Freight In and Freight Out (#177)
/In this podcast episode, we discuss the accounting issues related to freight in and freight out. Key points made are noted below.
Accounting for Freight In
Let’s start with freight in. This is the shipping and handling cost of bringing goods into a company. There’re a couple ways to deal with it. You’re allowed to include it in the cost of inventory. If you follow that path, some freight in cost may end up being capitalized into the month-end inventory. That means it won’t appear in the cost of goods sold until the related inventory items are eventually sold. That could work if you want to delay expense recognition.
Another option is to charge it straight to expense as incurred. This works pretty well if the amount of freight in is relatively small, and it reduces the amount of work involved in figuring out how much freight cost is included in the ending inventory balance. On the other hand, this could result in charging a bit more to expense up front than would otherwise be the case.
I come down pretty hard in favor of charging off freight in right away. Yes, it accelerates expense recognition a bit, but for most companies, the amount of expense involved is pretty small. The main reason for an immediate charge off is to keep freight in from mucking up the inventory records. It’s just one more item that gets loaded into the bill of materials or allocated through overhead, and one more item that the auditors need to be aware of when they examine the year-end inventory balance. And on top of that, you have to factor freight costs back out when doing a lower of cost or market analysis.
So, in short, I suggest charging freight in to expense as soon as you receive the invoice from the freight company.
But. There is one case where you might not want to do that, and that would be in a business with seasonal sales. Let’s say you produce goods all year long, but only sell them during a high season, like during the summer or the winter holidays.
If you were charging freight to expense all through the year, you’d have these odd looking financial statements that have a small amount of cost of goods sold in every month, but no offsetting sales, because sales only occur during the prime selling season.
In this case, you might have to capitalize the freight in cost, just to avoid questions from investors and lenders about why there’s this weird expense showing up in the income statement.
Accounting for Freight Out
And then there’s freight out. This is the shipping and handling cost required to deliver goods to customers. And, as was the case with freight in, there’re a couple of ways to account for it.
The basic method is to charge freight out to expense as soon as you incur the cost. A possible issue here is the timing of the recognition. Under the matching principle, all costs associated with a sale are supposed to be recognized in the same period as the sale. But, with freight out, you may not receive an invoice from the freight company until the next month, which means that the expense recognition is incorrectly delayed.
Given the amount of expense involved, a lot of companies don’t bother to accrue the expense in the correct period. They just wait for the freight invoice to arrive, and record it in whatever period that happens to be. I would say that accruing freight out in the proper period is more of a pain than it’s worth. You’d need to match up every shipment with every freight billing to see which shipments haven’t yet been invoiced by the shipping company, and estimate what the invoice should be, and then create an accrual. And to make the decision even easier, I’ve never heard of an audit firm that forces its clients to accrue for unrecorded freight out.
Another issue with freight out is what to do if you re-bill the freight charge to the customer. The choices are to either treat the billing as a form of revenue, or to offset the billing against the freight out expense.
Freight out billings to customers should only be treated as revenue if doing so is the primary revenue-generating activity of the business. It seems like a strange business model if that’s how a company turns a profit. Instead, you would normally offset freight billings to customers against the freight out expense line item. This should result in a pretty small freight out expense.
There may even be cases where the freight out expense is negative, if the amount billed is routinely higher than the amount of the expense. If so, that’s fine.
Another issue is where to report both types of freight expense in the income statement. Both should definitely be in the cost of goods sold. I’ve heard an argument that the cost of freight out should be listed in the sales department, but that just makes no sense. Freight is clearly a direct cost that’s associated with a product sale, so it has to be in the cost of goods sold. It doesn’t relate to the daily operations of the business, and so it shouldn’t be included in the sales department, or for that matter in the general and administrative area.