day of the fiscal year.
Inventory shipped f.o.b. shipping point is included in the purchaser’s inventory as soon as the merchandise is shipped.
On the other hand, if the goods are shipped f.o.b. destination the seller is responsible for shipping and the legal title does not pass until the goods arrive at their destination., the seller is responsible for shipping and legal title does not pass until the goods arrive at their destination (the customer's location). In our example, if the goods are shipped f.o.b. destination, Lothridge includes the merchandise in its 2011 ending inventory and the sale is recorded in 2012. Jabbar records the purchase in 2012.
GOODS ON CONSIGNMENT. Sometimes a company arranges for another company to sell its product under consignment the consignor physically transfers the goods to the other company (the consignee), but the consignor retains legal title.. The goods are physically transferred to the other company (the consignee), but the transferor (consignor) retains legal title. If the consignee can't find a buyer, the goods are returned to the consignor. If a buyer is found, the consignee remits the selling price (less commission and approved expenses) to the consignor.
Inventory shipped f.o.b. destination is included in the purchaser’s inventory only after it reaches the purchaser’s destination.
As we discussed in Chapter 5, because risk is retained by the consignor, the sale is not complete (revenue is not recognized) until an eventual sale to a third party occurs. As a result, goods held on consignment generally are not included in the consignee's inventory. While in stock, they belong to the consignor and should be included in inventory of the consignor even though not in the company's physical possession. A sale is recorded by the consignor only when the goods are sold by the consignee and title passes to the customer.
Goods held on consignment are included in the inventory of the consignor until sold by the consignee.
SALES RETURNS. Recall from our discussions in Chapters 5 and 7 that when the right of return exists, a seller must be able to estimate those returns before revenue can be recognized. The adjusting entry for estimated sales returns reduces sales revenue and accounts receivable. At the same time, cost of goods sold is reduced and inventory is increased (see Illustration 7-2 on page 345). As a result, a company includes in inventory the cost of merchandise it anticipates will be returned.
Now that we've considered which goods are part of inventory, let's examine the types of costs that should be associated with those inventory quantities.
Expenditures Included in Inventory
As mentioned earlier, the cost of inventory includes all necessary expenditures to acquire the inventory and bring it to its desired condition and location for sale or for use in the manufacturing process. Obviously, the cost includes the purchase price of the goods. But usually the cost of acquiring inventory also includes freight charges on incoming goods borne by the buyer; insurance costs incurred by the buyer while the goods are in transit (if shipped f.o.b. shipping point); and the costs of unloading, unpacking, and preparing merchandise inventory for sale or raw materials inventory for use.3 The costs included in inventory are called product costs costs associated with products and expensed as cost of goods sold only when the related products are sold.. They are associated with products and expensed as cost of goods sold only when the related products are sold.4
Expenditures necessary to bring inventory to its condition and location for sale or use are included in its cost.
Shipping charges on outgoing goods (freight-out) are reported in the income statement either as part of cost of goods sold or as an operating expense, usually among selling expenses. If a company adopts a policy of not including shipping charges in cost of goods sold, both the amounts incurred during the period as well as the income statement classification of the expense must be disclosed.5
Shipping charges on outgoing goods are reported either as part of cost of goods sold or as an operating expense, usually among selling expenses.
FREIGHT-IN ON PURCHASES. Freight-in on purchases is commonly included in the cost of inventory. These costs clearly are necessary to get the inventory in location for sale or use and can generally be associated with particular goods. Freight costs are added to the inventory account in a perpetual system. In a periodic system, freight costs generally are added to a temporary account called freight-in transportation-in; in a periodic system, freight costs generally are added to this temporary account, which is added to purchases in determining net purchases. or transportation-in, which is added to purchases in determining net purchases. The account is closed to cost of goods sold along with purchases and other components of cost of goods sold at the end of the reporting period. (See Illustration 8-4 on page 403.) From an accounting system perspective, freight-in also could be added to the purchases account. From a control perspective, by recording freight-in as a separate item, management can more easily track its freight costs. The same perspectives pertain to purchases returns and purchase discounts, which are discussed next.
The cost of freight-in paid by the purchaser generally is part of the cost of inventory.
PURCHASE RETURNS. In Chapter 7 we discussed merchandise returns from the perspective of the selling company. We now address returns from the buyer's point of view. You may recall that the seller views a return as a reduction of net sales. Likewise, a buyer views a return as a reduction of net purchases. When the buyer returns goods to the seller, a purchase return a reduction in both inventory and accounts payable (if the account has not yet been paid) at the time of the return. is recorded. In a perpetual inventory system, this means a reduction in both inventory and accounts payable (if the account has not yet been paid) at the time of the return. In a periodic system an account called purchase returns temporarily accumulates these amounts. Purchase returns are subtracted from purchases when determining net purchases. The account is closed to cost of goods sold at the end of the reporting period.
A purchase return represents a reduction of net purchases.
PURCHASE DISCOUNTS. Cash discounts also were discussed from the seller's perspective in Chapter 7. These discounts really are quick-payment discounts because they represent reductions in the amount to be paid by the buyer in the event payment is made within a specified period of time. The amount of the discount and the time period within which it's available are conveyed by terms like 2/10, n/30 (meaning a 2% discount if paid within 10 days, otherwise full payment within 30 days). As with the seller, the purchaser can record these purchase discounts reductions in the amount to be paid if remittance is made within a designated period of time. using either the gross method For the buyer, views a discount not taken as part of the cost of inventory. For the seller, views a discount not taken by the customer as part of sales of revenue. or the net method For the buyer, considers the cost of inventory to include the net, after-discount amount, and any discounts not taken are reported as interest expense. For the seller, considers sales revenue to be the net amount, after discount, and any discounts not taken by the customer as interest revenue.. Consider Illustration 8-3 which is similar to the cash discount illustration in Chapter 7.
Purchase discounts represent reductions in the amount to be paid if remittance is made within a designated period of time.
By either method, net purchases is reduced by discounts taken.Discounts not taken are included as purchases using the gross method and as interest expense using the net method.
On October 5, 2011, the Lothridge Wholesale Beverage Company purchased merchandise at a price of $20,000. The repayment terms are stated as 2/10, n/30. Lothridge paid $13,720 ($14,000 less the 2% cash discount) on October 14 and the remaining balance of $6,000 on November 4. Lothridge employs a periodic inventory system.
The gross and net methods of recording the purchase and cash payment are compared as follows:
*The inventory account is used in a perpetual system.
Conceptually, the gross method views a discount not taken as part of the cost of inventory. The net method considers the cost of inventory to include the net, after-discount amount, and any discounts not taken are reported as interest expense.6 The discount is viewed as compensation to the seller for providing financing to the buyer.
The gross method views discounts not taken as part of inventory cost.
Purchase discounts recorded under the gross method are subtracted from purchases when determining net purchases. The account is a temporary account that is closed to cost of goods sold at the end of the reporting period. Under the perpetual inventory system, purchase discounts are treated as a reduction in the inventory account.
The net method considers discounts not taken as interest expense.
The effect on the financial statements of the difference between the two methods usually is immaterial. Net income over time will be the same using either method. There will, however, be a difference in gross profit between the two methods equal to the amount of discounts not taken. In the preceding illustration, $120 in discounts not taken is included as interest expense using the net method and cost of goods sold using the gross method.
Illustration 8-4 compares the perpetual and periodic inventory systems, using the net method.
Inventory Transactions—Perpetual and Periodic Systems
The Lothridge Wholesale Beverage Company purchases soft drinks from producers and then sells them to retailers. The company began 2011 with merchandise inventory of $120,000 on hand. During 2011 additional merchandise is purchased on account at a cost of $600,000. Lothridge's suppliers offer credit terms of 2/10, n/30. All discounts were taken. Lothridge uses the net method to record purchase discounts. All purchases are made f.o.b. shipping point. Freight charges paid by Lothridge totaled $16,000. Merchandise with a net of discount cost of $20,000 was returned to suppliers for credit. Sales for the year, all on account, totaled $830,000. The cost of the soft drinks sold is $550,000. $154,000 of inventory remained on hand at the end of 2011.
The above transactions are recorded in summary form according to both the perpetual and periodic inventory systems as follows:
3 Generally accepted accounting principles require that abnormal amounts of certain costs be recognized as current period expenses rather than being included in the cost of inventory, specifically idle facility costs, freight, handling costs, and waste materials (spoilage). FASB ASC 330–10–30: Inventory–Overall–Initial Measurement (previously “Inventory Costs—An Amendment of ARB No. 43,, Chapter 4” Statement of Financial Accounting Standards No. 151 (Norwalk, Conn.: FASB, 2004)).
4 For practical reasons, though, some of these expenditures often are not included in inventory cost and are treated as period costs. They often are immaterial or it is impractical to associate the expenditures with particular units of inventory (for example, unloading and unpacking costs). Period costs are not associated with products and are expensed in the period incurred.
5FASB ASC 605–45–50–2: Revenue Recognition–Principal Agent Considerations–Disclosure–Shipping and Handling Fees and Costs (previously “Accounting for Shipping and Handling Fees and Costs,” EITF Issue No. 00–10 (Norwalk, Conn.: FASB, 2000) par. 6).
6 An alternative treatment is to debit an expense account called purchase discounts lost rather than interest expense. This enables a company to more easily identify the forgone discounts.