Transportation Cost, Purchase Returns and Allowances, and Cash Discounts Related to Inventory Purchases

Modified material by Carolyn Caldwell from pages 222-228, FUNDAMENTAL FINANCIAL ACCOUNTING CONCEPTS, 5^th Edition, Edmonds, Edmonds, McNair, Olds.

LO3

Explain the meaning of terms used to describe transportation costs, cash discounts, returns or allowances, and financing costs.

Purchasing inventory often involves: (1) incurring transportation costs, (2) returning inventory or receiving purchase allowances (cost reductions), and (3) taking cash discounts (also cost reductions). During its second accounting cycle, JPS encountered these kinds of events. The final account balances at the end of the 2001 fiscal year become the beginning balances for 2002: Cash, $12,000; Merchandise Inventory, $6,000; Common Stock, $15,000; and Retained Earnings, $3,000.

Effects of 2002 Events on Financial Statements

JPS experienced the following events during its 2002 accounting period. The effects of each of these events are explained and illustrated in the following discussion.

Event 1 JPS purchased merchandise inventory on account with a list price of $8,000. The payment terms were 2/10 n/30.

The expression 2/10 n/30Term indicating that the seller will give the purchaser a 2 percent discount on the gross invoice price if the purchaser pays cash for the merchandise within 10 days from the date of purchase. (two-ten net thirty) means the seller will allow a 2 percent discount if the purchaser pays cash for the merchandise within 10 days from the date of purchase. If the purchaser pays later than 10 days from the purchase date, the full amount is due within 30 days. Based on these terms, the net (cash) cost of the inventory is $7,840 [$8,000 × (100% – 2%)]. While alternative recording practices exist, we will use the gross methodA method of accounting for cash discounts that records inventory purchases at the net price (the list price minus the purchase discount)., recording inventory purchases at the gross price (the list price). If paid within the discount period, a cash discountDiscount offered on merchandise sold to encourage prompt payment; offered by sellers of merchandise and represent sales discounts to the seller when they are used and purchase discounts to the purchaser of the merchandise. representing a price reduction offered by a seller to a buyer to encourage prompt payment will be recorded at the time of payment. Since JPS is the buyer, this cash discount is a reduction in the cost of the inventoryReduction in the gross price of merchandise extended under the condition that the purchaser pay cash for the merchandise within a stated time (usually within 10 days of the date of the sale)..

The inventory purchase increases both assets (merchandise inventory) and liabilities (accounts payable) on the balance sheet. The income statement is not affected until later, when inventory is sold. Since the inventory was purchased on account, there was no cash outflow. These effects are shown here:

Cash

Accts.

Rec.

Inv.

Accts.

Pay.

Com.

Stk.

Ret.

Earn.

Rev.

Exp.

Net

Inc.

Cash

Flow

8,000

Event 2 JPS returned some of the inventory purchased in Event 1. The list price of the returned merchandise was $1,000.

To promote customer satisfaction, many businesses allow customers to return goods for reasons such as wrong size, wrong color, wrong design, or even simply because the purchaser changed his mind. The effect of a purchase return is the opposite of the original purchase. For JPS the purchase return decreases both assets (merchandise inventory) and liabilities (accounts payable). There is no effect on either the income statement or the statement of cash flows. Since the inventory purchase was originally recorded at the gross price, the return is also recorded at the gross price, $1,000. These effects are shown below:

Cash

Accts.

Rec.

Inv.

Accts.

Pay.

Com.

Stk.

Ret.

Earn.

Rev.

Exp.

Net

Inc.

Cash

Flow

(1,000)

Sometimes dissatisfied buyers will agree to keep goods instead of returning them if the seller offers to reduce the price. Such reductions are called allowancesReduction in the selling price of goods extended to the buyer because the goods are defective or of lower quality than the buyer ordered to encourage a buyer to keep merchandise that would otherwise be returned.. Purchase allowances affect the financial statements the same way purchase returns do.

Event 3 JPS paid cash to settle the account payable due on the inventory purchased in Event 1. The payment was made within the discount period.

The amount due is $6,860 ($8,000 original list price minus $1,000 return minus the discount of $140--2% of $7,000 remaining balance.) Recall that JPS had recorded the gross price, $8,000 in its Accounts Payable account and has adjusted Accounts Payable by the amount of the return. The discount will be reflected on the Income Statement as a reduction of cost of goods sold when the inventory is sold which will reduce net income then. Since paying the account payable is an operating activity, the statement of cash flows reflects a single outflow of $6,860. These effects are illustrated in the following financial statements model:

Cash

Accts.

Rec.

Inv.

Accts.

Pay.

Com.

Stk.

Ret.

Earn.

Rev.

Exp.

Net

Inc.

Cash

Flow

(6,860)

(140)

(7,000)

(6,860) OA

Event 4 The shipping terms for the inventory purchased in Event 1 were FOB shipping point. JPS paid the freight company $300 cash for delivering the merchandise.

The terms FOB shipping pointTerm that designates the buyer as the responsible party for freight costs (transportation-in costs). and FOB destinationTerm that designates the seller as the responsible party for freight costs (transportation-in costs). identify whether the buyer or the seller is responsible for transportation costs. If goods are delivered FOB shipping point, the buyer is responsible for the freight cost. If goods are delivered FOB destination, the seller is responsible. When the buyer is responsible, the freight cost is called transportation-inCost of freight on goods purchased under terms FOB shipping point that is usually added to the cost of inventory and is a product cost.. When the seller is responsible, the cost is called transportation-outFreight cost for goods delivered to customers under terms FOB destination; a period cost expensed when it is incurred.. The following table summarizes freight cost terms.

Responsible Party Buyer Seller

Freight Terms FOB shipping point FOB destination

Account Charged Merchandise Inventory Transportation Expense

Event 4 indicates the inventory was delivered FOB shipping point, so JPS (the buyer) is responsible for the $300 freight cost. Since incurring transportation-in costs is necessary to obtain inventory, these costs are added to the inventory account. The freight cost increases one asset account (Merchandise Inventory) and decreases another asset account (Cash). The income statement is not affected by this transaction because transportation-in costs are not expensed when they are incurred. Instead they are expensed as part of cost of goods sold when the inventory is sold. However, the cash paid for freight when inventory is delivered to customers is reported as an outflow in the operating activities section of the statement of cash flows. The effects of transportation-in costs are shown here:

Cash

Accts.

Rec.

Inv.

Accts.

Pay.

Com.

Stk.

Ret.

Earn.

Rev.

Exp.

Net

Inc.

Cash

Flow

(300)

300

(300) OA

Many real-world companies have found it more effective to impose a penalty for late payment than to use a cash discount to encourage early payment. The invoice from Arley Water Works is an example of the penalty strategy. Notice that the amount due, if paid by the due date, is $18.14. A $1.88 late charge is imposed if the bill is paid after the due date. The $1.88 late charge is in fact interest. If Arley Water Works collects the payment after the due date, the utility will receive cash of $20.02. The collection will increase cash ($20.02), reduce accounts receivable ($18.14), and increase interest revenue ($1.88).

Event 5a JPS recognized $24,750 of revenue on the cash sale of merchandise that cost $11,500.

The sale increases assets (cash) and stockholders’ equity (retained earnings). The revenue recognition increases net income. The $24,750 cash inflow from the sale is reported in the operating activities section of the statement of cash flows. These effects are shown below:

Event 5b JPS recognized $11,500 of cost of goods sold.

When goods are sold, the product cost—including a proportionate share of transportation-in and adjustments for purchase returns and allowances—is transferred from the Merchandise Inventory account to the expense account, Cost of Goods Sold. Recognizing cost of goods sold decreases both assets (merchandise inventory) and stockholders’ equity (retained earnings). The expense recognition for cost of goods sold decreases net income. Cash flow is not affected. These effects are shown here:

Event 6 JPS incurred $450 of freight costs on inventory delivered to customers.

Assume the merchandise sold in Event 5 was shipped FOB destination. Also assume JPS paid the freight cost in cash. FOB destination means the seller is responsible for the freight cost, which is called transportation-out. Transportation-out is reported on the income statement as an operating expense in the section below gross margin. The cost of freight on goods shipped to customers is incurred after the goods are sold. It is not part of the costs to obtain goods or ready them for sale. Recognizing the expense of transportation-out reduces assets (cash) and stockholders’ equity (retained earnings). Operating expenses increase and net income decreases. The cash outflow is reported in the operating activities section of the statement of cash flows. These effects are shown below:

Event 7 JPS purchased $14,000 of merchandise inventory on account with credit terms of 1/10 n/30. The inventory was delivered FOB destination. The freight costs were $400.

Merchandise inventory and accounts payable both increase by the gross price of the merchandise, $14,000 . Net income and cash flow are not affected. The freight costs do not affect JPS since the freight terms are FOB destination and the seller is responsible for them. These effects are shown here:

Cash

Accts.

Rec.

Inv.

Accts.

Pay.

Com.

Stk.

Ret.

Earn.

Rev.

Exp.

Net

Inc.

Cash

Flow

14,000

Event 8a JPS recognized $16,800 of revenue from the sale on account of merchandise that cost $8,660. The freight terms were FOB shipping point. The party responsible paid freight costs of $275 in cash. JPS does not offer a cash discount to customers.

The effect on the balance sheet of recognizing revenue is an increase in both assets (accounts receivable) and stockholders’ equity (retained earnings). The event increases revenue and net income. Since JPS sold the inventory on account, cash flow is not currently affected. These effects are illustrated here:

Event 8b JPS recognized $8,660 of cost of goods sold.

As discussed previously, when inventory is sold, the product cost is transferred from the Merchandise Inventory account to the expense account, Cost of Goods Sold. Recognizing cost of goods sold decreases both assets (merchandise inventory) and stockholders’ equity (retained earnings) by $8,660. The expense recognition for cost of goods sold decreases net income. Cash flow is not affected. The freight costs do not affect JPS since the freight terms are FOB shipping point and the buyer is responsible for them. These effects are shown here:

Event 9 JPS paid $9,900 cash in partial settlement of the account payable that arose from purchasing inventory on account in Event 7. The partial payment was made within the discount period for merchandise with a list price of $10,000.

Assume that JPS was not able to pay the entire account payable of $14,000 (recorded at the gross amount) in time to receive the 1% purchase discount offered by the supplier, but JPS was able to pay part of the liability within the discount period. The effect of the event on the balance sheet is to decrease assets (cash) $9,900 and (inventory) $100 for the discount and decrease liabilities (accounts payable) by $10,000. The $9,900 cash outflow is included in the operating activities section of the statement of cash flows. These effects are shown below.

Cash

Accts.

Rec.

Inv.

Accts.

Pay.

Com.

Stk.

Ret.

Earn.

Rev.

Exp.

Net

Inc.

Cash

Flow

(9,900)

(100)

(10,000)

(9,900) OA

Event 10 JPS paid $8,000 cash for selling and administrative expenses.

The effect on the balance sheet is to decrease both assets (cash) and stockholders’ equity (retained earnings). Recognizing the selling and administrative expenses decreases net income. The $8,000 cash outflow is reported in the operating activities section of the statement of cash flows. These effects are shown below.

Choi Company purchased $24,000 of inventory on account with payment terms of 2/10, n/30 and freight terms FOB shipping point. Freight costs were $1,200. Choi paid $18,000 of the accounts payable within the 10-day discount period. Choi sold all of the inventory for $32,000. Based on this information, determine the amount of gross margin and interest expense Choi would report on the income statement.

Gross Price                                                      $24,000

Plus Transportation-in                                           1,200

Total Gross Price                                              $25,200

Less Discount taken 18,000x2%                              360

Total Net Cost                                                 $24,840

Answer The cost of the inventory is determined as follows:

The gross margin is $7,160, the sales price less cost of goods sold ($32,000 – $24,840).

General Ledger Accounts

Exhibit 5–4 summarizes in T-account form the 2002 accounting events just described. A summary of these events follows here for your convenience. Before reading further, trace the effects of each event to the ledger accounts. Then trace the information in the ledger accounts to the 2002 financial statements displayed in Exhibit 5–5.