Consignment inventory refers to inventory that is sent (consigned) by one party to another party (consignee). Legally, the ownership of inventory is not transferred to the consignee at the time of transfer of inventory, which means that the legal title of goods belongs to the consignor. However, as accountants, do we only look at the legal structure of transactions or we look at the economic substance as well? Yes! You remember the substance over form principle.
Accounting of consignment inventory poses two possible accounting questions.
- Whether to record the sale at the time of consignment (transfer) of inventory; or
- Whether to record the sale when the consignee sells the goods to a third party.
Answer to the above question lies in determining when the control of goods is transferred to the consignee. The whole consignment arrangement needs to be evaluated and if the majority of indicators of control suggest that control of inventory is transferred to the consignee at the time of consignment of inventory, then sale is recorded at the time of consignment. Otherwise, no entry is recorded at the time of consignment. If the control is still with the consignor, it means that there is just a change in the location of the inventory. In such case, sale is only recorded when the consignee sells the goods to third parties.
Let’s take a look at the following example to get a better picture of this accounting concept.
Example – Consignment inventory
COOL Company is a washing machine manufacturer who has a consignment agreement with SMART Company, a retailer of washing machines. The terms of the agreement are as follows:
- SMART has the right to display the machines at its showroom.
- SMART has the responsibility of safekeeping the machines.
- When a machine is sold, regardless of the price at which that machine is sold to third party, SMART has to pay the factory price of the date at which the machine was consigned (the date at which the machine was delivered by COOL to SMART).
- Any machines that remain unsold after 4 months of the consignment must be purchased by SMART at the factory price of the date of consignment.
- SMART has the option to return the machines within 4 months from consignment without paying any penalty, however, it has never happened before.
To decide when to record the sale, we have to consider the following factors.
- SMART can return the machines to COOL without paying penalty. This is not usually the case where one has control over an asset. However, as this has never happened before, so we can say that the chances of SMART returning the machines are remote.
- SMART has the ability to obtain the benefits of holding the machines as well as bears the holding costs which are similar to the inventory holding costs.
- Inherent risks associated with holding inventory are also with SMART.
- SMART will pay the factory price prevailing at the date of transfer of inventory, which can be seen as if the sale happened at that date and the payment will be made later like in credit sales.
Considering the overall scenario, we can say that COOL transfers the control of machines to SMART at the time of consignment, therefore, COOL should record the sale at the time of consignment. Accordingly, SMART should recognize the machines as inventory in its books at the time of receiving the machines.
If the circumstances had indicated that control is not transferred to the consignee, then the inventory would have been kept in the books of account of the consignor, and sale would only be recorded when the consignee sells the inventory to third parties.