Problem 2 - Accounting Principles

Question

(LO 1) Which of the following should not be included in the physical inventory of a company? a. Goods held on consignment from another company. b. Goods shipped on consignment to another company. c. Goods in transit from another company shipped FOB shipping point. d. None of the above.

Step-by-Step Solution

Answer

Option (a): Goods held on consignment from another company.

Step 1: Understand Consignment Agreement

Goods held on consignment means that a company is storing goods for another company but doesn't own them. They belong to the company that consigned them. Thus, they should not be included in the holding company's physical inventory.

Step 2: Analyze Goods Shipped on Consignment

Even though your company ships goods on consignment, these goods remain your company's property until sold. So, these should be included in your physical inventory.

Step 3: Consider Goods in Transit (FOB Shipping Point)

FOB (Free On Board) shipping point means that ownership transfers to the buyer once the goods leave the seller's location. If the goods are in transit, the buying company should include them in their inventory.

Step 4: Determine the Correct Option

The only option that involves goods not belonging to the company is the one where goods are held on consignment from another company. Thus, option (a) is what should not be included in physical inventory.

Key Concepts

Consignment Agreements

A consignment agreement occurs when one company (the consignor) sends goods to another company (the consignee), but the ownership of these goods remains with the consignor until they are sold.
This is a popular arrangement in retail, where a supplier allows a retailer to display products without needing to purchase them upfront.
Some key features of consignment agreements include:

• The consignor retains ownership of the goods.
• The consignee sells the goods on behalf of the consignor.
• Payment to the consignor is usually made only after the goods are sold.

For inventory management, goods held on consignment by a retailer should not be incorporated into their physical inventory. Instead, they only account for goods they own. Understanding this is crucial, as it affects financial reporting and inventory valuation.

Physical Inventory

Physical inventory involves counting and recording all products that a company owns and holds that are ready for sale. This process is vital for inventory management, which helps businesses ensure accuracy in their stock records, avoid stockouts, and determine the cost of goods sold.
When conducting a physical inventory, it is important to ensure that only the products legally owned by the company are included. For instance:

• Goods held on consignment from another company should be excluded, as the company does not own them.
• Goods shipped on consignment to another company should remain in their inventory until sold.

Conducting regular physical inventory ensures that accounting records reflect the true economic events of the business. It also helps in identifying any loss or discrepancies in stock, fostering better inventory control and management.

Shipping Terms

Shipping terms, such as FOB (Free On Board), dictate when ownership and responsibility of goods transfer from the seller to the buyer. Understanding these terms is crucial for accurate inventory records and financial reports.
FOB shipping terms can be either "FOB shipping point" or "FOB destination":

• In an "FOB shipping point" agreement, ownership transfers once the goods leave the seller's premises. This means these goods should be included in the buyer's physical inventory as soon as they are shipped.
• In an "FOB destination" agreement, ownership transfers only when the goods arrive at the buyer's location. Until that point, the seller retains ownership.

Understanding these terms is fundamental to determining which goods should be included in physical inventory. Proper recognition ensures companies maintain accurate inventories and financial statements, ultimately supporting sound financial planning and decision-making.