Chapter 6.3® - Transfer of Ownership, FOB Shipping & FOB Destination Points - Accounting for Transportation Costs of Merchandise Inventory
The buyer and seller must reach an agreement on who is responsible for paying any freight costs and who bears the risk of loss during transit when the merchandise is being shipped. This question basically asks, “At what point does ownership transfer from the buyer to the seller?” The point of transfer is called the FOB point, and FOB stands for free on board. The point when ownership transfers from the seller to the buyer are a very important consideration because it determines who pays transportation costs and associated costs such as insurance while in transit. The party responsible for paying shipping costs is also responsible for insuring the merchandise during transit. There are 2 alternative points of transfer.
i) FOB shipping point
FOB shipping point is also known as FOB factory and means the buyer accepts ownership at the seller’s place of business. The buyer is then responsible for paying shipping costs, and bears ownership and risks of damage/loss when the goods are in transit or in transport. The goods also become a part of the buyer’s merchandise inventory at the shipping point.
ii) FOB destination
FOB destination means ownership of the goods transfers to the buyer when goods are delivered at the buyer’s place of business. This means the seller is responsible for paying shipping costs and bears the risk of damage/loss while in transit/transport. The seller also does not record revenue from this sale until the goods arrive at the destination because this transaction is not complete before that point.
Accounting for Transportation Costs
Shipping costs incurred on purchases are known as transportation-in or freight-in costs. If the terms of the purchase are FOB shipping, then this means the buyer is responsible for paying freight-in costs and the accounting cost principle requires these transportation costs to be included as part of the cost of acquiring merchandise inventory. This requires a separate accounting journal entry, and one is illustrated below. Consider Binti Kiziwi Corp. records a purchase of $1,500 Sony camera on credit on September 14th, 2009 and the shipping costs are 5% of the purchase price. Below is the journal entry recorded in the books of Binti Kiziwi Corp.
Recording Purchases of Inventory
In this section, we will tie in costs of inventory purchased, purchase discounts & allowances, returns and freight-in costs to compute the total cost of merchandise inventory. We will use the example of Binti Kiziwi Corp.
Looking at the inventory purchase schedule above, you get an idea of the entries involved in accounting for merchandise purchases. Also with this schedule, we fully satisfy the accounting cost principle that states that all costs incurred to get inventory ready for re-sale and for its intended purpose should be included in the final costs of the inventory purchases.