Inventory accounting is an important topic with complex issues that can causes confusion even to well-experienced accountants. But in this post, I focus on the most basic issue which is often overlooked; proper inventory ownerships. There are four issues that may cause confusion about proper inventory ownership: (1) goods in transit; (2) consignment sales; (3) product financing arrangements; and (4) sales with right to return given to customers, which are discussed, with case examples, on this post.
In spite of complexities an accountant may face in recognizing-classifying-measuring company’s inventory, the only matter financial statement’s users concern about is whether or not the inventory numbers, on the balance sheet, is correct (accurate).
From the accountant point of view, the question probably is: what point in time should inventory items be included in (through purchases) and excluded of (through sales) the company’s ownership?
IAS 2 defines inventories as items that are
“held for sale in the ordinary course of business; in the process of production for such sale; or in the form of materials or supplies to be consumed in the production process or in the rendering of services.”
In general, a company should record purchases and sales of inventory when legal title passes. For accounting purposes, it is necessary to determine when title has passed—so that you’re able to obtain an accurate measurement of inventory quantity and corresponding monetary representation of inventory and cost of goods sold in the financial statements.
If you think that everything in the company’s warehouse/storage is inventory belong to the company—thus should be recognized on company’s book—you are probably right but can be wrong too. “Why?” You may ask.
- Today, a loyal customer couldn’t afford to loose the chance of buying your new hot product but she has no more space to store the product at her own shop. So, she purchased your product, eventually paid you right away, and asked you favor to not ship the product yet, until a week later. Who own the inventory?
- Another case; you just shipped 50 pairs of hand-crochet gloves out to a store belong to your friend, today. You will get payment for any gloves sold later on and your friend get 20 percent commission of it. Who own the 50 pairs gloves?
Instead of a company owner, you are an accountant who works for the company; how would you treat such inventory situations?
Inventory Ownership Issue#1. Goods in Transit
Simply put; “goods in transit” are goods being shipped from seller to buyer at year-end.
At year-end, any goods in transit from seller to buyer may properly be includable in one, and only one, of those parties’ inventories—based on the terms and conditions of the sale.
Under traditional legal and accounting interpretation, goods are included in the inventory of the firm financially responsible for transportation costs. This responsibility may be indicated by shipping terms such as ‘free on board’ (FOB), ‘free alongside’ (FAS), ‘cost-insurance-freight’ (CIF), ‘cost-and-freight’ (C&F).
Let us talk about this one-by-one. Read on…
(a) FOB Term – The term FOB can come in two ways:
- FOB shipping point – Transportation costs are paid by the buyer and title passes when the carrier takes possession; thus these goods are part of the buyer’s inventory while in transit.
- FOB destination – transportation costs are paid by the seller and title does not pass until the carrier delivers the goods to the buyer; thus these goods are part of the seller’s inventory while in transit.
[Info_Box] If an FOB destination (or FOB shipping point) indicates a specific location at which title to the goods is transferred, such as “FOB California,” this means that the seller retains title and risk of loss until the goods are delivered to a common carrier in California who will act as an agent for the buyer.[/Info_Box]
(b) FAS Term – A sale transaction with FAS (free alongside) terms means the seller—who ships—must bear all expense and risk involved in delivering the goods to the dock next to (alongside) the vessel on which they are to be shipped. The buyer bears the cost of loading and of shipment; thus title passes when the carrier takes possession of the goods.
(c) CIF Term – In a CIF (cost, insurance, and freight) contract the buyer agrees to pay in a lump sum the cost of the goods, insurance costs, and freight charges. In a C&F contract, the buyer promises to pay a lump sum that includes the cost of the goods and all freight charges. In either case, the seller must deliver the goods to the carrier and pay the costs of loading; thus both title and risk of loss pass to the buyer upon delivery of the goods to the carrier.
(d) C&F Term – As same as the CIF term, except that it is without insurance premium coverage by the seller.
Keep in mind that these are meant only to define normal terms and usage; actual contractual arrangements between a given buyer and a given seller can vary widely. The accounting treatment, however, should in all cases strive to mirror the substance of the legal terms established between the parties.
For the sake of making it into more practical manner, let us construct a case example
Accounting for Goods in Transit Case Example
The Lie Dharma Apparel Inc is located in Costa Mesa, California, and obtains winter clothes from a supplier in Singapore. The delivery term is free alongside (FAS) a container ship in the harbor in Singapore, so that Lie Dharma Apparel takes legal title to the delivery once possession of the goods is taken by the carrier’s dockside employees for the purpose of loading the goods on board the ship. When the supplier delivers goods with an invoiced value of $250,000 to the wharf, it e-mails an advance shipping notice and invoice to Lie Dharma Apparel via an electronic data interchange (EDI) transaction, itemizing the contents of the delivery.
Lie Dharma’s computer system receives the EDI transmission, notes the FAS terms in the supplier file, and therefore automatically logs it into the company computer system with the following entry:
[Debit]. Inventory = $250,000
[Credit]. Accounts payable = $250,000
The goods are assigned an “In Transit” location code in Lie Dharma’s perpetual inventory system. When the clothes delivery eventually arrives at Lie Dharma’s receiving dock, the receiving staff records a change in inventory location code from “In Transit” to a code designating a physical location within the warehouse, CA for example.
[Info_Box]An overland shipping contract usually uses FOB term, since it takes such short time until the inventory is actually arrived at the buyer’s shipping dock. For such term a buyer only records inventories when inventory is received.[/Info_Box]
Inventory Ownership Issue#2. Consignment Sales
“Consignment” is defined as a marketing method in which the consignor ships goods to the consignee, who acts as an agent for the consignor in selling the goods. The inventory remains the property of the consignor until sold by the consignee.
In consignments, the consignor (seller) ships goods to the consignee (buyer), which acts as the agent of the consignor in trying to sell the goods, and get payment for every merchandizes (inventories) sold. On other hand, the consignee receives a commission. In other words, the consignee “purchases” the goods simultaneously with the sale of the goods to the final customer.
Goods out on consignment are included in the inventory of the consignor and excluded from the inventory of the consignee—thus, until they are actually sold to end customers.
A disclosure may be required of the consignee, however, since common financial analytical inferences, such as days’ sales in inventory or inventory turnover, may appear distorted unless the financial statement users are informed.
Consignment Transaction Case Example
The Lie Dharma Inc ships a consignment of its kids wear clothes to a retail outlet of the Kidz Store Inc. Lie Dharma’s cost of the consigned goods is $3,700, Lie Dharma shifts the inventory cost into a separate inventory account to track the physical location of the goods. The entry follows:
[Debit]. Consignment Out Inventory – Kidz Store Inc. = $3,700
[Credit]. Finished Goods Inventory = $3,700
A third-party shipping company ships the clothes inventory from Random Gadget to Kidz Store. Upon receipt of an invoice for this $550 shipping expense, Lie Dharma charges the cost to consignment inventory with the following entry:
[Debit]. Consignment out inventory – Shipping = $550
[Credit]. Accounts payable = $550
(To record the cost of shipping goods from Lie Dharma’s warehouse to Kids Store)
Kidz Store sells half the consigned inventory during the month for $2,750 in credit card payments, and earns a 22% commission on these sales, totaling $605. According to the consignment arrangement, Lie Dharma must also reimburse Kidz Store for the 2% credit card processing fee, which is $55 (=$2,750 × 2%).
The results of the sale, on Lie Dharma’s book, are summarized as follows:
Sales price to Kidz Store’s customer earned on behalf of Lie Dharma = $2,750
Less: Amounts due to Kidz Store in accordance with arrangement 22% sales commission = $605
Less Reimbursement for credit card processing fee = $55
Due to Lie Dharma = $2,090
Upon receipt of the monthly sales report from Kidz Store, Lie Dharma records the following entries:
[Debit]. Accounts receivable = $2,090
[Debit]. Cost of goods sold = $55
[Debit]. Commission expense = $605
[Credit]. Sales = 2,750
(To record the sale made by Kidz Store acting as agent of Lie Dharma, the commission earned by Kidz Store and the credit card fee reimbursement earned by Kidz Store in connection with the sale)
[Debit]. Cost of goods sold = $2,125
[Credit]. Consignment out inventory = $2,125
(To transfer the related inventory cost to cost of goods sold, including half the original inventory cost and half the cost of the shipment to Kidz Store [($3,700 + $550= $4,250) × ½ =$2,125])
Inventory Ownership Issue#3. Product Financing Arrangements
Simply put; product financing arrangement is an arrangement whereby a company buys inventory for another company that agrees to purchase the inventory over a certain period at specified prices which include handling and financing costs.
Alternatively, a company can buy inventory from another company with the understanding that the seller will repurchase the goods at the original price plus defined storage and financing costs.
How does a product financing arrangement work? What is the accounting treatment?
You can read other post of mine, in accounting topic, which specifically address the issue, with more detail explanation and case examples: Accounting for Product Financing Arrangements
Inventory Ownership Issue#4. Right to Return Purchases
A related inventory accounting issue that requires special consideration is the situation that exists when the buyer holds the right to return the merchandise acquired.
Keep in mind that it is not meant to address the normal sales terms found throughout commercial transactions—where buyer can return goods—whether found to be defective or not, within a short time after delivery, such as five days. Rather, this connotes situations where the return privileges are well in excess of standard practice, so as to place doubt on the veracity of the purported sale transaction itself.
When the buyer has the right to rescind the transaction under defined conditions and the seller cannot, with reasonable confidence, estimate the likelihood of this occurrence, the retention of significant risks of ownership makes this transaction not a sale, according to IAS 18.
The US GAAP, particularly FAS 48 (“Revenue Recognition When Right of Return Exists“) usefully elaborates on this situation and provides additional insight.
Under both standards:
- The sale is to be recorded if the future amount of the returns can reasonably be estimated.
- If the ability to make a reasonable estimate is precluded, the sale is not to be recorded until further returns are unlikely.
- Although legal title has passed to the buyer, the seller must continue to include the goods in its measurement and valuation of inventory.
In some situations, a “side agreement” may grant the nominal customer greatly expanded or even unlimited return privileges, when the formal sales documents (air way bill, bill of sale, bill of lading, etc.) make no such reference. These situations would be highly suggestive of financial reporting irregularities, in an apparent attempt to overstate revenues in the current period (not to mention the risk reporting high levels of sales returns in the following period, if customers do indeed avail themselves of the generous terms).
In such circumstances, these sales should in all likelihood not be recognized, and the goods nominally sold should be returned to the reporting company’s inventories.
Four inventory accounting issues, related to goods ownerships, have just been discussed. At the end of the period, however, the inventory balance on the balance sheet should be mechanically linked with cost of goods sold on the income statements. To achieve the goal, you would need to carefully record every single inventory transactions (whatever it is), along the inventory cycle—i.e. raw material received, raw material moved to the line of production, finished goods moved to the finished good warehouse, obsolescence, stolen, and finished goods sold out or moved to other warehouses—without failures. What is journal entry of each transaction? I have posted a good Summary of Journal Entry since the beginning until the end of the inventory cycle: Journal Entry for Inventory Transactions.