Inventory Part 2: inventory purchases and contractual terms - YouTube

>> Welcome to Inventory Part 2, Accounting for Inventory Purchases and the Legal Ownership

of Inventory or FOB Shipping Point and Destination.

So my disclaimer and copyright notice, the information and opinions

in this presentation are those of the author only, and not the author's employers

or affiliated organizations including but not limited to Irvine Valley College,

the South Orange County Community College District, or Chapman University.

The presentation is for educational purposes only,

and does not constitute any legal or accounting advice whatsoever.

Any company names or references to publicly traded companies

or well-known privately held companies that are used

in these presentations are the trademarks and/or copyrights of those respective companies.

And for this presentation, I'm using a couple different definitions coming from Investopedia

as well as -- let me pull this up right here just so I can give them the proper shout out.

Right over here, accounting tools website.

So again, they were extremely helpful in terms of obviously having that information

up on the web, and helping me better give you the information.

So there's a lot of good things that are out there.

So don't forget to use them, especially those websites.

Okay. So when we're accounting for inventory purchases -- and this is really important.

So when we're going through and doing this, when we look at this,

essentially we're focusing right now on, you know, what happens when a buyer

or a retailer is purchasing from a manufacturer.

And then ultimately when that buyer or that retailer is going

to be reselling to its customers.

So we're going to be looking at some terminology that's used.

Costs that are going to be increasing our inventory account for a retailer.

Costs that will be reducing inventory holding costs,

and then when the legal title to inventory passes.

So the first one up here is that are in terms of our contractual terms, or the payment terms.

And so when a manufacturer or a wholesaler enters into business with a retailer,

and they're going to do this after they've done a credit check or a reference check on a buyer,

especially if the buyer is a first time customer,

they want to see if the buyer is credit worthy.

The seller and buyer will normally agree to certain terms on a contract.

And one of these terms or incentives, may be a discount to the buyer,

if the buyer makes an early payment.

And so the way that the manufacturer can be going through,

where the seller can reflect this on their invoice is as follows.

You'll see this here, 2/10 net, or n30.

What does this mean?

It means that if the buyer pays within 10 days, the buyer will receive a 2% discount.

The full amount is due in 30 days.

So again 2 is the percentage discount if they pay within 10 days.

The full amount is due within 30 days.

Now, you might be asking, "Tchaikovsky, are those real day,

are those calendar days, are those business days?"

It's going to depend upon the contract.

So right over here, we have 3/15 n45.

What does that mean?

Well, if the buyer pays within 15 days, a buyer is going to be receiving a 3% discount.

The full amount is due in 45 days.

So again, these refer here to payment discounts.

And when we go through future examples, what we'll be going through and doing is learning how

to go through and record these various different types

of discounts whether they pay within the payment terms.

Okay. So one of the things though, about these discounts and you will see essentially,

a lot of accounting CPA Review and a lot of books will say, "Oh my God, if you don't take --

or all my all my Jesus, or whatever your favorite religion is,

if you don't take advantage of these discounts, the world is going to come to an end.

I don't know what will happen.

But if you don't take an advantage of this 2% discount.

It's crazy."

And they're partially right.

But I want just to kind of be aware of that when you start a business and cash is king,

if you don't have enough cash to operate, it's not going to work out.

And because of this, what they're saying is partially true.

I'm going to show you the computation.

However, it's not necessarily the very best thing to go through in as far

as it may not be the most wisest thing to go through and do.

And you know, really should invoice discounts always be taken by a buyer?

And it's not necessarily.

And again, if it may make sense of buyer has a lot of cash resources.

However, if a buyer has limited cash resources or large pending obligations,

the buyer may not want to take the discount.

And again, if the retailer is paying for its inventory early, meaning within 10 or 15 days

and taking the discount, but it's taking that retailer 90 days to sell that inventory

that they just purchase, think about that.

Now they're out of that cash for that 75-day period.

So becomes really critical to kind of really kind of think this through.

And I cover a lot of different things about cash flow projections, and managerial accounting.

And so that'll be something we'll cover in a future video.

So right over here in terms of the discounts.

So if a buyer comes over here, there's going to be two things.

There's going to be a dollar amount loss and the effective rate I lose essentially,

by not taking advantage of that discount.

The dollar amount loss is somewhat easy.

If a buyer purchases $10,000 worth of goods on January 1st and the seller's terms are 3/10,

net 30, which means if they pay within 10 days, it's a 3% discount.

The full amount's due in 30 days.

What is the amount of the loss in both dollars and annual percentage rates?

Or this should actually be the effective interest rate.

If the buyer pays for the inventory on January 30th, the buyer is going

to be paying the full dollar amount of $10,000, because that's within those 30 days.

If the buyer had paid for the inventory 20 days earlier,

the buyer could have taken that $300 discount.

How did I get that?

Three percent times the amount of the invoice.

So right there.

So then we get over here to computing discounts loss, and I went to accounting tools,

this website right here, and I'm going to give him a big shout out.

I'll include this link in the presentation so you can kind of go here.

So again, great little thing right here that had like this write up basically an overview

of credit terms, if you want to go through and read more about this.

But the one area that I was specifically focused on here was this cost of credit.

And again, it's because it's covered by a lot of different accounting textbooks,

sometimes covered by the CPA exam.

So when you look at this over here, and this is at a loss of 2%.

So what you're really going through here and doing is you're taking that discount percentage.

You're dividing it by 100% less the discount, and then you're multiplying it by 360,

divided by the fully allowed payment days,

which in their example was 30 minus the discount days, which was 10.

And when you come up with this, you end up getting I believe it's 18 by 0.0204,

which gives you an annual effective interest rate of 36.72%.

So let's go through and do this one for our particular question.

So right over here is that with our example, our terms are 3/10, net 30.

So the way that I went through and computed this, is I took 3%, which was a discount

from our example, divided this by 100 minus 3%, or 97.

I then multiplied this by 360 divided by 30 less 10 or 20.

So this 3% divided by 0.97 is 0.309278505.

And then this 360 divided by 20 is going to be 18.

And this is going to be at 55.67% and that I lose this amount

by not taking advantage of the particular discount.

So again, this is the formula for computing, loss discounts.

And it's something that I will not really be covering

in my financial accounting classes just because of the lower level.

In my opinion, also the upper level, it's just more of, you know,

kind of a food for thought terms of discussion.

However, I'm just putting it out here, sounds like good extra credit.

And right over here, this is the real challenge with this, is that again,

this can be extremely misleading to the buyers not in a strong financial position,

and they may compromise their cash liquidity.

Additionally, and as I was mentioning before, if the inventory that the buyer is purchasing

from the seller takes a longer time to turn over,

this can create further liquidity problems.

And if you want to try going to your investor and saying, "Hey, I spent all this money

because I took advantage of a purchase discount,"

the investor is probably going to look at you like an idiot.

And saying, "You really want more money for me."

And that's not going to be good.

So let's move over here just to kind of look at in terms

of what costs increase the inventory account?

So again, this is from the perspective of I am a retailer, right?

So I'm going through and I'm purchasing my inventory.

What increases the costs are basically the cost of my inventory?

The first one, obviously, is my inventory purchases from the manufacturer.

Okay, so when I'm buying inventory, I'm debiting inventory, crediting cash or accounts payable.

That's an inventory purchase.

If I'm paying freight in, or transportation, which is just another word for shipping charges,

to get the inventory to our facility, that will also be included in inventory costs.

So that's also something freight in transportation in,

is something I can be including in my inventory costs.

The last one right here is going to be our -- or the last two customs, duties and tariffs.

If I'm purchasing items from a foreign country, and those retail goods are subject to tariffs,

if I pay for those tariffs, or if I'm paying for customs duties,

that's also considered to be a cost of the inventory.

Also too here are inventory holding costs.

And I'm not really going to cover that here.

That's more of an intermediate accounting topic.

But it's things like warehousing.

And again, I'm just kind of leaving that out there.

It's something you want to be further looking at on your own if you're interested.

But I would not be really beyond these three right here.

I wouldn't be really going beyond in depth in terms of it's more

of an intermediate accounting issue.

So what causes the decreases to the inventory accounts?

So right over here, I have my inventory purchases, my freight in, my transportation in,

the shipping costs to get the inventory to our facility.

So again, all those parts here, what decreases it?

Well, when I sell inventory, and this kind of goes back to our earlier example,

how did I record it when I was buying the item from Costco?

Well, what I did was is I debited cost of goods sold, and I credited inventory.

What also is going to be decreasing are inventory accounts.

We're going to have purchase discounts,

which means I'm taking advantage that's the 2/10, net 30.

What will also be reducing our inventory?

Well, if I return goods back to the manufacturer that may be defective.

Okay, so that's an example of a purchase return.

A purchase allowance can be given to me if say the manufacturer says, "Hey,

Tchaikovsky, you've been a great customer.

Therefore, I'm going to give you a purchase allowance, say of like 80, or you know what,

how much whatever the dollar amount is."

So again, a purchase allowance is different from a return

because in a return I'm physically returning the items.

A purchase allowance is just something to be given to me so that I would actually go through

and keep it, keep the item, proper halves or something else.

So to give you an example of this, I once purchased a computer, a PC from a manufacturer.

I decided I did not want it.

So I called them up.

And I said, "Hey, will you take the item back?"

They said, "Sure, but before we take it back, how would you like to keep it."

And they ended up trying to offer me I think it was

about 60% off the price, just to keep the item.

So again, it's kind of something you want to go through and consider as you're looking at,

that's really something there that again,

because if you take an item back it can be a huge, huge hassle.

Okay, so those are examples of the decreases to the inventory account.

Okay? So when does title pass for inventory?

And this right over here, I pulled this from Investopedia.

But when the buyer records a purchase of the inventory

or when the seller records an inventory sale to the buyer, it's not going to depend upon whether

or not the goods are physically held by the buyer or the seller

or by the transportation company.

It's really rather who owns the title the goods depends upon the shipping terms.

And so pulled this from Investopedia, great website.

I've had former students tell me that they got internships.

Actually, this is an IVC student who transferred to UCLA.

She shared with me that she was able

to obtain an investment banking job by just studying Investopedia.

And I don't really doubt that.

All that financial education is here.

And so right over here, you look at Investopedia, they are they are

yet delivering again, helping us out with what is Free on Board.

So but Free on Board is a shipment term that's used

to indicate whether the seller or the buyer who owns the goods.

So when you see FOB shipping point, or FOB origin, the title of the goods,

meaning that when do you record the transaction,

happens when essentially the goods are shipped out of the sellers warehouse.

It's not when the buyer receives them.

So something is sold FOB shipping point, and even if the buyer doesn't receive it

for a week later, the buyer still technically owns the goods.

And we would record the transaction on the shipment date.

Conversely, if it's something that's being sold FOB destination, then the title is not going

to transfer until the buyer receives the goods at their place of business.

So again, very important to understand between FOB shipping and FOB destination.

So let's go through some examples.

Example 1, seller ships buyer $10,000 worth of goods on February 1st, terms FOB destination.

Buyer receives the goods on February 4th.

When should the buyer and seller record the purchase or the sale of goods?

So the key here is that it was FOB destination.

That means we don't record the sale

until the buyer receives it, which will be on February 4th.

So that's the example right here.

Over to or Example 2, the seller ships buyer $10,000 worth of goods

on February 1st, terms FOB shipping point.

The buyer receives the goods on February 10th.

When should the buyer and seller record the purchase and the sale of goods?

Well, because this was FOB shipping point, okay, is that what we're going

to be doing is we're going to be recording this when the goods were shipped

or right here -- and like I love this slide.

It's kind of tricking with me.

It's like, well this little pop up go away and I go right down here?

Oh, it went away.

No, it's going to be February 1st.

Okay, so February 1st is when I'm going to be going through

and recording the particular transaction.

So I record the transaction on February -- oh, there it goes.

Just left me.

So let's see if it comes back.

So I'm going to be recording this transaction on February 1st

as the terms were FOB shipping point.

I don't care when I physically received it if the terms were FOB shipping point.

So the next one here is I believe it is time for us to go through and practice.

So our next videos are going to be focusing on the transactions

for recording various different items.

We're going to be looking at this separately for a buyer and a seller

as the accounting treatment for each is different.

Okay, so again, thank you for watching.

Don't forget to like and subscribe.

And I will see you on the next video.

Have a great one.