There are two types of entities for which the accounting for inventory is relevant. The merchandising entity [generally referred to as a retailer, dealer, or wholesaler/distributor] purchases inventory for resale to its customers. The manufacturer buys raw materials, and processes those raw materials using labor and equipment into finished goods that are then sold to its customers. While the production process is progressing, the costs of the raw materials, salaries and wages paid to the labor force [and related benefits], depreciation of the machinery, and an allocated portion of the manufacturer’s overhead are accumulated by the accounting system as work in process [WIP]. Finished goods inventory is the completed product which is on hand awaiting shipment or sale. In the case of either type of entity we are concerned with answering the most—important—same basic questions: At what point in time should the items be included in inventory (ownership)?
Through this post, I am going to discuss issues affect determination of inventory ownership in greater level of detail: goods in transit, consignment arrangements, product financing arrangements and sales made by buyer having the right of return, illustrated with case examples, calculations, and its journal entries. Enjoy!
Generally, in order to obtain an accurate measurement of inventory quantity, it is necessary to determine when title legally passes between buyer and seller. The exception to this general rule arises from situations when the buyer assumes the significant risks of ownership of the goods prior to taking title and/or physical possession of the goods. Substance over form in this case would dictate that the inventory is an asset of the buyer and not the seller, and that a purchase and sale of the goods be recognized by the parties irrespective of the party that holds legal title.
The most common error made in this area is to assume that an entity has title only to the goods it physically holds. This may be incorrect in two ways: (1) goods held may not be owned, and (2) goods that are not held may be owned. Four issues affect the determination of ownership: goods in transit, consignment arrangements, product financing arrangements, and sales made with the buyer having the right of return where this post is emphasized on.
Goods in Transit
At year-end, any goods in transit from seller to buyer must be included in one of those parties’ inventories based on the conditions of the sale. Such goods are included in the inventory of the firm financially responsible for transportation costs. This responsibility may be indicated by shipping acronyms such as FOB, which is used in overland shipping contracts, or FAS, CIF, C&F, and ex-ship, which are used in maritime contracts. Let’s discuss it a bit. Read on…
- Free on Board [FOB] Delivery Term – The term FOB is an abbreviation of “free on board.” If goods are shipped FOB destination, transportation costs are paid by the seller and title does not pass until the carrier delivers the goods to the buyer. These goods are part of the seller’s inventory while in transit. If goods are shipped FOB shipping point, transportation costs are paid by the buyer and title passes when the carrier takes possession of the goods. These goods are part of the buyer’s inventory while in transit. The terms FOB destination and FOB shipping point often indicate a specific location at which title to the goods is transferred, such as FOB Cleveland. This means that the seller retains title and risk of loss until the goods are delivered to a common carrier in Cleveland who will act as an agent for the buyer. The rationale for these determinations originates in agency law, since transfer of title is conditioned upon whether the carrier with physical possession of the goods is acting as an agent of the seller or the buyer.
- Free Alongside [FAS] Delivery Term – A seller who ships FAS (free alongside) 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 costs of loading and shipment. Title passes when the carrier [as agent for the buyer] takes possession of the goods.
- Cost-Insurance-and-Freight [CIF] Delivery Term – In a CIF contract the buyer agrees to pay in a lump sum the cost of the goods, insurance costs, and freight charges.
- Cost and Freight [C&F] Shipping Term – In a C&F (cost and freight) 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 buyer’s agent/carrier and pay the costs of loading. Both title and risk of loss pass to the buyer upon delivery of the goods to the carrier.
- Ex-ship Delivery Term – A seller who delivers goods ex-ship bears all expense and risk until the goods are unloaded, at which time both title and risk of loss pass to the buyer.
Goods in Transit Case Example
Lie Dharma Vacuum Company is located in Santa Fe, New Mexico, and obtains compressors from a supplier in Hong Kong. The standard delivery terms are free alongside (FAS) a container ship in Hong Kong harbor, so that Lie Dharma 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 $120,000 to the wharf, it e-mails an advance shipping notice (ASN) and invoice to Lie Dharma 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 = $120,000
[Credit]. Accounts payable = $120,000
The goods are assigned an “In Transit” location code in Lie Dharma’s perpetual inventory system. When the compressor 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.
Lie Dharma’s secondary compressor supplier is located in Vancouver, British Columbia, and ships overland using free on board (FOB) Santa Fe terms, so the supplier retains title until the shipment arrives at Lie Dharma’s location. This supplier also issues an advance shipping notice by EDI to inform Lie Dharma of the estimated arrival date, but in this case Lie Dharma ’s computer system notes the FOB Santa Fe terms, and makes no entry to record the transaction until the goods arrive at Lie Dharma ’s receiving dock.
In consignment arrangements, the consignor ships goods to the consignee, who acts as the agent of the consignor in trying to sell the goods. In some consignments, the consignee receives a commission and is, in effect, acting as an agent of the consignor. In other arrangements, the consignee “purchases” the goods simultaneously with the sale of the goods to the customer. Goods on consignment are included in the inventory of the consignor and excluded from the inventory of the consignee.
Consignment Arrangement Case Example
Putra Handset Company (PHC) ships a consignment of its cordless phones to a retail outlet of the Consignee Corporation. PHC’s cost of the consigned goods is $3,700. PHC shifts the inventory cost into a separate inventory account to track the physical location of the goods.
The entry follows:
[Debit]. Consignment out inventory = $3,700
[Credit]. Finished goods inventory = $3,700
A third-party shipping company ships the cordless phone inventory from PHC to Consignee. Upon receipt of an invoice for this $550 shipping expense, PHC charges the cost to consignment inventory with the following entry:
[Debit]. Consignment out inventory = $550
[Credit]. Accounts payable = $550
(To record the cost of shipping goods from the factory to Consignee)
Consignee 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, PHC must also reimburse Consignee for the 2% credit card processing fee, which is $55 ($2,750 × 2%). The results of this sale are summarized as follows:
Sales price to Consignee’s customer earned on behalf of PHC $2,750
Less: Amounts due to Consignee in accordance with
arrangement 22% sales commission (605)
Reimbursement for credit card processing fee (55)
Due to PHC $2,090
Upon receipt of the monthly sales report from Consignee, PHC 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 Consignee acting as agent of PHC, the commission earned by Consignee and the credit card fee reimbursement earned by Consignee in connection with the sale)
[Debit]. Costs 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 consignee [($3,700 + $550 = $4,250) × 1/2 = $2,125]).
Product Financing Arrangements
A product financing arrangement is a transaction in which an entity (referred to as the “Sponsor”) simultaneously sells and agrees to repurchase inventory to and from a financing entity [ASC 470-40 addresses the issues involved with product financing arrangements]. The repurchase price is contractually fixed at an amount equal to the original sales price plus the financing entity’s carrying and financing costs. The purpose of the transaction is to enable the sponsor enterprise to arrange financing of its original purchase of the inventory. The various steps involved in the transaction are illustrated below:
- Step-1: In the initial transaction the sponsor “sells” inventoriable items to the financing entity in return for the remittance of the sales price and at the same time agrees to repurchase the inventory at a specified price (usually the sales price plus carrying and financing costs) over a specified period of time.
- Step-2: The financing entity borrows from a bank (or other financial institution) using the newly purchased inventory as collateral.
- Step-3: The financing entity remits the proceeds of its borrowing to the sponsor and the sponsor presumably uses these funds to pay off the debt incurred as a result of the original purchase.
- Step-4: The sponsor then, over a period of time as funds become available, repurchases the inventory from the financing entity for the specified price plus carrying and financing costs.
FASB ruled that the substance of this transaction is that of a borrowing transaction, not a sale. That is, the transaction is, in substance, no different from the sponsor directly obtaining third-party financing to purchase inventory. ASC 470-40 specifies that:
The proper accounting by the sponsor is to record a liability in the amount of the selling price when the funds are received from the financing entity in exchange for the initial transfer of the inventory.
The sponsor proceeds to accrue carrying and financing costs in accordance with its normal accounting policies. These accruals are eliminated and the liability satisfied when the sponsor repurchases the inventory. The inventory is not removed from the balance sheet of the sponsor and a sale is not recorded. Thus, although legal title has passed to the financing entity, for purposes of measuring and valuing inventory, the inventory is considered to be owned by the sponsor.
Example Of A Product Financing Arrangement
The Maldives Illumination Company (MIC) has borrowed the maximum amount it has available under its short-term line of credit. MIC obtains additional financing by selling $280,000 of its candle inventory to a third party financing entity. The third party obtains a bank loan at 6% interest to pay for its purchase of the candle inventory, while charging MIC 8% interest and $1,500 per month to store the candle inventory at a public storage facility. As MIC obtains candle orders, it purchases inventory back from the third party, which in turn authorizes the public warehouse to drop ship the orders directly to MIC’s customers at a cost of $35 per order. Since this is a product financing arrangement, MIC cannot remove the candle inventory from its accounting records or record revenue from sale of its inventory to the third party. Instead, the following entry records the initial financing arrangement:
[Debit]. Cash = $280,000
[Credit]. Short-term debt = $280,000
After one month, MIC records accrued interest of $1,867 [= $280,000 × 8% interest × 1/12 year] on the loan, as well as the monthly storage fee of $1,500, as shown in the following entry:
[Debit]. Interest expense = $1,867
[Debit]. Storage expense = $1,500
[Credit]. Accrued interest = $1,867
[Credit]. Accounts payable = $1,500
On the first day of the succeeding month, MIC receives a prepaid customer order for $3,800. The margin on the order is 40% and, therefore, the related inventory cost is $2,280. MIC pays the third party $2,280 to buy back the required inventory as well as $35 to the public storage facility to ship the order to the customer, and records the following entries:
[Debit]. Short-term debt = $2,280
[Credit]. Cash = 2,280
(To repurchase inventory from the third-party financing entity)
[Debit]. Cash = $3,800
[Credit]. Sales = $3,800
(To record the sale to the customer)
[Debit]. Cost of goods sold = $2,280
[Debit]. Inventory = $2,280
(To record the cost of the sale to the customer)
[Debit]. Freight out = $ 35
[Credit]. Accounts payable = $35
(To record the cost of fulfilling the order)
ASC 470-40 identifies variations of the terms of the above arrangement that also meet the criteria for being accounted for as product financing arrangements.
- The third-party financing entity purchases the inventory directly from the sponsor’s supplier (instead of from the sponsor) with a simultaneous agreement to sell the inventory to the sponsor.
- The sponsor enters into an agreement with a third-party financing entity to control the disposition of product that has been purchased by the third party either from the sponsor or from the sponsor’s supplier.
Sales Made With the Buyer Having The Right Of Return
Another issue requiring special consideration exists when a buyer is granted a right of return, as defined by ASC 605-15. The seller must consider the propriety of recognizing revenue at the point of sale under such a situation. The sale is recorded only when six specified conditions are met including the condition that the future amount of returns can be reasonably estimated by the seller. If a reasonable estimate cannot be made, then the sale is not recorded until the earlier of the expiration date of the return privilege or the date when all six conditions are met. Similar to product financing costs, this situation results in the seller continuing to include the goods in its measurement and valuation of inventory even though legal title has passed to the buyer.