Accounting: The Language of Business - Vol. 2 (Intermediate: Part 159)

(Proverbs 30:25)

“Ants are creatures of little strength, yet they store up their food in the summer;”

Short-Term Operating Assets: Inventory (Part E) 

by

Charles Lamson

Costs Included in Inventory

Inventory costs reflect the price paid for the goods to be held for resale or the manufacturing costs incurred in producing the units, including materials, labor, and allocated overhead. The costs initially also include expenditures such as freight-in costs, the transportation costs incurred to bring the inventory to the appropriate location. Other capitalized costs include packaging and handling costs. These reasonable and necessary expenditures are considered to have asset value because they are required to acquire the inventory. Freight-out costs, transportation costs incurred by the seller to move the inventory to the buyer, are expensed as a component of selling, general, and administrative expenses when incurred.

Although the accounting standards specify general rules, there is a great deal of discretion regarding cost in inventory and to expense as incurred. For example, in its significant accounting policies footnote in the 2016 financial statements, Foot Locker explained that it capitalized transportation, distribution center, and sourcing costs in inventory and merchandise inventory (Gordon, Raedy, Sannella, 2019, Intermediate Accounting, 2nd ed. p. 514). The  cost of inventory excludes expenditures related to abnormal costs. The treatment is based on the theory that abnormal costs are not reasonable and necessary and do not represent asset value. Abnormal costs include abnormal spoilage and access freight, which are costs that exceed the normal costs expected to be incurred.

Purchase Discounts

Finally, inventory costs are reduced by purchase discounts. Purchase discounts reduce the amount that is due to sellers if the buyer pays within a certain time period. Purchase discounts are related to sales discounts discussed in Part 138. The company selling the inventory offers a discount to the buyer. The selling company accounts for the sales discount. The company buying the inventory accounts for the purchase discount. A typical purchase discount is stated as 2/10, n/30, which means the buyer will receive a 2% discount by paying within 10 days; otherwise, the buyer must pay the balance within 30 days. There are two acceptable approaches to recording purchase discounts: the gross method and the net method.

Gross Method. Under the gross method, a company making a purchase initially records the inventory and accounts payable at the full (gross) purchase amounts on the invoice.

1. If the buyer pays after the discount period the accounting is simple because the full amount is paid. That is, the amount of cash paid is the gross amount of the payable and inventory on the books.

2. If the buyer pays within the discount period the journal entry must reflect the discount. That is, when a buyer takes a purchase discount, the buyer pays less cash than the gross account payable on the books: The net amount is the difference between the gross amount and the discount. The company still needs to remove the gross amount of the payable because it is no longer owed to the seller, but less cash is needed to liquidate the liability. Under a perpetual system, the buyer credits the inventory account for the difference between the gross payable amount and the net cash paid, reducing the value of the inventory to the net amount. We discuss only the perpetual system here. However, a company using a periodic system (discussed in Part 156) would credit purchase discounts, a contra account to purchases.

Net Method. Under the net method, the company making the purchase assumes that it will take the discount and initially records the accounts payable and inventory at the net amount.

1. If the buyer pays within the discount period, then the journal entry treats the amount of cash paid as the net amount of the payable on the books.

2. If the buyer pays after the discount period the buyer pays more cash than the net payable on the books. The difference is the amount of the discount lost by not paying within the discount period. By not paying on time, the company incurs an additional cost that represents interest accrued on the unpaid balance after the discount. The buyer debits the difference to interest expense to reflect the fact that this difference is an amount due to the seller for providing financing.

Example 10.4 illustrates accounting for purchase discounts under both the growth and net methods.

In practice, the net method is more appropriate than the gross method, because buyers usually take the discount. thus, recording the payable as the net amount is likely an accurate portrayal of the amount that the buyer will ultimately pay and therefore minimizes the need for adjustments. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 513-515*

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