Purchase commitments are commitments by a business to purchase goods or services at some future date at a fixed price. A business will agree to a purchase commitment in order to fix its prices over a period of time. For example, a business might contract to purchase 2,000 units of inventory at a contract price of 1.25 a unit within 6 months.
While purchase commitments can protect the business from price increases they also create a problem when the price of the product falls below the contract price. If the contract cannot be cancelled, the business is committed to purchasing products at a price higher than the current market value of that product and needs to account for the purchase commitment loss.
Purchase Commitments Example
Suppose a business has contracted to purchase 4,000 units of a product within 6 months at a fixed price of 2.25, resulting in a total cost of 9,000 (4,000 x 2.25).
At the year end none of the product has been delivered and the unit price has fallen to 2.00. Since the purchase order commitment contract cannot be cancelled the business is now contracted to purchase the 4,000 units at a price higher than the current market price of the product and must therefore recognize a loss.
The purchase commitments loss is calculated as follows.
Contracted price = 4,000 x 2.25 = 9,000 Market value = 4,000 x 2.00 = 8,000 Purchase commitments loss = Contracted price - Market value Purchase commitments loss = 9,000 - 8,000 = 1,000
Purchase Commitments Accounting Journal Entry
The purchase commitment loss is recognized in the accounting records using the following journal entry.
|Loss on purchase commitments||1,000|
|Purchase commitments liability||1,000|
The debit represents the loss recorded in the income statement of the business in the period in which the decline in price occurred. The credit reflects the balance sheet liability the business has to purchase inventory at a price higher than the current market value.
Further Decline in the Product Price
Suppose now that following the year end the business completes its contract and takes delivery of the 4,000 units of product and adds them to its inventory. At the time of delivery the price has declined even further to 1.80 a unit.
The total purchase commitments loss to the business is now calculated as follows.
Contracted price = 4,000 x 2.25 = 9,000 Market value = 4,000 x 1.80 = 7,200 Purchase commitments loss = Contracted price - Market value Purchase commitments loss = 9,000 - 7,200 = 1,800
Purchase Commitment Journal Entry
Assuming the business operates a perpetual inventory system, the following purchases commitments journal entry is made.
|Purchase commitments liability||1,000|
|Loss on purchase commitments||800|
The inventory is recorded at the market value of the product purchased 7,200 (4,000 x 1.80). However, the business owes the supplier the full contracted amount of 9,000 (4,000 x 2.25) which is reflected by the credit entry to accounts payable.
The difference between these two amounts is the total purchase commitments loss of 1,800. This loss is partially covered by the purchase commitment liability account established at the previous year end to recognize the loss before delivery took place of 1,000. The balance of the loss of 800 resulting from the second price fall is an expense included in the income statement for the period.
The calculation of the two amounts are summarized below.
Before delivery following the first price decline: Contracted price = 4,000 x 2.25 = 9,000 Market value = 4,000 x 2.00 = 8,000 Loss = 9,000 - 8,000 = 1,000 At delivery following the second price decline: Previous price = 4,000 x 2.00 = 8,000 Market value = 4,000 x 1.80 = 7,200 Loss = 8,000 - 7,200 = 800
Cancellable Purchase Commitments
In the event that the contract can be cancelled or amended the purchase commitment loss is not probable and therefore is referred to in a footnote as a contingent liability and not accrued in the accounts.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.