Periodic Inventory - Freight Costs: Videos & Practice Problems

In inventory management, understanding how delivery expenses, known as freight costs, are accounted for is crucial. These costs can either be borne by the buyer or the seller, depending on the shipping terms. In a periodic inventory system, delivery expenses are recorded in a special account called Freight In, rather than directly debiting the inventory account. This account accumulates all costs associated with receiving inventory.

One key shipping term to know is FOB Shipping Point (Free On Board Shipping Point). This term indicates that ownership of the goods transfers from the seller to the buyer at the shipping point. Consequently, the buyer is responsible for the shipping costs incurred during transit. For example, if a buyer orders 500 items at $5 each under FOB shipping point terms, the total inventory cost would be calculated as:

$$\text{Total Inventory Cost} = \text{Quantity} \times \text{Price per Item} = 500 \times 5 = 2500$$

In this scenario, if the shipping cost is $35, the buyer would record this in the Freight In account, which is an asset account that increases the overall value of inventory. The accounting entries would reflect the purchase and shipping costs as follows:

1. Debit Purchases for $2,500 (increasing inventory value).

2. Debit Freight In for $35 (capitalizing the shipping cost as part of inventory).

3. Credit Accounts Payable for $2,535 (total amount owed to the supplier and shipping service).

This process illustrates the concept of capitalization, where costs are added to the balance sheet as assets rather than being expensed immediately on the income statement. By capitalizing these costs, the total asset value increases, reflecting the true cost of acquiring inventory.

In the context of shipping terms, understanding the difference between FOB (Free On Board) shipping point and FOB destination is crucial for accounting and inventory management. With FOB destination, the ownership of goods transfers from the seller to the buyer only when the goods arrive at the buyer's location. This means that the seller is responsible for the delivery costs associated with transporting the goods.

For instance, consider a scenario where a buyer orders 500 items at $5 each under FOB destination terms. In this case, the total purchase amount would be calculated as:

Purchase Amount = Quantity × Price per Item = 500 × 5 = $25,000.

Since the seller covers the delivery fees, the buyer does not incur any additional costs for shipping. Therefore, the buyer records the purchase in their accounting records with a debit to Purchases for $25,000 and a credit to Accounts Payable for the same amount, reflecting the liability incurred from the purchase.

On the seller's side, they would record the delivery expense incurred, which might be $35 in this example. This would be recorded as a debit to Selling Expense, increasing their expenses, and a credit to Accounts Payable or Cash, depending on how the delivery was paid for. However, the buyer does not need to make any entry for the delivery fee since it is not their expense.

Overall, the transaction impacts the buyer's financial statements by increasing their assets (inventory) and liabilities (accounts payable) by the same amount, maintaining the balance in the accounting equation. This understanding of FOB destination terms is essential for accurately recording transactions and managing financial statements in business operations.