Guided Readings for Financial Accounting, Lesson 8.2 – Mastery Level

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1

SUGGESTION: Read the third section of Chapter Eight (“The Calculation of Cost of Goods Sold”). This section of the textbook begins by looking at the importance of the FOB point—the moment at which goods are transferred from the ownership of the seller to the ownership of the buyer.

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(8Q20) – Ace Company buys inventory from Zebra Company. The goods cost Zebra $23,000 but were sold to Ace for $41,000. This merchandise was shipped by Zebra on December 28, Year One, and arrived at Ace’s location on January 3, Year Two. When does Ace record the purchase? When does Zebra record the sale?

(8A20) – In an inventory transaction such as the one between Ace and Zebra, an FOB point must be established. It is usually set by the seller or negotiated by the two parties. The FOB point identifies when title to goods is legally conveyed from seller to buyer. If the transfer from Zebra to Ace is FOB shipping point, the transaction is recorded by both parties on December 28, Year One. If it is FOB destination, their recording must wait until the items arrive on January 3, Year Two.

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(8Q21) – On December 31, Year One, Kenan Corporation counts its inventory and finds items costing $400,000 actually on hand . One other piece of inventory that the company had bought recently for $19,000 is in transit from the seller. It was shipped FOB destination. What should be reported as the total cost of Kenan’s ending inventory?

(8A21) – The inventory purchased by Kenan was shipped FOB destination and has not yet arrived. Thus, title has not passed to the buyer. These goods do not yet belong to Kenan and should not be included in its inventory. Kenan’s reported balance remains $400,000. It does not hold title to the $19,000 in merchandise that is in-transit at the end of the year. This transaction will be recorded by both parties when it arrives in Year Two.

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(8Q22) – On December 31, Year One, Kenan Corporation counts its inventory and finds $400,000 actually on hand. One piece of inventory that Kenan sold near the end of Year One is in transit to the buyer. It costs Kenan $23,000 but was sold for $39,000. The merchandise was shipped to the customer FOB destination. What should be reported as the total cost of Kenan’s ending inventory?

(8A22) – The sold inventory was shipped FOB destination but has not yet been received by the buyer. Until the merchandise reaches the FOB point, this inventory still belongs to Kenan (the seller). Thus, it should still be included in Kenan’s inventory at its $23,000 cost. Kenan’s total ending inventory is $400,000 on hand plus this $23,000 in transit or $423,000.

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(8Q23) – Kenan Corporation counts its inventory on hand on December 31, Year One, and finds $400,000. One other piece of inventory that the company recently bought for $19,000 is in transit from the seller. It was sent to Kenan FOB shipping point. Another piece of inventory that Kenan sold a few days ago is in transit to the buyer. It costs Kenan $23,000 but is sold for $39,000. Kenan sent it to the buyer FOB shipping point. What is the total cost of Kenan’s ending inventory?

(8A23) – The first inventory item was purchased FOB shipping point. Because it has been shipped, it now belongs to Kenan. The $19,000 cost should be included in the physical count. The inventory that was sold was also FOB shipping point. It has been shipped so this merchandise no longer belongs to Kenan. It was not counted (it was not there). That handling was correct. It is not part of the company’s ending inventory. The company’s total ending inventory is $400,000 on hand plus $19,000 in transit or $419,000.

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SUGGESTION: Work the first Test Yourself question in Section 8.3 of Chapter Eight (“A company buys 144 inventory items …”) and also the One Step Further question. These questions involve determining the effect of a mistake. Both companies (the buyer and the seller) make the wrong recording and the question asks you to determine the result. Such questions stretch the way you consider these transactions. They can build a stronger knowledge foundation. Think about what should be recorded. You can do it.

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(8Q24) – Andrews buys inventory from Jackson for $37,000. Delivery costs to receive these goods are $2,000. Andrews buys inventory from Wilson for $44,000. Unfortunately, this inventory was destroyed by an accident as it was being transported from Wilson to Andrews. In the first case, who is responsible for the $2,000 in delivery costs? In the second case, who is responsible for any uninsured loss due to the accident?

(8A24) – Transportation costs and losses incurred while inventory is in transit are normally the responsibility of the owner of the property during that time. Ownership is determined by the FOB point. If a sale is FOB shipping point, the goods belong to the buyer while in transit. Transportation costs and any losses are borne by the buyer. If a sale is FOB destination, the goods continue to belong to the seller until delivered. In that case, unless otherwise agreed on, the seller is responsible for transportation and in-transit losses.

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The following statement is included in the end-of-chapter material as a True or False question. “Ace Company reports Year One Cost of Goods Sold as $324,000 using a periodic system. One inventory item was not recorded or counted. Ace had bought the item from Zebra for $6,000. Zebra shipped it on December 28, Year One, and Ace received it on January 5, Year Two. It was shipped FOB shipping point. Ace should have reported cost of goods sold as $330,000.” That statement is False. Why is that statement False?

The previous statement is False. In a periodic system, cost of goods sold is computed as beginning inventory plus purchases less ending inventory. The $6,000 shipment was not recorded at all. It is in-transit and was shipped FOB shipping point. Thus, purchases (a positive) and ending inventory (a negative) should both be increased by $6,000. In the formula, these two cost increases will offset. The net result is that cost of goods sold remains at $324,000.

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Read the fourth section of Chapter Eight (“Reporting Inventory at Lower of Cost or Net Realizable Value”). It is a short section and should not take much time. Although companies maintain records to monitor the cost of the inventory on hand, that is not necessarily the figure reported as Inventory on the balance sheet. A more conservative figure—the lower of cost or net realizable value—is actually appropriate in many cases. This section looks at that reporting.

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Within Section 8.4, you will find a link to a video titled, Monitoring Inventory Using a Perpetual System. Watch that video carefully because it reviews much of the chapter up to this point.

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Within Section 8.4, you will find a link to a video titled, Monitoring Inventory Using a Periodic System. This video gives you the chance to review the financial reporting of an inventory account when a periodic inventory system is in use.

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(8Q25) – Inventory is normally reported at its cost. However, if the value of goods falls below cost, then this lower number is used because accounting tends to be conservative. Inventory is actually reported on a balance sheet at the lower of cost or net realizable value. How is net realizable value determined in connection with the reporting of inventory?

(8A25) – The definition of value for inventory was changed in U.S. GAAP a few years ago. It is now in line with IFRS. The value used in reporting inventory is net realizable value—the amount that can be collected from a sale after subtracting all costs needed to make the sale. Acquisition cost is usually lower than an item’s net realizable value unless a problem has arisen (for example, goods become damaged, old, or out of fashion). Reporting inventory at the lower of cost or net realizable value reflects any such problems.

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(8Q26) – The Chapel Hill Company has inventory costing $90,000. It is composed of three items—item A costing $20,000, item B costing $30,000, and item C costing $40,000. They have been held for some time. The company believes their sales value is now $22,000 for A, $36,000 for B, and $43,000 for C. It is likely to cost $5,000 in commissions to sell each item. What should Chapel Hill report as its ending inventory at lower of cost or net realizable value?

(8A26) – According to U.S. GAAP, net realizable value (NRV) is: $17,000 for A ($22,000 - $5,000), $31,000 for B ($36,000 - $5,000), and $38,000 for C ($43,000 - $5,000). Item A has a NRV $3,000 below its cost ($20,000 - $17,000). Item B has a cost $1,000 below NRV ($31,000 - $30,000). Item C has a NRV $2,000 below its cost ($40,000 - $38,000). In reporting inventory, the lower of cost or net realizable value is used. Item A is $17,000 (NRV), Item B is $30,000 (cost), and Item C is $38,000 (NRV). Inventory is reported at $85,000.

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The following statement is included in the end-of-chapter material as a True or False question. “If the sales value of a company’s inventory increases after its acquisition, the company should record a gain.” That statement is False. Why is that statement False?

The previous statement is False. According to U.S. GAAP, inventory is reported at the lower of its cost or net realizable value. Net realizable value is used for reporting purposes but only when it has fallen below the cost of the item. That can happen for many reasons such as age or damage. Increases in the value of inventory are not recorded until the item is actually sold.

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Read the fifth section of Chapter Eight (“Determining Inventory on Hand”). This section looks at several inventory counting issues. For example, what happens when a physical count finds that the balance on inventory on hand is different than the amount shown in the perpetual inventory records? Also, why might a company decide to estimate its current inventory?

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(8Q27) – The Pippin Company maintains a perpetual inventory system that currently shows a total inventory balance of $500,000. A physical count is taken to verify the accuracy of these records and only $480,000 in inventory is found. How does the company record the necessary $20,000 inventory reduction?

(8A27) – Even in a well maintained perpetual system, errors and losses occur. Here, inventory must be reduced by a $20,000 credit to match the count. The entry depends on the explanation for the missing merchandise. If goods were sold but not properly removed from the T-account, cost of goods sold is debited $20,000 as the correction. If the goods were lost, stolen, or the like, the debit is to a loss account. The company will not always know why the difference took place. Often, the change is simply recorded as cost of goods sold.

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(8Q28) – There are many different types of accountants: (1) financial accountants who maintain the system that leads to the preparation of financial statements, (2) managerial accountants who help people inside an entity obtain the information needed for decision making, (3) independent auditors who examine and report on financial statements, and (4) tax accountants who ensure that all tax laws are followed. Another type is a forensic accountant. What is the role of a forensic accountant?

(8A28) – Forensic accounting involves expert investigations where information has been lost or manipulated in some manner. For example, a forensic accountant might be hired to estimate the loss from a warehouse fire or from a major embezzlement. Instead of focusing on one company, the forensic accountant moves from job to job to solve specific problems that have arisen.

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(8Q29) – Ace Company starts the new year with inventory costing $90,000. During the year, the company purchased more inventory with a cost of $280,000. At the same time, a portion of this inventory was sold for a total of $360,000. Typically, the company’s sales include a markup equal to 30 percent of the sales price. Based on this limited information, what is the estimated amount of inventory that is still on hand?

(8A29) – The company starts with inventory costing $90,000 and then buys another $280,000 for a total cost of $370,000. Sales are $360,000 but that figure includes a markup. Gross profit is 30 percent of the sales price or $108,000. With a sales price of $360,000, the $108,000 markup means that the cost of the inventory sold was $252,000. The company had inventory costing $370,000 but sold merchandise with an estimated cost of $252,000 leaving $118,000 still on hand.

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SUGGESTION: Work the Test Yourself question in Section 8.5 of Chapter Eight (“On January 1, Year One, the Wysocki Company …”). This problem asks you to estimate the inventory on hand at the current time. Cost of goods sold for this period is not available. Information is presented to help you figure out a reasonable estimate of cost of goods sold. Think about what you are given and how to use it. Look at the explanation to ensure that you know how to make this estimation.

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(8Q30) – Ace Company starts the year with inventory costing $90,000. During the year, the company purchases more inventory with a cost of $280,000. At the same time, inventory was sold for a total of $360,000. Typically, the company’s sales include a mark up of 30 percent. The company hires a forensic accountant to estimate the cost of the remaining inventory. Why would the company take this step?

(8A30) – One reason to estimate inventory is because a loss has occurred and the parties involved (the reporting company and its insurance company) need to know the amount. Inventory might have been damaged by flood or fire or possibly stolen. Second, a concern could arise about the accuracy of a physical count. The estimate is made to check those figures. Third, many companies report interim financial statements, often each quarter. In that reporting, an estimate is easier to perform than a count.

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The following statement is included in the end-of-chapter material as a True or False question. “The Waynesboro Company always has gross profit equal to 30 percent of sales. This year, the company started with inventory costing $50,000 and made purchases of $100,000 and sales of $120,000. A fire destroyed all of the inventory on hand except for merchandise costing $6,000. The loss is estimated at $60,000.” This statement is True. How do you know that $60,000 is the correct amount of the estimate?

The previous statement is True. The company begins the year with inventory costing $50,000 and then buys $100,000 more for a total of $150,000. Sales are $120,000 but that includes a markup said to be 30 percent (or $36,000). Cost of goods sold is $84,000 ($120,000 less $36,000). Total inventory was $150,000 but the company sold goods with an estimated cost of $84,000. That leaves $66,000. The company recovered inventory costing $6,000. The amount destroyed must have been $60,000.