Andrew – Page 35 – Financial Memos

Our accounting tutorial series continues to grow, and today, we are looking at consignment inventory. In terms of inventory accounting, this is one of the more accessible topics to deal with, but it does have a few issues you need to be aware of that can trip accounting students up. What is Consignment Inventory? Consignment inventory describes the practice of selling merchandise on behalf of another party. For example, person A contracts person B to sell their stock on their behalf. Person B will usually take physical possession of the inventory, but not legal ownership and with little control over what can be done with it, other than to sell it on behalf of person A or send it back to them. So in accounting terms, this presents us with an "interesting" issue (I know, fascinating to three other people and me). When consignment goods are sent from person A to person B, who records the asset? Who records the sale? And that is what we will look at next. Accounting Concepts for Consignment Inventory Substance v Form The accounting for transactions should always reflect the substance of what is going on. This provides the reader with that information with the best picture of what is happening. Over the years, accounting conceptual frameworks push reporting entities towards greater transparency in their reporting and better reflect the actual business of what is going on rather than what the entity may wish to present. An excellent example of this is in the world of leases, in particular the previous split between operating and finance leases. As an auditor, I remember a conversation where a client told me a lease was an operating lease because that is what the contract said, but the lease was financing in nature in substance. International Financial Reporting Standard (IFRS) 16 was a significant step forward in this area. Assets and Control However, we must return to the topic at hand, being accounting for consignment inventory. What we have here is inventory that is often moving locations and sold by an agent. In our example, we will use our trusty ABC Ltd. ABC Ltd has a stock of lawnmower widgets that it wishes to sell through XYZ Ltd, which operates in another state. So at the moment, ABC has on-hand $50,000 worth of these widgets. These widgets would be recorded on their balance sheets at the reporting date if still held because they meet the definition of an asset. And to get the definition of an asset, we turn to IFRS "The Conceptual Framework for Financial Reporting", for guidance, where s 4.1 defines an asset as: "... a present economic resource controlled by the entity as a result of past events." And goes on to s 4.2 and defines an economic resource as: " ... a right that has the potential to produce economic benefits." Now that ABC Ltd has decided to sell these widgets under assignment, should they continue to recognise them as assets? The answer, in most cases, will be yes. Normally the assignee, XYZ Ltd, can only do with the inventory by the assignor (ABC Ltd). In substance, ABC Ltd retains control of the stock, even when they no longer physically hold it. We will look at how an accounting system would record debits and credits of consignment stock. Example Journal Entry of Consignment Inventory Accounting We will only be looking at this example from the consignor's point of view, i.e. ABC Ltd. The consignee's book will reflect the opposite sides of the transaction regarding accounts receivable, selling commissions and bank movements. To work through our example, here are a few more details we'll need to complete the example: ABC Ltd entering into a consignment arrangement with XYZ Ltd on May and the goods are shipped from ABC Ltd to XYZ Ltd on May 6;XYZ sells the 50 per cent of the widgets in May, 40 per cent in June and returns the remaining 10 per cent to ABC Ltd on July 15;The cost of the widgets is $50,000, being 100 units at $500 each;The Widgets were sold for $900 each;Monthly sales are settled one week after month end;XYZ Ltd receives a 20 per cent of the selling price, and;Shipping costs were $500 and insurance for transport and storage was $1,000. 1. Shipping of Consignment DateAccount NameDebitCreditMay 5Shipping Expense500Insurance Expense1,000Bank1,500 Before the goods are shipped, ABC Ltd pays for the transportation and insurance costs for the assignment. The two debits increase these expenses, while the credit decreases the bank asset account. The next day the widgets are shipped from ABC Ltd's warehouse to XYZ's warehouse. The first entry below records the creation of the consignment inventory asset account and the cost of the goods being assigned $50,000. The inventory credit reflects the reduction in goods held on-site by ABC Ltd. DateAccount NameDebitCreditMay 6Consignment Inventory50,000Inventory (widgets)50,000 2. Sale of Consignment Inventory Sales in May By the end of May, XYZ Ltd has sold 50 per cent of the widgets, selling for $900 a unit. The calculation for the sales figure would be: 100 units x 50 % x $900 = $45,000 From this sale of $45,000 worth of widgets XYZ Ltd would have earned: $45,000 x 20% = $9,000 Thus in May, ABC Ltd earned $36,000 in net sales from its consignment agreement. ABC and XYZ have a very fast automated billing and receipt system and can record all of these transactions at the end of the month. The first entry for ABC Ltd is to record the cost of goods sold. DateAccount NameDebitCreditMay 31Cost of Goods Sold25,000Consignment Inventory25,000 The following entry for month-end records the net sales and accounts receivable generated. As ABC Ltd receives the net sales proceeds from XYZ Ltd, these are brought to account. DateAccount NameDebitCreditMay 31Accounts Receivable36,000Sales (net)36,000 We then move onto the net sales for May as reported by XYZ Ltd. The journal entry below brings to account the deposit of $36,000 into ABC's bank account from XYZ. And the credit of $36,000 eliminates the monthly receivable asset, which has now been settled. DateAccount NameDebitCreditJune 7Bank36,000Accounts Receivable36,000 Sales in June At the end of June, XYZ Ltd has sold another 40 per cent of ABC's stock, and the following data is processed by ABC Ltd, including the cash received in July. The calculations for June are: 100 units x 40 % x $900 = $36,000 And from June sales worth $36,000 XYZ Ltd would have earned: $36,000 x 20% = $7,200 While ABC Ltd will book net sales of $28,800 and cost of goods sold of $20,000 (40 units x $500). DateAccount NameDebitCreditJune 30Accounts Receivable28,800Sales (net)28,800 DateAccount NameDebitCreditJune 30Cost of Goods Sold20,000Consignment Inventory20,000 And then on July 7, the payment from XYZ Ltd for the June sales would be receipted as: DateAccount NameDebitCreditJuly 7Bank28,800Accounts Receivable28,800 3. Return of Unsold Consignment Inventory The final transactions are to record the return of unsold stock back to ABC Ltd. On July 15, XYZ Ltd ships back to ABC the remaining ten units it didn't sell. On the return of these goods, the transport and insurance costs were met by XYX Ltd. DateAccount NameDebitCreditJuly 7Inventory5,000Consignment Inventory5,000 So our final journal entry closes the consignment inventory account with a debit and brings these back to regular inventory. Conclusion And that journal entry brings us to the end accounting tutorial on the proper accounting for consignment inventory. We always welcome readers feedback, so please drop a comment below or raise a question on our to ask a question page.