Guided Readings for Financial Accounting, Lesson 8.1 – Mastery Level
“How Does a Company Gather Information about its Inventory?” The
following guided readings cards were created to accompany the updated
third edition of Chapter Eight (Version 3.1) of Financial
Accounting authored by Joe Hoyle, C. J. Skender, and Leah Kratz
and published by FlatWorld.
Copyright 2022 by Joe Hoyle
Watch the opening video for Chapter Eight in the textbook:
Introduction to Chapter Eight.
This chapter is the first of two that examines the financial reporting of inventory and cost of goods sold. Many companies are created specifically to sell inventory: automobiles, books, shampoos, and the like. It is not surprising that the reporting of the asset (inventory) and the expense (cost of goods sold) is quite important.
SUGGESTION: Read the first section of Chapter Eight (“Determining and Reporting the Cost of Inventory”). This section introduces Chapter Eight by explaining how the capitalized cost reported for a company’s inventory is computed. What amounts are included in the cost figure incurred in acquiring the merchandise a company holds for sale?
(8Q1) – In accounting, what does the term “capitalization” mean?
(8A1) – Capitalization means that an incurred cost is added to an asset account rather than to an expense account. Costs are capitalized if they are expected to provide future economic benefits. To be reported as an asset, a cost should help the reporting company generate additional revenue or become more profitable in the future.
(8Q2) – The process of accounting for inventory begins by determining the cost incurred to obtain merchandise for the purpose of being sold. In general, what costs are capitalized in reporting the acquisition of inventory?
(8A2) – In accounting for inventory, all normal and necessary costs to get merchandise into condition and position to be sold (to generate revenue) must be capitalized. If a cost is not expected to create a future economic benefit, it should be expensed rather than capitalized.
(8Q3) – Ace Company is located in New York and sells computers. It buys a computer from a manufacturer in Cleveland, Ohio, for $6,000. Ace pays $230 to have the machine delivered to its retail store in New York City. Ace pays 3 technicians a total of $1,500 to install the necessary software and make sure the computer is operational. On its balance sheet, what is reported as the cost of this inventory? What is the capitalized cost?
(8A3) – Ace Company has incurred a total cost of $7,730 ($6,000 + $230 + $1,500) to get the inventory (a computer) into condition and position so that it can be sold. Each of these three costs appears to be normal and necessary. Therefore, they should all be capitalized. The reported cost of the asset (inventory) is $7,730. This is the same process as shown in Table 8.1 in the textbook.
(8Q4) – Ace Company is located in New York City and sells computers. It buys a computer from a manufacturer in Cleveland, Ohio, for a total capitalized cost of $7,730. The computer is later sold to a customer in Buffalo, New York, for $10,000. Ace pays $400 to have the computer delivered to this customer. How does Ace account for the $400 delivery cost?
(8A4) – All normal and necessary costs to get inventory into a condition and position to be sold are capitalized (added to the recorded cost of the inventory). This cost is then moved to cost of goods sold at the time of sale. The $400 cost to deliver the inventory to the customer was incurred after the sale was made. It leads to no additional revenue. It is a cost of making the sale rather than a cost of the inventory. The $400 is reported as a delivery expense when incurred and not as an additional cost of the inventory.
Work the first Test Yourself question in Section 8.1 of Chapter Eight (“Near the end of Year One, the Morganton …”) as well as the One Step Further follow-up. The company is buying and selling lawn mowers and incurs several different costs. You must determine which of these costs is capitalized and which is expensed. Then, determine the specific cost of the one that is sold. It is a realistic problem. Companies that sell inventory must make this type of computation every day.
(8Q5) – The Almond Company sells inventory to the Tory Company for $9,000. Almond’s invoice (bill) includes the notation “2/10,n/30.” What information is communicated to Tory by this notation?
(8A5) – The term “2/10,n/30” is spoken as “two ten, net 30.” It indicates to the buyer that a 2 percent discount can be taken if the invoice is paid within 10 days of being received. The remaining net balance (the total reduced by any payment made to date) is due within 30 days. Because the purchase was for $9,000, the buyer can pay $8,820 in 10 days ($9,000 reduced by 2 percent or $180) or the entire $9,000 in 30 days. It is a common business decision: Should the company wait 20 days and then pay the extra $180? Many companies prefer to pay early and save the money.
(8Q6) – The Almond Company sells inventory to the Tory Company for $9,000. Almond’s invoice includes the notation “2/10,n/30.” The buyer can earn a 2 percent discount by paying in 10 days rather than in 30 days. Why is Almond offering this discount to the buyer?
(8A6) – Cash discounts are offered to entice quick payment. Until collected, the money is not available for use by Almond. Sellers want to receive cash as soon as possible so the money can be invested in new inventory or other property that will generate additional profits. Quick payment also eliminates the possibility of a bad debt which is more likely to happen as a receivable grows older.
(8Q7) – The Almond Company sells inventory to the Tory Company for $9,000. Almond’s invoice includes the notation “2/10,n/30.” The buyer will earn a 2 percent discount by paying in 10 days rather than in 30 days. Is Tory likely to take advantage of this offer?
(8A7) – Most companies take advantage of all such discounts because of the value of the savings. Tory can save $180 (2 percent of $9,000) simply by paying 20 days quicker than required. As the textbook indicates, on an annual basis that is a lot of money. That offer is one that is difficult to refuse unless the buyer is having severe liquidity problems.
(8Q8) – What does the term “liquidity” mean?
(8A8) – Liquidity refers to an entity’s ability to hold sufficient cash resources so that it can pay bills as they come due and still have enough money to meet other operating needs. A company is said to have “liquidity problems” if it has access to less cash than is needed to operate efficiently.
(8Q9) – The Almond Company sells inventory to the Tory Company for $9,000. Almond’s invoice includes the notation “2/10, n/30.” The buyer will earn a 2 percent discount by paying in 10 days rather than in 30 days. What does Tory report as the capitalized cost of this inventory?
(8A9) – If the buyer takes the discount, a total of $180 is saved (2 percent of $9,000) and the inventory has a capitalized cost of $8,820. This process can be seen in Table 8.2 in the textbook. If the buyer does not take the discount, no money is saved and the inventory has a capitalized cost of $9,000.
The following statement is included in the end-of-chapter material as a True or False question. “Inventory is bought for $600 on terms of 2/10,n/60. Thus, if payment is made in 10 days, the buyer only has to pay $540.” That statement is False. Why is that statement False?
The statement is False. Inventory is acquired here for $600 but the seller offers a 2/10, n/60 discount. The buyer can pay 2 percent less if payment is made in 10 days. In that case, the discount is 2 percent of $600 or $12. The buyer pays $588 ($600 less $12) and not $540.
SUGGESTION: Read the second section of Chapter Eight (“Perpetual and Periodic Inventory Systems”). It is merely five pages. Companies can use either of two recording systems to monitor the cost of its inventory. One system provides more useful information but is more costly. The other provides little information but has less cost. Company officials must decide if the additional information is worth the extra cost.
(8Q10) – Some companies maintain their inventory records using a perpetual system. What type of system is that? What are the advantages and disadvantages of a perpetual inventory system?
(8A10) – When a company uses a perpetual inventory system, an ongoing record is maintained of the amount of inventory on hand as well as the total amount sold this year (cost of goods sold). The advantage is that company officials have a significant amount of information available to help them make good decisions about buying and selling inventory. The disadvantage is that a perpetual system is more costly to implement although improvements in technology have reduced the cost considerably over the decades.
(8Q11) – Ace Company maintains a perpetual inventory system. It buys one piece of inventory for $40 cash and pays another $3 to have it delivered to its retail store in San Francisco. The inventory is then sold for $76 cash. How are these transactions recorded?
(8A11) – In a perpetual system, inventory costs are capitalized as
incurred. Cost of goods sold is recorded at the time of sale.
When the purchase is made, inventory is debited for $40 and then $3.
Later, when the sale is made, cash is debited for $76 and sales revenue is credited. Then, another entry is made to record a debit to cost of goods sold for $43 and a credit to inventory for the same amount.
In the first chapters of this book, companies have always used perpetual inventory systems for convenience because it is an easy system to understand. In reality, a number of methods and variations can be created to monitor the cost of inventory on hand and the amount that has been sold to date.
(8Q12) – In a perpetual inventory system, both a general ledger T-account and a subsidiary ledger are used. What is found in each of these two ledgers?
(8A12) – The general ledger contains the Inventory T-account used to maintain the current monetary total for all the company’s merchandise. In contrast, the subsidiary ledger holds individual balances for the various types of inventory. For example, if this is a hardware store, the subsidiary ledger could maintain a balance for hammers, a balance for nails, a balance for saws, and so on. The total balance of all subsidiary ledger accounts should be equal to the general ledger “Inventory” total.
Work the Test Yourself question in Section 8.2 of Chapter Eight (“A grocery store carries cans of tuna fish, …”). This question looks at how a perpetual system collects information. It addresses both the general ledger accounts and the use of a subsidiary ledger. Notice that three of these answers are correct. Only one is not true. Which is it? Read the answer carefully. Use these questions to help you learn.
(8Q13) – Instead of a perpetual system, a company can also maintain its inventory records using a periodic system. What type of system is that? What are the advantages and disadvantages of a periodic inventory system?
(8A13) – In a periodic system, no ongoing record of either inventory or cost of goods sold is kept. The T-accounts do not show the inventory currently on hand or the inventory that has been sold. Instead, the various costs of acquiring inventory are recorded so that any cost increases can be addressed quickly. A periodic system has a few advantages. It is cheap and focuses on monitoring costs. The disadvantage is that it provides little information about the inventory on hand to help officials make wise decisions.
(8Q14) – Now that computers have reduced the cost of a perpetual inventory system substantially, why does any company continue to use a periodic inventory system?
(8A14) – Some companies have small quantities of inventory. With just a few items, the cost of a perpetual system (even if reduced) is not warranted. Other companies hold only low cost items and do not face sophisticated buying and selling decisions. Furthermore, hybrid systems are often used. A company’s perpetual system might be designed to monitor the number of units while a periodic system records costs. This approach is popular to provide up-to-date quantity data at a lower cost than a complete perpetual system.
(8Q15) – Ace Company maintains a periodic inventory system. The company buys one piece of inventory for $40 cash and pays another $3 to have the item delivered to its store in Houston. The inventory is then sold for $76 cash. How are these transactions recorded? Table 8.4 in the textbook shows the recording of the purchasing part of this question.
(8A15) – In a periodic system, inventory costs are monitored
separately. Inventory on hand and cost of goods sold are not
determined until financial statements are prepared.
When bought, purchases of inventory is debited $40 and transportation-in is debited $3. That provides important cost information. When sold, sales revenue is credited $76. No cost of goods sold is recorded at that time because the company is not monitoring that cost.
SUGGESTION: Work the second Test Yourself question in Section 8.2 of Chapter Eight (“A company starts operations in Year One and buys ten units …”) and the One Step Further question. This question compares the reporting process employed in a periodic system with that used in a perpetual system. What information is available in each of these systems? Read what the explanation tells you.
(8Q16) – What is meant by the term “physical inventory?” What is its significance in a periodic inventory system? What is its significance in a perpetual inventory system?
(8A16) – A physical inventory is merely the counting of inventory on hand. In a periodic system, a physical inventory is taken at the end of each fiscal period so that both the amount of inventory and the cost of goods sold can be determined mathematically and reported on the company’s financial statements.
(8A16) – continued
In a perpetual system, a physical inventory is taken on occasion (maybe once a year when it is most convenient) to verify the accuracy of the inventory records.
(8Q17) – In a periodic inventory system, neither the current inventory balance nor cost of goods sold is known. How are these figures determined so that financial statements can be produced?
(8A17) – A physical inventory count is taken at the end of each year when a periodic system is used. This figure serves as the inventory reported on the balance sheet. Cost of goods sold is then calculated by a formula: beginning inventory plus purchases (and related costs) minus ending inventory. This formula determines the amount of inventory that is no longer held by the company. That figure is assumed to be the cost of the goods sold during the period.
(8Q18) – Cost of goods sold is calculated in a periodic system using the formula: beginning inventory plus purchases (and other normal and necessary costs) of inventory during the period less ending inventory. How are those three balances actually determined?
(8A18) – (1) Beginning inventory can be taken from the prior year balance sheet. Or, it is the total of the physical count at the end of the previous year. It is also the opening balance in the inventory T-account. (2) The cost of purchases for the period is the summation of the T-account balances for current purchases, transportation-in, assembly costs, and the like. The total reflects the normal and necessary costs of acquisitions during the period. (3) A physical count at the end of the current year determines the goods still held.
(8Q19) – A company purchases inventory costing $328,000 this year but receives a discount of $9,000 for quick payment. Transportation costs of $22,000 are paid to have these items delivered to the company store. Beginning inventory was $57,000 but fell to only $34,000 by the end of the year. What was the cost of goods sold for the period?
(8A19) – The total cost of inventory purchases for this year is $341,000: purchases of $328,000 less discounts of $9,000 plus transportation costs of $22,000. Cost of goods sold can then be calculated as: $57,000 (beginning inventory) plus $341,000 (purchases and related costs) less $34,000 (ending inventory) or $364,000. Companies have been making that computation for hundreds of years.