Dallas Manufacturing engaged in five transactions involving inventory at the end

Question

Dallas Manufacturing engaged in five transactions involving inventory at the end of 2014:

1. Ordered $50,000 of inventory on December 29, 2014. The goods were shipped on December 30, 2014, with the terms FOB shipping point. Dallas received the inventory on January 4, 2015.

2. Received an order to sell inventory with a cost of $40,000. The goods were shipped to the customer on December 31, 2014, and received on January 3, 2015. The terms of the sale were FOB shipping point.

3. Received an order to sell inventory with a cost of $15,000. The goods were shipped to the customer on December 29, 2014, and received on January 2, 2015. The terms of the sale were FOB destination.

4. Ordered $10,000 of inventory on December 27, 2014. The inventory was shipped on December 27, 2014, with the terms FOB destination. Dallas received the inventory on December 31, 2014.

5. Ordered $75,000 of inventory on December 30, 2014. The inventory was shipped on December 31, 2014, with the terms FOB destination. Dallas received the inventory on January 3, 2015.

Assume that Dallas included in inventory (12/31/14) all items from the five cases above. Explain how the resulting financial statements would be misstated.

Explanation / Answer

"Free on board (FOB) shipping point" and "free on board destination" are international trade terms that specify where the title of goods are transferred to the buyer from the seller.

Analysing the five instances of Dallas Manufacturing on the above lines, we have:

Since the terms are FOB shipping point, the ownership has passed on to Dallas on 30th, December, and hence has to be included in inventory. As Dallas has included it, there is no misstatement. Only condition is that it is to be shown as Goods in Transit.

As the terms are FOB shipping point, the property in the goods has passed on to the customer on December, 31st. Hence, its inclusion in inventory is wrong. The inventory remains overstated to the extent of $40,000.

Further, as the sale has already taken place, Dallas should have treated the transaction as sale (ie: recognise the revenue). Since, Dallas has not done this, the sales are understated to the extent of the sale value of the goods, with resultant understatement of the profit therefrom. The debtors would also be understated to the extent of the sale value.

As the terms are FOB destination, the property in the goods has not passed on and it is in order that Dallas has included it in the stock. However, it has to be shown as stock in transit.

Since the inventory is received on 31st December, its inclusion is in order and there is not misstatement.

Since the inventory is received after 31st December (being bought on FOB destination basis), it should not be included in stock. As Dallas has included it in stock, it amounts to overstatement of inventory to the extent of $75000, with corresponding overstatement of Creditors for Supplies A/c. Income reported would not be affected as purchases would have gone up the same extent.

Note: It is presumed that Dallas has passed entries in its books in line with the treatment it has given to the            inventory.

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