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CHAPTER 5
THE PURCHASE AND SALE OF INVENTORY
CHAPTER OVERVIEW
The chapter begins with an overview of the purchase and sale of inventory cycle. This leads to a
discussion of merchandise inventory, how inventory is purchased (including purchase discounts,
purchase returns and allowances, and shipping costs), and the physical flow of inventory through
a company.
The next part of the chapter discusses the four basic inventory cost flow assumptions: specific
identification; weighted average; first-in, first-out (FIFO); last-in, first-out (LIFO). The two
methods of record keeping for inventory (periodic and perpetual) are then presented. Next, the
inventory cost flow assumptions are combined with the record-keeping systems to illustrate six
possible inventory systems that a company may use.
Next, a summary problem is presented that continues the Team Shirts example from previous
chapters and presents the student with transactions for the fifth month of business. The student is
then required to make adjusting entries at the end of May and prepare the four financial
statements for the business.
Afterwards, there is a discussion of the lower-of-cost-or-market rule, and how to use inventory
information for analysis is given. At the end of the chapter, there is a discussion of the business
risks and controls associated with inventory.
LEARNING OBJECTIVES
After completing Chapter 5, your students should be able to answer these questions:
1. Calculate and record the purchase and sale of inventory.
2. Explain the two methods of inventory record keeping.
3. Define and calculate inventory using the four major inventory cost flow assumptions
and explain how these methods affect the financial statements.
4. Analyze transactions and prepare financial statements with the purchase
of inventory.
5. Explain the lower-of-cost-or-market rule for valuing inventory.
6. Define and calculate the gross profit ratio and the inventory turnover.
7. Describe the risks associated with inventory and the controls that minimize
risks.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 5-1
CHAPTER OUTLINE
Acquiring and Selling Merchandise (LO 1)
I. The acquisition and payment cycle begins when someone in a company requests goods or
services needed by the company.
a. A purchase requisition is sent to the purchasing agent.
b. The purchasing agent selects a vendor based on price, quality, and ability to deliver.
c. The purchasing agent sends a purchase order to the vendor.
i. A purchase order is a record of a company’s request to a vendor for goods
and services. It may be referred to as a P.O.
ii. It states what is needed, the prices, and the delivery time.
II. Recording purchases
a. Perpetual inventory system is a method of record keeping that involves updating the
accounting records at the time of every purchase, sale, and return.
i. Inventory records are updated as each purchase or sale is made.
ii. Requires a continuous updating of inventory records
b. Periodic inventory system is a method of record keeping that involves updating the
accounting records only at the end of the accounting period.
III. Who pays the freight costs to obtain inventory?
a. FOB (free on board) shipping point means the buying firm pays the shipping costs.
i. Freight costs are called freight-in.
ii. Included in the cost of the inventory
b. FOB destination means the vendor (selling firm) pays the shipping costs.
i. No freight cost for purchaser to account for
ii. Seller accounts for shipping as freight-out or delivery expense.
Teaching Tip
Use Exhibit 5.3, Shipping Terms, to explain the implications to the buyer and the seller.
IV. Purchase returns and allowances are amounts that decrease the cost of the inventory
purchases due to the returned or damaged merchandise.
a. Inventory is increased.
b. Accounts payable is decreased.
c. A purchase allowance occurs when goods are damaged or defective but are kept by
the purchaser with a cost reduction.
V. Purchase discount is the reduction in the price of an inventory purchase for prompt
payment according to the term specified by the vendor.
a. Discount terms example: 2/10, n/30. This means the purchaser may take a 2%
discount if payment is received within ten days. Otherwise, the full amount is due in
30 days.
b. The discount, if taken, decreases the inventory account.
VI. Cost of goods available for sale is the total of beginning inventory plus the purchases
made during the period.
Teaching Tip
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 5-2
Before starting the discussion of inventory flow and inventory cost flow, explain the basic
relationship of inventory to cost of goods sold:
Purchases
- Purchase Discounts
- Purchase Returns & Allowances
+ Freight In
= Net Purchases
Beginning Inventory
+ Net Purchases
= Cost of Goods Available for Sale
- Ending Inventory
= Cost of Goods Sold
VII. Selling merchandise
a. Recording sales
i. Increase sales revenue.
ii. Increase cash (if cash sale) or accounts receivable (if credit sale).
b. Sales returns and allowances is an account that holds amounts that reduce sales due
to customer returns or allowances for damaged merchandise.
i. This is a contra-revenue account and will be deducted from sales revenue on
the income statement.
c. Sales discount is a reduction in the sales price of a product offered to customers for
prompt payment.
i. This is also a contra-revenue account and will be deducted from sales revenue
on the income statement.
d. Sales taxes
i. Additional amounts collected at the time of sale for sales taxes are a liability
that the firm owes to the government.
Recording Inventory: Perpetual versus Periodic Record Keeping (LO 2)
I. Perpetual
a. Advantages
i. The inventory records are always current.
ii. A physical count can be compared to the records to see if there is any
inventory shrinkage.
b. Disadvantage is the system may be too cumbersome if a firm doesn’t have an up-to-
date computer system.
II. Periodic
a. Inventory records only updated at the end of a period
b. Does not separately identity inventory shrinkage
Inventory Cost Flow Assumptions (LO 3)
I. Inventory flow refers to the physical passage of goods through a business.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 5-3
II. Inventory cost flow refers to the flow of the costs associated with the goods that pass
through a business.
III. GAAP allows a company to select one of several basic inventory cost flow
assumptions:
a. Specific identification method
b. Weighted-average method
c. First-in, first-out (FIFO) method
d. Last-in, first-out (LIFO) method
IV. Specific identification method is the inventory cost flow method in which the actual
cost of the specific goods sold is recorded as cost of goods sold.
a. Each item sold must be identified as coming from a specific purchase and at a
specific unit cost.
b. Usually used when there is a small quantity of high value items in inventory
V. Weighted-average method is the inventory cost flow method in which the weighted
average cost of goods available for sale is used to calculate the cost of goods sold and
the ending inventory.
a. An average unit cost is calculated by dividing the total cost of goods available for
sale by the total number of units available for sale.
b. The average unit cost is weighted because the number of units at each different
price is used to weight the unit costs.
VI. First-in, first-out (FIFO) method is the inventory cost flow method that assumes the
first items purchased are the first items sold.
a. The cost of the first goods purchased is assigned to the first goods sold.
b. The cost of goods on hand at the end of a period is determined from the most
recent purchases.
VII. Last-in, first-out (LIFO) method is the inventory cost flow method that assumes the
last items purchased are the first items sold.
a. The cost of the last goods purchased is assigned to the cost of goods sold.
b. The cost of goods on hand at the end of a period is assumed to be the cost of
goods purchased earliest.
c. If using LIFO, must provide extra disclosure in the financial statements.
Teaching Tip
Stress this point to students: While FIFO seems to be most reasonable in terms of physically
handling goods, any of the methods may be used to account for the cost of goods. The physical
flow of the goods does not have to be the same as the cost flow of the goods.
Teaching Tip
LIFO does not match the physical flow of goods for most companies. Ask students to think of a
company that would physically handle its inventory by this method. Possible answers: sand or
gravel company; dirt contractor.
Teaching Tip
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 5-4
At first it may seem to students that FIFO and LIFO are just the opposite of what they sound like.
Help students remember which is which by reminding them “First-in-first-out to cost of goods
sold” means the last purchases are left to value ending inventory (Last-in-still-there).
“Last-in-first-out to cost of goods sold” means the beginning inventory and first purchases are
left to value ending inventory (First-in-still-there).
Teaching Tip
Use the examples in the textbook to illustrate the effect of the four methods on cost of goods sold
(on the income statement) and inventory (on the balance sheet). Also, ask the students to name
examples of companies that use these four methods to account for the physical flow of their
inventories. Explain that these companies may use any of the four methods to account for the
cost of their inventory, regardless of how the inventory physically flows through the business.
How Inventory Cost Flow Assumptions Affect the Financial Statements (LO 3)
I. No matter which method a company selects, the cost of goods available for sale is the
same.
II. The inventory cost flow assumption and record-keeping method determine how that
dollar amount of cost of goods available for sale is divided between cost of goods sold
and ending inventory.
III. Periodic record keeping
a. Weighted average periodic
i. Cost of all goods available for sale for the entire accounting period are used to
calculate a weighted-average cost.
ii. Inventory records and cost of goods sold are updated at the end of the
accounting period.
b. FIFO periodic
i. Oldest goods in the inventory are sold first.
ii. Inventory records and cost of goods sold are updated at the end of the
accounting period.
c. LIFO periodic
i. Newest goods in the inventory are sold first.
ii. Inventory records and cost of goods sold are updated at the end of the
accounting period.
IV. Perpetual record keeping
a. Weighted average perpetual
i. Inventory is recorded every time a sale is made.
ii. Calculate a new weighted-average cost every time a purchase or sale is made.
This is called the moving weighted average.
b. FIFO perpetual
i. Oldest goods in the inventory are sold first.
ii. Inventory records and cost of goods sold are updated at every purchase and
sale.
c. LIFO perpetual
i. Newest goods in the inventory are sold first.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 5-5
ii. Inventory records and cost of goods sold are updated at every purchase and
sale.
Teaching Tip
Use Exhibit 5.16 to illustrate the different possibilities for cost flow record-keeping assumptions.
V. Income tax effects of LIFO and FIFO
a. Because inventory cost flow assumptions affect the financial statements, GAAP
requires disclosure about these assumptions and related information in the notes to the
financial statements.
VI. How do firms choose an inventory cost flow method?
a. Compatibility with similar companies
b. Maximize tax savings and cash flows
c. Maximize net income
Applying Inventory Assumptions to Team Shirts (LO 4)
I. The summary problem uses the Team Shirts example developed in previous chapters.
II. Transactions for the month of May are introduced.
III. The students are required to make the necessary adjusting entries and prepare financial
statements for the month of May.
Complications in Valuing Inventory: Lower-of-Cost-or-Market Rule (LO 5)
I. GAAP requires companies to compare the cost of their inventory at the end of the period
with the market value of that inventory
a. The lower-of-cost-or-market rule is the rule that requires firms to use the lower of
either the cost or the market value (replacement cost) of its inventory on the date of
the balance sheet.
b. Replacement cost is the cost to buy similar items in inventory from the supplier to
replace the inventory.
II. If market value is lower than cost, inventory is written down, which lowers net income.
III. If market value is higher than cost, inventory is not written up.
Financial Statement Analysis (LO 6)
I. Gross profit ratio
a. Gross profit ratio is equal to the gross profit (sales minus cost of goods sold) divided
by sales.
b. Used for evaluating firm performance
c. Tells the percentage of sales that is profit
d. A small shift in gross margin ratio can translate into large shifts in net income.
II. Inventory turnover ratio
a. Inventory turnover ratio is defined as cost of goods sold divided by average
inventory.
b. Measures how quickly a firm sells its inventory
c. The average days in inventory ratio is the number of days it takes, on average, to
sell an item of inventory.
d. It is computed by dividing 365 by the inventory turnover ratio.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 5-6
Business Risk, Control, and Ethics (LO 7)
I. Inventory: risks and controls
a. Inventory must be protected from damage and theft.
i. Locked storage rooms and limited access
ii. Segregation of duties
b. Inventory must also be protected from loss as a result of obsolescence.
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 5-7
c. CHAPTER 5 NAME
___________________________________
TEN-MINUTE QUIZ Section _____________ Date____________
_____________________________________________________________________________
_
_____ 1. Merchandise inventory is classified as a:
a. Long-term asset
b. Current liability
c. Current asset
d. Revenue
_____ 2. Discount terms of 1/10, n/45 mean:
a. 10% discount if paid within 45 days
b. 1% discount if paid within 10 days
c. 1% discount if paid within 45 days
d. No discount is allowed
_____ 3. Net purchases consists of:
a. Purchase discounts
b. Gross purchases
c. Purchase returns and allowances
d. All of the above
_____ 4. Which of the following inventory methods uses the cost of the oldest goods on
hand to calculate cost of goods sold?
a. Last-in, first-out (LIFO)
b. First-in, first-out (FIFO)
c. Weighted average
d. Specific identification
_____ 5. Which of the following inventory methods uses the cost of the newest goods on
hand to calculate cost of goods sold?
a. Last-in, first-out (LIFO)
b. First-in, first-out (FIFO)
c. Weighted average
d. Specific identification
_____ 6. Which of the following inventory systems requires that cost of goods sold is
calculated at the time of each sale?
a. Periodic
b. Weighted average
c. Perpetual
d. All of the above
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 5-8
Use the following data for questions 7-9:
Clayton Enterprises reported the following for the month of March:
Beginning inventory 100 @ $5
Purchase 3/15 80 @ $6
Purchase 3/22 70 @ $7
Sales 200 @ $18
_____ 7. What is the balance of ending inventory under FIFO?
a. $250
b. $300
c. $350
d. None of the above
_____ 8. What is the balance of ending inventory under LIFO?
a. $250
b. $300
c. $350
d. None of the above
_____ 9. What is the balance of ending inventory under weighted-average cost?
a. $294
b. $300
c. $326
d. None of the above
_____ 10. The inventory turnover ratio is calculated as:
a. Gross margin divided by sales
b. Gross margin divided by average inventory
c. Cost of goods sold divided by average inventory
d. Cost of goods sold divided by sales
ANSWER KEY - CHAPTER 5 – TEN-MINUTE QUIZ
C
B
D
B
A
C
C
A
A
d. C
Copyright © 2011 Pearson Education, Inc. publishing as Prentice Hall 5-9
