Learning Questions and Answers for Financial Accounting, Lesson 8.1 – Mastery Level

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1

You should have already gone through the first section of the Guided Readings Cards for Chapter Eight. Therefore, you might already have answers for some (or many) of the following questions. Read them carefully. Judge your level of understanding by reading my answers at the bottom. Then, go through the questions a second or even a third time. It is not important how many times it takes to learn the material. It is important that you are able to provide good answers for all of these questions.

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(1) – A company buys one piece of inventory. It has a normal cost of $18. However, because of a special sale, the company is able to buy the inventory for only $15. The company has always been able to sell this type of merchandise for $25. On its balance sheet, what should the company report for this inventory -- $15, $18, $25, or some other number?

(2) – A company buys inventory and pays several amounts of money for various reasons such as delivery and assembly. From a reporting perspective, what are the two options for reporting each of those amounts?

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(3) – “Capitalization” means a cost is added to an asset account. “Expensing” means a cost is added to an expense account. If a company records a particular cost by adding it to the inventory T-account, which of these rules is being applied?

(4) – A company buys an item of inventory for $460. It pays a delivery company another $30 to get that merchandise to its sales showroom. The inventory is eventually sold. The company pays $20 to have the item delivered to the customer. How are these three costs reported?

(5) – A company buys inventory for $300 and then pays another $40. The $40 was not viewed as a normal and necessary cost. However, the company added the $40 to the inventory account. Later, the inventory was sold. By how much was net income incorrectly reported for this period?

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(6) – A company buys merchandise for $1,000. The invoice received from the seller is marked “2/10, n/30.” What does that mean?

(7) – Most companies try to take advantage of all sales discounts. Why?

(8) – A company uses a perpetual inventory system. What does that mean?

(9) – A company buys inventory for $11 in cash and pays another $2 for transportation to receive the goods. The inventory is then sold for cash of $18. What are the journal entries if a perpetual inventory system is used?

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(10) – What are the advantages and disadvantages of using a perpetual inventory system?

(11) – A company uses a periodic inventory system. What does that mean?

(12) – Why would a company ever use a periodic inventory system with the availability of modern technology?

(13) - A company buys inventory for $11 in cash and pays another $2 in transportation to receive the goods. The inventory is then sold for cash of $18. What are the journal entries if a periodic inventory system is used?

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(14) – A company can use a hybrid system to monitor inventory and its costs. What does that most likely mean?

(15) – What is a physical inventory?

(16) – In a periodic inventory system, when is a physical inventory taken?

(17) – In a perpetual inventory system, when is a physical inventory taken?

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(18) – In a perpetual system, cost of goods sold is monitored in an ongoing T-account. Every sale changes cost of goods sold right then. How is cost of goods sold determined in a periodic system?

(19) – In a periodic inventory system, cost of goods sold is determined using a formula. What is that formula?

(20) – In the formula to determine cost of goods sold, beginning inventory plus purchase costs less ending inventory, what is actually being calculated?

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These first questions cover the cost of inventory, the difference in perpetual and periodic inventory systems, and other related topics. There is nothing here that you cannot do, especially with a little practice. Work on the questions as many times as you need so that your understanding corresponds with the answers below

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(1) – A company buys one piece of inventory. It has a normal cost of $18. However, because of a special sale, the company is able to buy the inventory for only $15. The company has always been able to sell this type of merchandise for $25. On its balance sheet, what should the company report for this inventory -- $15, $18, $25, or some other number?

Unless there is a problem with the inventory (it is damaged or old, for example), it is reported at historical cost. In this case, that is $15. That is the amount the company willingly sacrificed to obtain this merchandise.

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(2) – A company buys inventory and pays several amounts of money for various reasons such as delivery and assembly. From a reporting perspective, what are the two options for reporting each of those amounts?

When a cost is incurred, the company can record an asset (the cost represents a future economic benefit) or an expense/loss (the cost does not represent a future economic benefit – it represents a past economic benefit). According to conservatism, if a company is not sure whether a cost reflects a future economic benefit, it should be recorded as an expense (or loss).

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(3) – “Capitalization” means a cost is added to an asset account. “Expensing” means a cost is added to an expense account. If a company records a particular cost by adding it to the inventory T-account, which of these rules is being applied?

Any cost that the buyer incurs that is normal and necessary to get the item into position and condition to be sold is capitalized. In my live class, I draw an X on the board and write, “Sales Point.” Then, I tell the class, “Any cost that helps you get to that point is probably going to be capitalized. Any cost that you incur after that point is probably going to be expensed because the sale has already been made.”

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(4) – A company buys an item of inventory for $460. It pays a delivery company another $30 to get that merchandise to its sales showroom. The inventory is eventually sold. The company pays $20 to have the item delivered to the customer. How are these three costs reported?

The $460 and $30 are both normal and necessary to get the inventory into a condition and position to be sold. Inventory is reported at $490. When the sale is made, this $490 is switched from inventory (asset) to cost of goods sold (expense). The $20 cost occurs after the inventory is sold and does not meet the capitalization criteria. It is recorded as a delivery expense.

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(5) – A company buys inventory for $300 and then pays another $40. The $40 was not viewed as a normal and necessary cost. However, the company added the $40 to the inventory account. Later, the inventory was sold. By how much was net income incorrectly reported for this period?

Once the inventory is sold, net income is correctly reported even though two accounts are wrong. Cost of goods sold (expense) is reported as $340 but the additional $40 should not have been capitalized. The company should have reported cost of goods sold as $300 and the $40 as an expense (or loss). The separate expense balances are reported incorrectly but the total is still the appropriate $340. Net income is properly stated.

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(6) – A company buys merchandise for $1,000. The invoice received from the seller is marked “2/10, n/30.” What does that mean?

The buyer can deduct a 2 percent discount ($20) if the invoice is paid within 10 days after being received. Otherwise, the entire amount must be paid by the end of 30 days. The company can pay $980 after 10 days or wait 20 more days and pay $1,000.

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(7) – Most companies try to take advantage of all sales discounts. Why?

A 2 percent discount for paying 20 days sooner is a nice reward for such a short period of time. If possible, company officials will always take that offer and save the money.

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(8) – A company uses a perpetual inventory system. What does that mean?

The cost of inventory is updated each time merchandise is either bought or sold. Cost of goods sold is recorded as soon as merchandise is sold. In simple terms, companies record changes in both the inventory account and cost of goods sold as they take place.

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(9) – A company buys inventory for $11 in cash and pays another $2 for transportation to receive the goods. The inventory is then sold for cash of $18. What are the journal entries if a perpetual inventory system is used?

When bought, inventory is debited for $13 ($11 and $2) and cash is credited for $13. When sold, cash is debited for $18 and sales revenue is credited for $18. In a perpetual inventory system, cost of goods sold is also debited for $13 and inventory is credited for $13. Both the increase and the decrease in inventory are recorded immediately.

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(10) – What are the advantages and disadvantages of using a perpetual inventory system?

The advantage is that company officials always know what inventory they have on hand and how much profit they have earned to date on sales. Such information is valuable for internal decision making. The company is more likely to buy the inventory it needs at the time when it is most needed. However, such systems can be expensive to set up and monitor. If officials do not plan to use the information, the company has no reason to pay the extra amount for a perpetual system.

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(11) – A company uses a periodic inventory system. What does that mean?

The company will keep track of its individual costs but it makes no attempt to monitor the inventory currently on hand or the cost of goods sold to date. Although the company maintains a record of its various costs (purchase of inventory, transportation, assembly, and the like), it does not record either the quantity or the cost of the merchandise on hand. Likewise, the company makes no attempt to keep a record of its cost of goods sold for the current period. Available information about inventory is quite limited.

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(12) – Why would a company ever use a periodic inventory system with the availability of modern technology?

Some companies have only a small amount of inventory and the cost of monitoring those amounts should be minimized. Officials for some companies do not expect to make use of inventory data. In that situation, the company has no reason to pay the added cost for a perpetual system if the information will not be used.

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(13) - A company buys inventory for $11 in cash and pays another $2 in transportation to receive the goods. The inventory is then sold for cash of $18. What are the journal entries if a periodic inventory system is used?

Purchases of inventory is debited for $11 and transportation-in is debited for $2. Cash is credited for $13. Then, cash is debited for $18 and sales revenue is credited for the same $18. The purchases of inventory and transportation-in costs are monitored but neither inventory nor cost of goods sold appears in the entries. They are not part of a periodic inventory recording system.

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(14) – A company can use a hybrid system to monitor inventory and its costs. What does that most likely mean?

As in in the previous question, all journal entries are made using a periodic inventory system which is simple and allows the company to monitor various costs. However, the quantity (but not the cost) of inventory and cost of goods sold is recorded using a perpetual system. The company knows how many units are on hand and how many have been sold but does not know the exact cost. This gives the company a considerable amount of information in a relatively cheap system.

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(15) – What is a physical inventory?

A physical inventory is a count of the amount of merchandise that a company currently has on hand. The cost of the individual units can then be applied to this quantity to determine the total cost of these goods.

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(16) – In a periodic inventory system, when is a physical inventory taken?

In a periodic system, the inventory count is traditionally performed on the last day of the fiscal year or within a few days of the end of the year. It is needed to determine inventory on the balance sheet and to calculate cost of goods sold on the income statement.

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(17) – In a perpetual inventory system, when is a physical inventory taken?

In a perpetual system, the balances for inventory and cost of goods sold are already available in T-accounts. A physical count is not urgently needed. The physical inventory is only taken to check the accuracy of those figures. Unless the company has a reason to believe that the records are not appropriately accurate, the company can take the count and adjust the records whenever it is most convenient.

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(18) – In a perpetual system, cost of goods sold is monitored in an ongoing T-account. Every sale changes cost of goods sold right then. How is cost of goods sold determined in a periodic system?

In a periodic system, the company does not attempt to maintain an immediate record of cost of goods sold. Instead, (1) purchase costs are monitored during the period, (2) a physical inventory is taken at or near the end of the year, and (3) cost of goods sold is calculated using a formula. The company does not know its cost of goods sold until this calculation is made.

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(19) – In a periodic inventory system, cost of goods sold is determined using a formula. What is that formula?

The company starts with the cost of its beginning inventory and then adds in all of the current inventory acquisition costs for the new year. The cost of the ending inventory is then subtracted to determine cost of goods sold. This formula is important for reporting inventory: beginning inventory plus the total of inventory purchase costs less ending inventory leaves the cost of goods sold to be reported on the income statement.

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(20) – In the formula to determine cost of goods sold, beginning inventory plus purchase costs less ending inventory, what is actually being calculated?

The calculation determines the cost of the inventory that is missing or gone. Because there is no other information available in a periodic system, the assumption is made that the inventory that is gone has been sold. Thus, companies claim that they are computing cost of goods sold.

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That should give you a good start on our two-chapter coverage of inventory and cost of goods sold. Make sure that you are comfortable with your answers for all of these questions. Run through them occasionally to keep the information fresh in your mind.

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