What Does "FOB" Mean in Accounting?

FOB stands for Free on Board, and there are two types – FOB shipping point and FOB destination. The difference is a big deal in business because it determines who pays shipping costs and who loses out if the shipment is stolen, lost or damaged. FOB in accounting terms determines when the buyer and seller record the sale in their ledgers.

The history of FOB is full of other shipping terms. Originally it meant "freight on board" and still does in many parts of the world. If, say, the goods were shipped from New York as "FOB New York," that meant the seller's responsibility was to get everything to the boat in good shape. Once they were "passed over the rail" of the vessel they became the buyer's responsibility. If they were damaged or fell overboard, it was the buyer's financial loss, not the seller. Today, FOB still refers to goods transported by water, not air. The term is defined by how it's used in the contract:

• FOB Shipping Point or FOB Origin: Once the goods leave the supplier's shipping dock, responsibility for the goods falls on the buyer.
  
• FOB Destination: The buyer takes responsibility when the goods arrive at the receiving dock.
  
• Freight prepaid: The seller pays the shipping costs.
  
• Freight collect: The buyer pays the shipping cost.
  
• Freight collect and allowed: The buyer pays for shipping but deducts it from the seller's payment.
  
• Cost, insurance and freight (CIF): Similar to FOB Origin Prepaid, this gives the buyer ownership of the goods at the point they ship from. The seller, however, pays for shipping and freight costs. 

If you're shipping within the United States, the meanings are slightly different from the terms used in overseas shipments. Those are defined by the International Chamber of Commerce and known as incoterms. To avoid confusion, agreements often specify this: FOB Tokyo (Incoterms 2010) tells you you're using FOB as defined in the 2010 version of the incoterms.

Usually the name of the actual port – Miami, Los Angeles, New York, Savannah – replaces "destination" or "shipping point" on the labels. Whether the shipping fees are prepaid or collect doesn't affect who owns the goods. If the goods are sent FOB Origin Freight Prepaid, the buyer accepts the goods when they leave the seller's dock, but the seller still pays the freight charges.

For new importers, going CIF or FOB Destination often makes excellent sense. If they don't have the resources or expertise to arrange shipping and insurance, it's easier to let the seller handle all those details. The seller will probably charge them more than for FOB Shipping Point, however.

FOB status can settle what would otherwise be business disputes. A buyer receiving goods FOB Destination might send them back to the seller if the shipment is badly damaged. If the goods are FOB Shipping Point, the buyer is legally responsible for any damage in transit. It's unlikely the seller is going to take them back. Some buyers prefer FOB Destination because that lets them make the call on how the goods should be shipped, protected from damage and insured.

From an accountant's viewpoint, FOB matters because it determines when you record the sale. For example, suppose the contract for a $200,000 shipment of jewelry sets the terms as FOB Origin. As soon as the gems leave the dock, the sale has closed. The seller can report $200,000 in accounts receivable and deduct $200,000 from the inventory account. For the buyer, it's the opposite. Once they take ownership of the goods, they can record an increase in inventory of $200,000 and $200,000 in accounts payable. If the shipment is FOB Destination, the same transactions take place, but only when the goods arrive at the receiving dock.

Whichever party pays for shipping will have to enter those costs in the ledger too. They can include the physical handling and loading of the goods, the cost of transporting them to the vessel, shipping and insurance. Buyers and sellers account for them differently though. If the shipment is FOB Destination, the buyer can credit them to inventory costs, then to cost of goods sold when he disposes of them. The seller can treat the expenses as part of the cost of goods sold.

It's not unusual for the sale contract to treat the sale differently from the ledger. FOB in accounting says the buyer in an FOB Shipping Point transaction takes ownership at the supplier's dock. Actually entering the goods into inventory away from the buyer's home base is difficult, so the contract may say the buyer receives and takes possession of the goods at the destination point. This doesn't affect the accounting entries.

In accrual accounting, you report income and expenses at the moment you earn money or incur a debt. In FOB Destination transactions, the sale takes place when the receiving dock accepts the goods even if the buyer won't pay for the shipment for another 30 days. The buyer still records the inventory purchase and notes the money owed in accounts payable. When they settle the bill, they erase the amount in accounts payable and reduce the amount in their cash account.

This becomes significant when you make out your financial statements for the quarter or any other period. The seller's income statement shows the FOB sale as income as soon as it's made. The cash flow statement only records sales when the money comes in. The income statement shows whether your business is profitable; the cash flow statement shows whether you have enough cash on hand to pay employees and creditors.

It's possible to do business on a cash basis. In that case, the seller wouldn't record the transaction in the ledger until the buyer pays them. This is simpler, but it gives you less information. Recording only cash transactions doesn't give you a picture of how much you owe, how many sales have closed in the past month or how much money you can anticipate coming into the company in the next month or two. That makes it harder to judge how profitable you are. If you're a publicly traded company, generally accepted accounting principles (GAAP) require you use accrual accounting.

One worry for sellers shipping overseas, particularly with new customers, is whether the buyer will pay up. Startups dealing with small shipments often use PayPal or similar systems, but the costs can cut into profits. Sight drafts that allow the seller to draw their payment out of the buyer's bank account are a standard method in international shipping. A letter of credit from the buyer's bank can also protect the seller from cheating buyers.

If you use accrual accounting and the buyer doesn't pay, you have to report this in your accounts receivable. Say the buyer defaulted on a $3,000 toy shipment after you entered it in your ledgers. You cut $3,000 from accounts receivable and enter $3,000 in the bad debt expense account. If you know from experience that, say, 7 percent of your accounts receivable won't be paid, you set up an "allowance for doubtful accounts" entry in your records. Subtracting 7 percent of accounts receivable on your financial statements gives you a more realistic view of how much income to expect.