978-0136115274 Chapter 5 Lecture Notes

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.

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

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.

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

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.

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.

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.

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

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

A

d. C