Example of FOB Inventory Entries

FOB and Inventory in Transit – Study Notes

FOB Overview
  • FOB stands for Free On Board.
  • In practice, terms are used to indicate when ownership and risk transfer from seller to buyer during transit.
  • The transcript emphasizes a simplified view:
    • FOB implies that the buyer will pay for the goods later after receiving an invoice.
    • The typical consequence is that the buyer records Accounts Payable because payment occurs after receipt of the invoice.
  • Important distinction: the phrase "FOB" is commonly followed by either FOB shipping point or FOB destination, which determines when ownership/risk transfers.
Key Concepts and Definitions
  • Ownership transfer points:
    • FOB Shipping Point: Ownership transfers to the buyer when goods leave the seller’s shipping dock (in transit under the buyer’s control).
    • FOB Destination: Ownership transfers to the buyer when goods arrive at the buyer’s location (seller bears risk during transit).
  • In-transit inventory: Inventory that is on its way from seller to buyer; depending on FOB terms, it may be owned by the buyer or seller while in transit.
  • Accounts Payable (AP): A liability representing amounts owed to suppliers; typical for credit purchases where payment is made after invoicing.
  • Freight costs:
    • Freight-in (inbound freight) can be included in the cost of inventory if the terms make the freight part of the inventory cost.
    • Freight-out (outbound freight) is typically an expense to the seller.
  • Cash discounts and refunds:
    • If payment occurs within discount terms, the cash paid may be less than the invoice amount, and a Purchase Discounts account may be used as a contra to purchases.
    • If a refund or discount is received, appropriate adjusting entries reduce the liability or cash outlay accordingly.
Journal Entries by Scenario

Assumptions used for entries:

  • Perpetual inventory system (inventory is updated continuously).
  • Purchase amount before freight is denoted as $P.
  • Freight-in (inbound) amount is $F if included in cost.
  • Invoice total (including freight, if applicable) is $I.
  • Discount terms if offered are denoted by the rate d (e.g., 2% = 0.02).
A. FOB Shipping Point (Buyer takes ownership at shipment)
  • On shipment date (goods leave seller):
    • Entry:
      ext{Dr Inventory}
      ext{Cr Accounts Payable} \
      ext{(to recognize goods in transit as inventory and the corresponding liability)}
    • If inbound freight is paid by buyer and is included in cost:
      ext{Dr Inventory} \
      ext{Cr Cash/Accounts Payable}
  • If freight-in is included in the invoice amount: total inventory cost increases by $F$.
    • Example: If goods cost $P$ and freight-in is $F$, then on shipment:
      ext{Dr Inventory}
      ext{Cr Accounts Payable} \ ext{Total increase} = P + F
  • On payment of the invoice (when you actually pay):
    extDrAccountsPayable extCrCashext{Dr Accounts Payable} \ ext{Cr Cash}
  • If you take a cash discount on payment within terms:
    • Assume discount rate is $d$ and invoice amount is $I$.
    • Pay amount after discount: extCashPaid=Iimes(1−d)ext{Cash Paid} = I imes (1 - d)
    • Entry:
      extDrAccountsPayable extCrCashimes(1−d) extCrPurchaseDiscountsimesdext{Dr Accounts Payable} \ ext{Cr Cash} imes (1 - d) \ ext{Cr Purchase Discounts} imes d
    • Net effect: liability is settled and cash outlay is reduced by the discount; the discount is typically recorded in a separate Purchase Discounts account.
B. FOB Destination (Buyer takes ownership at delivery)
  • On shipment date: no entry for the buyer (ownership remains with seller).
  • On delivery date (goods arrive at buyer):
    • Entry:
      ext{Dr Inventory}
      ext{Cr Accounts Payable (or Cash if paid on delivery)}
    • If inbound freight is included in the seller’s charge and terms do not place freight-in on buyer, the buyer’s entry remains the purchase of goods; freight is handled by seller.
  • If the buyer uses inbound freight arrangements separately, inbound freight cost can be included in the cost of inventory only if terms specify it.
Numerical Example (Concrete Illustration)
  • Assume: Purchase price $P = 5{,}000$, inbound freight $F = 500$, FOB shipping point, no discount.
  • Inventory cost at shipment (in transit):
    extInventoryinTransit=P+F=5,000+500=5,500ext{Inventory in Transit} = P + F = 5{,}000 + 500 = 5{,}500
  • Journal entries:
    • At shipment (goods leave seller):
      extDrInventory(GoodsinTransit) extCrAccountsPayable 5,500ext{Dr Inventory (Goods in Transit)} \ ext{Cr Accounts Payable} \ 5{,}500
    • On payment of invoice (assuming no discount):
      extDrAccountsPayable extCrCash 5,500ext{Dr Accounts Payable} \ ext{Cr Cash} \ 5{,}500
  • If a 2% cash discount is offered and the invoice is paid within discount window:
    • Invoice amount: $I = 5{,}500$; discount $d = 0.02$.
    • Cash paid: extCashPaid=5,500imes(1−0.02)=5,410ext{Cash Paid} = 5{,}500 imes (1 - 0.02) = 5{,}410
    • Entries:
      extDrAccountsPayable extCrCashimes0.98 extCrPurchaseDiscountsimes0.02ext{Dr Accounts Payable} \ ext{Cr Cash} imes 0.98 \ ext{Cr Purchase Discounts} imes 0.02
  • For FOB destination (buyer receives on delivery, no entry until delivery):
    • On delivery:
      $$ ext{Dr Inventory} \ ext{Cr Accounts Payable} \