Gross Recording of Purchases/Discounts
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A fundamental accounting issue is how to account for purchase transactions when discounts are offered. One technique is the gross method of recording purchases. This technique records purchases at their total gross or full invoice amount:
If payment is made within the discount period, the purchase discount is recognized in a separate account. The Purchase Discounts account is similar to Purchases Returns & Allowances, as it is deducted from total purchases to calculate the net purchases for the period:
If payment is made outside the discount period, the entry is quite straightforward:
Net Recording of Purchases/Discounts Lost
Rather than recording purchases gross, a company may elect to record the same transaction under a net method. With this technique, the initial purchase is again recorded by debiting Purchases and crediting Accounts Payable, but only for the net amount of the purchase (the purchase less the available discount):
If payment is made within the discount period, the entry is quite straightforward because the payable was initially established at net of discount amount:
If payment is made outside the discount period, the lost discounts are recorded in a separate account. The Purchase Discounts Lost account is debited to reflect the added cost associated with missing out on the available discount amount:
Comparison of Gross vs. Net
In evaluating the gross and net methods, notice that the Purchase Discounts Lost account (used only with the net method) indicates the total amount of discounts missed during a particular period. The presence of this account draws attention to the fact that discounts are not being taken; frequently an unfavorable situation. The Purchase Discounts account (used only with the gross method) identifies the amount of discounts taken, but does not indicate if any discounts were missed. For reporting purposes, purchases discounts are subtracted from purchases to arrive at net purchases, while purchases discounts lost are recorded as an expense following the gross profit number for a particular period.
The following diagram contrasts the gross and net methods for a case where the discount is taken. Notice that $4,900 is accounted for under each method. The Gross method reports the $5,000 gross purchase, less the applicable discount. In contrast, the net method only shows the $4,900 purchase amount.
The next diagram contrasts the gross and net methods for the case where the discount is lost. Notice that $5,000 is accounted for under each method. The gross method simply reports the $5,000 gross purchase, without any discount. In contrast, the net method shows purchases of $4,900 and an additional $100 charge pertaining to lost discounts.
A potentially significant inventory-related cost pertains to freight. The importance of considering this cost in any business transaction cannot be understated. The globalization of commerce, rising energy costs, and the increasing use of overnight delivery via more expensive air transportation vehicles all contribute to high freight costs. Freight costs can easily exceed 10% of the value of a transaction. As a result, business negotiations relate not only to matters of product cost, but must also include consideration of freight terms. Freight agreements are often described by abbreviations that describe the place of delivery, when the risk of loss shifts from the seller to the buyer, and who is to be responsible for the cost of shipping. One very popular abbreviation is F.O.B. This abbreviation stands for "free on board." Its historical origin apparently related to a seller's duty to place goods on some shipping vessel without charge to the buyer. Whether that historical explanation is exactly correct or not is unclear. What is important to know is that F.O.B. is a common term.
The F.O.B. point is normally understood to represent the place where ownership of goods transfers. Along with shifting ownership comes the responsibility for the purchaser to assume the risk of loss, a duty to pay for the goods, and the understanding that freight costs beyond the F.O.B. point will be borne by the purchaser.
In the drawing at right, notice that money is paid by the seller to the transport company in the top illustration. This is the case where the terms called for F.O.B. Destination -the seller had to get the goods to the destination. This situation is reversed in the middle illustration: F.O.B. Shipping Point ~ the buyer had to pay to get the goods delivered. The third illustration calls for the buyer to bear the freight cost (F.O.B. Shipping Point). However, the cost is prepaid to the trucker by the seller as an accommodation. Notice that the buyer then sends a check (in blue) to the seller to reimburse for the prepaid freight; ultimately the buyer is still bearing the freight cost. Of course, other scenarios are possible. For example, terms could be F.O.B. St. Louis, in which case the seller would pay to get the goods from New York to St. Louis, and the buyer would pay to bring the goods from St. Louis to Los Angeles.
Take a moment and look at the invoice presented earlier in this chapter for Barber Shop Supply. You will notice that the seller was in Chicago and the purchaser was in Dallas. Just to the right of the invoice date, you will note that the terms were F.O.B. Dallas. This means that Barber Shop Supply is responsible for getting the goods to the customer in Dallas. That is why the invoice
included $0 for freight; the purchaser was not responsible for the freight cost. Had the terms been F.O.B. Chicago, then Hair Port Landing would have to bear the freight cost; the cost might be added to the invoice by Barber Shop Supply if they prepaid the cost to a transportation company, or Hair Port might be expected to prepare a separate payment to the transport company. Next are presented appropriate journal entries to deal with alternative scenarios.
o If goods are sold F.O.B. destination, the seller is responsible for costs incurred in moving the goods to their destination. Freight cost incurred by the seller is called freight-out, and is reported as a selling expense that is subtracted from gross profit in calculating net income.
o If goods are sold F.O.B. shipping point, the purchaser is responsible for paying freight costs incurred in transporting the merchandise from the point of shipment to its destination. Freight cost incurred by a purchaser is called freight-in, and is added to purchases in calculating net purchases:
o If goods are sold F.O.B. shipping point, freight prepaid, the seller prepays the trucking company as an accommodation to the purchaser. This prepaid freight increases the accounts receivable of the seller. That is, the seller expects payment for the merchandise and a reimbursement for the freight. The purchaser would record this transaction by debiting Purchases for the amount of the purchase, debiting Freight-In for the amount of the freight, and crediting Accounts Payable for the combined amount due to the seller.
Importantly, cash discounts for prompt payment are not usually available on the freight charges. For example, if there was a 2% discount on the above purchase, it would amount to $200 ($10,000 X 2%), not $208 ($10,400 X 2%).