Inventory ownership and capitalization

Since a trading company can either be a buyer or a seller, you need to consider both points of view in assessing inventory ownership. Below is a summary of the impacts to the inventory balance on an in transit inventory during year-end depending if the company is a buyer or the seller of the merchandise:

Consigned goods

Consignment is an arrangement whereby a company (the consignor) delivers goods to another company (the consignee) but the title is retained by the consignor until the goods are finally sold to the end customer. The consignee becomes responsible to sell the goods as an agent and has the ability to return unsold goods, thereby bearing no risk in the arrangement.

In a consignment arrangement, the goods are included in the inventory of the consignor because the title has not passed during the delivery. It is accounted for only as a reclassification of the inventory cost plus any shipping cost paid to deliver the goods to the consignee. For example, a consignor ships goods costing $\$10,000$ to a consignee and pays $\$500$ in freight:

The $\$500$ freight is capitalized, not expensed.

If the company is a consignee, even if physically in the consignee’s warehouse, the consigned goods (also called goods held on consignment) are not included in its balance sheet as inventories.

Obsolete inventories

When for whatever reason an inventory item cannot be sold anymore, it is deemed as obsolete. These items are not expected to bring future benefits to the company and should not be a part of a company’s assets anymore. The cost of the obsolete inventories should be written off in the period when they are determined to be obsolete. A sample journal entry is as follows:

When inventories have salvage values, it means a portion of their costs can be recovered through sale. This topic is covered by “inventory valuation” in a subsequent section.

What costs to include in inventory

Another issue related to inventory accounting is the determination of what constitutes the capitalizable costs of an inventory. A company routinely pays for costs of different nature and we need to determine if such payments should go to the income statement (as expenses) or to the balance sheet (as inventories).

Inventoriable costs include:

• Costs to purchase the inventory which include the purchase price, transport costs, handling costs, and other costs directly attributable to the purchase of raw materials or finished goods. These amounts are recorded net of any trade discounts and rebates.
• Costs of conversion include costs required to directly or indirectly convert raw materials or work-in-progress inventories into finished goods. Examples are direct labor costs, variable and fixed overheads. This is common only for manufacturing companies.
• Other costs incurred in bringing the inventories to their present location and condition.

The following items are expensed in the income statement and are therefore not included as inventoriable costs:

• Abnormal costs related to freight, handling, and wasted materials (spoilage). Only the abnormal, unexpected portion of these costs is expensed - normal (routine) freight-in and expected spoilage are still inventoriable costs.
• Storage costs except when the storage costs are required for the production process (i.e., inventory handling costs related to the raw materials of a manufacturing company)
• Administrative overhead costs. These costs are not directly or indirectly related to the production of goods so they are excluded from inventory costs
• Selling costs
• Costs to transport goods to the customer or freight-out (note that costs to transport inventories to a consignee are inventoriable costs)

Example: Computing inventoriable cost

A retailer buys inventory for $\$20,000$, pays $\$800$ in freight-in to get the goods to its warehouse, and receives a $\$500$ trade discount from the supplier. It also pays $\$300$ in administrative costs and $\$200$ in sales commissions related to the purchase.

Only the purchase price, freight-in, and trade discount affect inventoriable cost - administrative costs and selling costs are expensed as incurred.

Inventoriable cost: $\$20,000-\$500+\$800=\$20,300$

Answer: $\$20,300$