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Recording What Comes In
Quantitative Analysis · Chapter 4: Inventory Management and QueuingSection 4.5 · lesson 16 of 5512 min · free with a free account
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In this lesson
How inventory purchases are accounted for - systems, journal entries, freight terms, discounts and write-downs.
- Distinguish perpetual from periodic inventory systems
- Journalise purchases, freight-in, returns and allowances
- Apply FOB terms to goods in transit and to freight liability
- Price a forgone 2/10 net 30 discount and apply the LCNRV rule
Transcript
Everything said in the video, section by section (1,867 words). Read along, or search it.
Inventory Management and Queuing · Section 4.5
Recording What Comes In
Welcome to section four point five, Recording What Comes In. Every unit of inventory that arrives at a loading dock is two things at once. It is a physical object in a warehouse, and it is an entry in a ledger. This section is about the ledger side. We will meet the two systems firms use to track inventory, and see when each one fits. We will write the journal entries for purchases, for inbound freight, and for returns. We will use shipping terms to decide who owns goods that are still on a truck. We will price the cost of turning down a cash discount, and the number will surprise you. And we will apply the rule that forces a write-down when market value falls below cost. Everything closes with one full worked example, from purchase to final payment. None of this is hard, but every step of it is easy to get subtly wrong.
Operations Meets Accounting
Every Receipt Is Also a Journal Entry
Start with the two people who care about the same pallet of goods. The operations manager wants to know where it is, and how many units are on hand. The accountant wants to know something quite different. What did it cost, who legally owns it, and when did we become liable to pay? Both views are correct, and both have to stay in step. When they drift apart the damage is not merely administrative, because assets are misstated on the balance sheet. Cost of goods sold comes out wrong, which means reported profit is wrong as well. And managers make decisions on numbers that quietly do not describe reality. So the machinery in this section is not bookkeeping trivia. It is what keeps the warehouse and the financial statements telling the same story.
Two Tracking Systems
Continuous Books, or a Count at Period End
There are two ways to keep inventory records, and the choice shapes everything downstream. The perpetual system updates the inventory account in real time. A purchase raises the balance the moment goods are received. A sale lowers it the moment they leave the warehouse. Barcode scanners and enterprise systems fire those entries automatically, with nobody typing. That gives you continuous review, the ability to see the exact stock level at any instant. You can trigger a reorder when the balance falls below a reorder point. And you can detect shrinkage, by comparing what the books say against a physical count. The periodic system does none of that. It updates inventory only at a quarter end or a year end. Between counts, purchases sit in a separate Purchases account, and the books do not know the stock level. Cost of goods sold is then computed once, from opening stock plus purchases, less closing stock.
Side By Side
What Each System Gives You, and What It Costs
Line the two systems up feature by feature, and the trade-off becomes obvious. Perpetual updates on every transaction. Periodic updates only at period end. Perpetual recognises cost of goods sold at each sale. Periodic recognises it once, from the formula, after the counting is done. Real-time stock visibility is a yes for perpetual and a flat no for periodic. Shrinkage detection is the difference that matters most. Under a perpetual system you compare the book balance against the count, and the gap is your loss. Under a periodic system, theft and damage never surface as separate items at all. They are absorbed into cost of goods sold, invisible and unexplained. The price of that visibility is setup cost, which is why small shops historically stayed periodic. A hardware store selling nails could not justify tracking every single unit.
The Purchase Entries
Three Entries Cover Most Inventory Purchases
Now the entries themselves. Assume a perpetual system, because that is the modern default. The core purchase entry is genuinely simple. Inventory, an asset, goes up. And something reflects the outflow: Accounts Payable on credit, or Cash if you paid on the spot. Buy one hundred units on credit for five thousand dollars, and you debit Inventory five thousand. You credit Accounts Payable for the same amount. Nothing else moves. Next, freight. Suppose inbound freight costs three hundred dollars and the buyer is responsible. The instinct is to expense it, and the instinct is wrong. Freight is part of getting the goods to a saleable location, so it is capitalised into inventory cost. Debit Inventory three hundred, and credit Cash or a freight payable. Finally, returns. Send back four hundred dollars of defective goods, and both the asset and the liability shrink. Debit Accounts Payable four hundred, credit Inventory four hundred. An allowance works the same way, except the goods never move.
Freight Terms
FOB Decides Who Owns the Goods in Transit
Freight terms look like jargon, but they answer a genuine legal question. F O B stands for free on board. It marks the exact point where ownership, and therefore risk of loss, passes from seller to buyer. And whoever owns the goods in transit is the one who pays the freight. Under F O B shipping point, ownership transfers at the seller's loading dock. The buyer owns the goods the moment they leave, bears the risk, and pays the freight. Under F O B destination, ownership transfers at the buyer's receiving dock. The seller carries both the risk and the freight bill right up to delivery. Now the trap, and auditors look for it every single year. Goods in transit on the balance sheet date belong to somebody, even sitting on a motorway. Under shipping point the buyer counts them in ending inventory, although nothing has arrived yet.
Reading The Terms
2/10 Net 30, and What It Actually Offers
Suppliers routinely offer a cash discount to get paid sooner. The shorthand looks like a fraction, and it trips people up. Two ten, net thirty. Read it in plain English. Two per cent off if you pay within ten days. Otherwise the full amount is due within thirty days. The first number is the discount, and the second is the deadline to earn it. The last is the day the whole invoice falls due. One fifteen net forty-five, and three ten net sixty, follow exactly the same grammar. So the invoice divides time into two zones. Inside the window, you pay less. Outside it, you pay in full, and you have bought yourself extra days of cash. The question every finance team should ask is what those extra days actually cost.
The Hidden Cost
Skipping the Discount Is Expensive Borrowing
Here is where a bookkeeping detail becomes a financing decision. Take a ten thousand dollar invoice, on terms two ten, net thirty. Pay on day ten and you hand over nine thousand eight hundred dollars. Wait until day thirty and you hand over the full ten thousand. So two hundred dollars buys you twenty extra days of cash. That is a loan from your supplier, and every loan has an interest rate. The annual rate is the discount, divided by one hundred minus the discount. Multiply that by three hundred and sixty-five, over the net days minus the discount days. Plug the terms in. Two over ninety-eight, times three hundred and sixty-five over twenty. That works out at roughly thirty-seven point two per cent a year. Use a three hundred and sixty day banker's year and you get about thirty-six point seven per cent. Either way, you are borrowing at well over thirty per cent. A line of credit is cheaper. A bank loan is cheaper. Most credit cards are cheaper. Disciplined firms take the discount.
Recording The Discount
Two Payment Dates, Two Sets of Entries
Recording the discount is where the perpetual system shows its character. The discount does not go to a separate income account. It is credited straight to Inventory, so the goods are recorded as having cost less. Walk it through. On the first of April you buy ten thousand dollars of inventory on credit. Debit Inventory ten thousand, and credit Accounts Payable ten thousand. On the ninth of April, comfortably inside the ten day window, you pay. Debit Accounts Payable the full ten thousand, because that whole liability is being cleared. Credit Inventory two hundred for the discount, and credit Cash nine thousand eight hundred. The entry balances, and the inventory now sits on the books at nine thousand eight hundred. Take the other path and pay on the thirtieth of April instead. Debit Accounts Payable ten thousand, credit Cash ten thousand, and that is the whole entry. Inventory stays at ten thousand, and two hundred dollars of value has simply gone.
LCNRV
When Market Value Falls Below Cost
Accounting has a deliberate bias. Given the choice, it would rather understate an asset than overstate one. The lower of cost or net realisable value rule applies that bias to inventory. If market value falls below what you paid, you write the asset down now. You do not wait until the goods finally sell to admit the loss. Net realisable value is the estimated selling price in the ordinary course of business. From that you subtract any costs to complete, and any costs to sell. Take five hundred units of obsolete electronics, carried at eighty dollars each. That is forty thousand dollars sitting on the balance sheet. The selling price has collapsed to sixty dollars, and selling costs are five dollars a unit. Net realisable value is therefore fifty-five dollars, well below the eighty dollars recorded. Each unit is written down by twenty-five, so the total write-down is twelve thousand five hundred dollars. At year end, debit loss on inventory write-down, or cost of goods sold, and credit Inventory.
Worked Example
A $20,000 Purchase, Start to Finish
Time to put every piece together in a single transaction. On the first of March, ABC Trading Company buys inventory from XYZ Supply Company. The invoice is twenty thousand dollars, on credit. Freight of four hundred dollars is incurred to deliver the goods. Terms are F O B destination, two ten net thirty, and ABC runs a perpetual system. Step one is the purchase itself. Debit Inventory twenty thousand, and credit Accounts Payable to XYZ, twenty thousand. Strictly, under F O B destination, ownership passes only when the goods arrive, so dating the entry March first is a simplification here. Step two is the freight, and step two is the interesting one. There is no entry at all. Under F O B destination the seller owns the goods in transit, so freight is XYZ's expense. It never touches ABC's books, and the recorded inventory cost stays at twenty thousand. Had the terms read F O B shipping point, ABC would have debited Inventory four hundred dollars instead.
The Two Paths
Pay on Day 10, or Give Up $400
Step three is a choice, and it is worth real money. Path A. Pay on the tenth of March, comfortably inside the discount window. Two per cent of twenty thousand dollars is four hundred dollars. So debit Accounts Payable twenty thousand, credit Inventory four hundred, credit Cash nineteen thousand six hundred. Path B. Pay on the thirtieth of March, still within the net period, but too late for the discount. Debit Accounts Payable twenty thousand, and credit Cash twenty thousand. Now compare the two outcomes side by side. Path A pays nineteen thousand six hundred, and carries the inventory at that same figure. Path B pays the full twenty thousand, and carries it at twenty thousand. The saving is four hundred dollars of real cash, simply for paying twenty days earlier. Annualised, that wait cost ABC roughly thirty-seven per cent. Unless the firm truly has no cash and cannot borrow, take the discount every time. Section four point six turns this around, and asks what cost leaves the books when goods are sold.
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What is the difference between FOB shipping point and FOB destination?
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What is the lower of cost or net realizable value rule for inventory?
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