What is Cut-off Procedure?
The process to ensure that transactions are recorded in the proper accounting period is known as cutoff . For inventory, the general rule is that all items owned by the entity as of the inventory date should be included, regardless of location. For goods in transit, if they are shipped free on board (fob) destination, ownership does not pass from the seller to the purchaser until the purchaser receives the goods from the common carrier. For goods shipped fob shipping point, title passes from the seller to the purchaser once the seller turns the goods over to the common carrier.
In practice, purchases are recorded upon receipt, based on the date indicated on the receiving report. Inventory generally is relieved for items sold as of the date of shipment. In this manner, the accounting entries to record the purchase and sale of inventory correspond to the physical movement of the goods at the company. Assuming an accurate physical count of goods on hand is achieved, companies effectively eliminate cutoff errors by verifying that purchases have been recorded in the period of receipt and sales have been recorded in the period of shipment. This usually is accomplished by matching accounts payable invoices to receiving reports, and matching sales invoices to shipping documents. The procedure described above guarantees that both sides of the accounting entry are recorded in the same period.
The inventory amount is recorded through the physical count and valuation, whereas the accounts payable/cost of sales amount is recorded through the matching procedure. This method implies all purchases are fob destination and all sales are fob shipping point. Although this is unlikely to be the case, the approach works in practice because goods in transit are typically not significant, and the procedure is applied consistently. Companies that have a significant volume of goods in transit and varying terms regarding transfer of ownership should scrutinize the inventory cutoff calculations. For example, a fob destination sale that was in transit at period end would be recorded prematurely using the method described above. As a result, pretax income would be overstated by the gross margin on the sale, accounts receivable would be overstated, and inventory would be understated. Such a situation normally is considered more of a revenue recognition issue than an inventory issue. The effect of a similar situation for a purchase would merely affect the balance sheet, because there is no margin involved for the buyer.
Legal Complications in Determining Stock Cut-off
In situations where a strict legal determination of ownership is impractical or other cutoff questions arise, the terms of the sales agreement, the intent of the parties involved, industry practices, and other factors should be considered.
Prerequisites for Effective Cut-off of Inventory Stock
Achieving an accurate cutoff is enhanced by controlling the shipping, receiving, and transfer activity during the physical count. Also, source documents (e.g., receiving reports, shipping reports, bills of lading) pertaining to goods shipped and received around the inventory date must be reviewed closely to verify that transactions have been recorded in the proper period.