Purchase Commitment Accounting: Loss, Recovery and Delivery

A purchase commitment is a contract to buy inventory at a set price for future delivery. Under U.S. GAAP (ASC 330-10-35-17), the buyer records nothing at signing. If the contract is firm, noncancelable, and unhedged, and the goods’ recoverable value drops below the contract price, the buyer records a loss and a liability in that period.

Firm means the contract is binding. Noncancelable means the buyer cannot walk away without a real penalty. Unhedged means the buyer has no hedging arrangement to offset the risk of a price decline. A separate question is whether the buyer can recover its purchase cost through a firm sales contract with a customer. At delivery, the buyer clears the liability and records the inventory and the amount owed to the supplier.

A purchase agreement can protect a buyer from shortages while exposing it to falling prices. The invoice may arrive in January even though the buyer already knew in December that it would lose money. Recording the loss in the period the price drops puts it in the right year. The liability set up at that point keeps the same loss from hitting income again when the goods arrive.

Key takeaways

• Signing a purchase commitment creates no journal entry, even when the contract is noncancelable.
• A material commitment may warrant disclosure in the notes.
• If the contract is firm, noncancelable, and unhedged, and the contract price is more than the buyer can recover, record a loss and an estimated liability in the period the value drops.
• If the value recovers before delivery, reduce the liability and record a recovery, but never more than the loss already recorded.
• At delivery, debit Inventory for the contract price minus the remaining liability, debit the liability, and credit Accounts Payable for the full contract price.

Video: Purchase commitment accounting in 6 minutes

This 6-minute Farhat Lectures video covers the same topic. Jump to the part you need:

• 0:06 What a purchase commitment is
• 0:28 Why no asset or liability is recorded at first
• 0:37 Cancelable versus noncancelable contracts and disclosure
• 1:10 Recognizing a loss when the contract price is above market price
• 3:26 Example: a $6 million land lease contract for oil extraction
• 4:08 Recording the loss and the estimated liability
• 4:55 Partially reversing a loss recorded earlier

Watch Purchase Commitments on YouTube

What is a purchase commitment?

A purchase commitment is an agreement to buy a set quantity of inventory at a set price, with delivery weeks, months, or even years later. Buyers like it because it locks in supply. Sellers like it because it locks in the sale.

Not every order is treated the same way. A routine purchase order that the buyer can cancel, and that is priced when the goods ship, creates no entry and no disclosure. A firm, noncancelable contract at a fixed price is the kind that can lead to a note disclosure or a recorded loss.

When does purchase commitment accounting require an entry?

Read the contract terms before comparing prices. Can the buyer walk away without a meaningful penalty? Is the price fixed? Have the goods transferred to the buyer? Is the buyer protected by a firm resale agreement? Each answer narrows what the balance sheet should show.

A contract is executory while both parties still owe their performance. A signed order alone generally gives the buyer neither inventory on hand nor an invoice payable. A material commitment may nevertheless warrant a note describing its nature and extent. Recording a loss is a separate decision. If firm customer orders protect the buyer’s margin and the contract cost is recoverable, a decline in a supplier’s current price alone does not establish a net loss.

The rule comes from the Financial Accounting Standards Board (FASB). In its Accounting Standards Codification (ASC), paragraphs 330-10-35-17 and 35-18 cover net losses on firm inventory purchase commitments.

The loss is measured the same way as a loss on inventory you already own. For companies that use FIFO or average cost, that means comparing the contract price with net realizable value (NRV). NRV is the expected selling price minus the costs to complete, sell, and ship the goods. Companies that use LIFO or the retail inventory method compare the contract price with market, which generally means current replacement cost within upper and lower limits.

A firm sales contract can protect the buyer if the net proceeds cover the purchase cost. For example, if the buyer must pay $12 per filter and has agreed to resell each one for $11, it still expects a $1 loss per filter even with no selling costs. When a loss is recorded, ASC 330-10-50-5 requires it to be shown separately in the income statement. Textbooks usually place it under other expenses and losses.

The wording goes back to Accounting Research Bulletin (ARB) No. 43, chapter 4, statement 10, issued in 1953 and since replaced by the Codification. You can still read it in FASB’s archive of original pronouncements: ARB 43, chapter 4, statement 10.

Purchase commitment journal entry example: a loss at year-end

Suppose Beacon Supply signs a noncancelable agreement on November 1, 20X1 to buy 4,000 replacement filters for $12 each. Delivery and transfer of control occur in February 20X2. Beacon has no hedge. It also has no firm sales contract that would let it recover the purchase cost. It has made no prepayment. It uses a perpetual inventory system. Beacon uses FIFO, so it measures any loss against net realizable value (NRV), meaning the expected selling price minus selling costs. Assume any loss is material, which means large enough to matter to someone reading the financial statements.

November 1. The contract total is $48,000. At signing, that cost is recoverable and neither party has performed. Beacon makes no journal entry.

December 31. The filters’ NRV has dropped. Beacon can now recover only $10.50 per filter after selling costs. The expected shortfall is $1.50 × 4,000 = $6,000. Beacon recognizes the loss in 20X1 and reports a current liability because settlement is due in February.

Your textbook may use different account names. Some, including Kieso’s Intermediate Accounting, debit Unrealized Holding Gain or Loss (Income) where this example uses Loss on Purchase Commitment. The amounts and the logic are the same. To watch a loss entry like this one being recorded, go back to the video above and start at 4:08.

What happens when the price recovers before delivery?

Suppose the estimated net amount recovers to $11.25 per filter in January. Beacon still expects a loss, but the shortfall is now just $0.75 × 4,000 = $3,000. Reducing the liability from $6,000 to $3,000 recognizes a $3,000 recovery in 20X2. Beacon records only the change since year-end. The video above walks through a partial reversal like this one starting at 4:55.

The February entry assumes the January estimate still holds and the supplier bills Beacon on credit. Debits of $45,000 and $3,000 equal the $48,000 payable. Across both periods the net loss is $6,000 less $3,000, or $3,000. That equals the difference between the invoice and the recorded inventory. Paying the invoice later simply debits Accounts Payable and credits Cash.

If the recoverable amount instead fell further, Beacon would update the liability for the additional shortfall before clearing it. If it rose above $12 before delivery, the maximum cumulative recovery would be the $6,000 originally recognized. The liability can return to zero. A favorable unperformed purchase contract does not create an additional gain under the ordinary inventory treatment in this example.

Common mistakes with purchase commitments

• Recording an entry at signing. No goods have moved and neither side has performed, so there is nothing to record on day one.
• Crediting Inventory for the loss. The buyer does not own the goods yet. The credit goes to Estimated Liability on Purchase Commitment.
• Recording inventory at the full contract price at delivery. The loss was already recorded, so inventory comes in at the contract price minus the remaining liability. In the Beacon example that is $45,000, not $48,000.
• Recording a gain above the original contract price. A recovery can only undo a loss already recorded. Once the liability is back to zero, stop.
• Recording a loss on a contract the buyer can cancel, or one protected by firm sales contracts. If the loss can be avoided or is already covered, there is no loss to record.

Working through inventory this week? The Farhat Lectures Intermediate Accounting course is a good next stop.

Purchase commitment disclosure vs. loss recognition vs. inventory write-down

A $48,000 contract and a $6,000 loss describe different exposures. The first is the agreed price for future goods. The second is the estimated unrecoverable portion. A note can explain the commitment to readers even when there is no recognized loss. When a material loss has arisen, giving readers a note alone would leave earnings and liabilities misstated.

The timing also separates this topic from writing down inventory you already hold to the lower of cost and net realizable value. For the opposite case, where certain inventory can be carried above cost, see inventory at net realizable value. Before receipt, Beacon has no filters to write down. After control transfers, the balance sheet includes inventory. A different issue arises when goods of different values arrive on one invoice, as the basket purchase allocation example illustrates.

Under International Financial Reporting Standards (IFRS), a purchase contract is onerous when its unavoidable costs exceed the economic benefits the buyer expects from it. If the buyer can cancel an unperformed order without a penalty, it can avoid the loss. When a contract is onerous, IAS 37 requires the buyer to recognize a provision for the unavoidable loss.

Practice questions and answers

1. A supplier quotes $8 today for goods a buyer has agreed to buy at $9. The buyer can cancel without cost. What loss does the buyer record on the order?

None on these facts. The buyer can avoid the difference, so it has no unavoidable loss on this order.

2. A firm order covers 900 units at $20. The buyer expects net proceeds of only $17 per unit and has no protection. What is the entry if the loss is material?

Debit Loss on Purchase Commitment and credit Estimated Liability on Purchase Commitment for $2,700. The calculation is 900 × ($20 − $17). The goods have yet to transfer, so the buyer does not credit Inventory.

3. The $2,700 liability is still on the books when the goods arrive, and the estimate is unchanged. How does the buyer record a credit purchase?

Debit Inventory $15,300 and debit the estimated liability $2,700. Credit Accounts Payable $18,000. The price due to the vendor is fixed, and the prior loss already explains the difference.

Frequently asked questions

Is a purchase commitment recorded on the balance sheet?

Not at signing. Neither side has performed yet, so the buyer records no asset and no liability. A liability shows up only if a firm, noncancelable commitment is expected to produce a loss. A material commitment may warrant disclosure in the notes even when the buyer records no liability.

What is the journal entry for a loss on a purchase commitment?

Debit Loss on Purchase Commitment and credit Estimated Liability on Purchase Commitment. The amount is the contract price minus what the buyer can recover on the goods. Some textbooks call the debit Unrealized Holding Gain or Loss (Income).

Where does a loss on a purchase commitment go on the financial statements?

The loss goes on the income statement, and ASC 330-10-50-5 requires it to be shown separately. Textbooks usually place it under other expenses and losses. The estimated liability goes on the balance sheet, as a current liability when delivery is due within a year.

What happens if the price recovers before delivery?

The buyer reduces the liability and records a recovery in income. The recovery can never be more than the loss already recorded. Once the liability is back to zero, any further price increase is ignored.

How does IFRS treat a loss on a purchase commitment?

Under IAS 37, a purchase contract is onerous when its unavoidable costs exceed its expected economic benefits. The buyer recognizes a provision for the unavoidable loss. If it can cancel an unperformed order without a penalty, it has no loss to provide for.

Why is the estimated liability smaller than the contract price?

It measures the unavoidable net loss, while the full invoice covers the goods to be received. Once the supplier delivers, the invoice payable replaces the obligation to perform under the purchase agreement.

Can the buyer record a gain when it locks in a good price?

With an ordinary executory inventory contract and no previously recognized loss, a favorable price creates no gain at signing. A later increase can reverse an existing loss up to its recorded amount.

Would a periodic system use a different debit at delivery?

A buyer using periodic records ordinarily debits Purchases where the perpetual example debits Inventory. The commitment liability and contractual amount owed follow the same logic.

About the author

Mansour Farhat, CPA, CIA, CFE, CGMA, is the founder of Farhat Lectures. He teaches accounting to CPA, CMA, and EA candidates and to college accounting students through farhatlectures.com and the Farhat Lectures YouTube channel.