AFM101 Chapter Notes - Chapter 8: Perpetual Inventory, Gross Profit, Income Statement

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Chapter 8
ANSWERS TO QUESTIONS
1. Inventory often is one of the largest amounts listed under assets on the statement of
financial position, which means that inventory represents a significant amount of the
resources available to the business. The inventory may be excessive in amount, which
is a needless waste of resources; alternatively it may be too low, which may result in
lost sales. Therefore, for internal users inventory control is very important. On the
income statement, inventory exerts a direct impact on the amount of income.
Therefore, statement users are interested particularly in the amount of this effect and
the way in which inventory is measured. Because of its impact on both the statement
of financial position and the income statement, inventory is of particular interest to all
statement users.
2. Fundamentally, inventory should include those items, and only those items, legally
owned by the business. That is, inventory should include all goods ready for sale and
in saleable condition that the company owns, regardless of their particular location at
the time.
3. The cost principle governs the measurement of the ending inventory amount. The
ending inventory is determined in units and the cost of each unit is applied to that
number. Under the cost principle, the unit cost is the sum of all costs incurred in
obtaining one unit of the inventory item in its present state.
4. The cost of goods available for sale is the sum of the beginning inventory and the cost
of goods purchased during the period. Cost of sales is the cost of goods available for
sale less the ending inventory.
5. Beginning inventory is the stock of goods on hand (in inventory) at the start of the
accounting period. Ending inventory is the stock of goods on hand (in inventory) at
the end of the accounting period. The ending inventory of one period automatically
becomes the beginning inventory of the next period.
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6. When a perpetual inventory system is used, the unit cost must be known for each
item sold at the date of each sale for the following reasons. First, the units sold and
their costs are removed from the perpetual inventory record and the new inventory
balance is determined. Second, an up-to-date cost of sales figure is determined from the
perpetual inventory record and an entry in the accounts is made as a debit to Cost of
sales and a credit to Inventory. In contrast, when a periodic inventory system is used
the unit cost need not be known at the date of each sale. In fact, the periodic system is
designed so that cost of sales for each sale is not known at the time of sale. At the end
of the period, under the periodic inventory system, cost of sales is determined by
adding the beginning inventory to the total goods purchased for the period and
subtracting from that total the ending inventory amount. The ending inventory
amount is determined by means of a physical count of the inventory of goods
remaining on hand, where the units are valued on a unit cost basis in accordance with
the cost principle (by applying an appropriate inventory costing method).
7. The periodic inventory model reflects the way in which that system operates. Under
this system the beginning inventory and purchases (during the period) are
accumulated, the sum of which is goods available for sale. It is necessary, therefore,
that the ending inventory be determined by actual inventory count at the end of the
period. Cost of sales is computed by subtracting the ending inventory from goods
available for sale. The model: BI + P – EI = COS reflects the fact that, under the periodic
inventory model, cost of sales is computed as a residual amount.
In contrast, the perpetual inventory system involves maintaining a continuous
(running or perpetual) inventory record during the accounting period. The beginning
inventory, each purchase during the period, and each sale during the period, are
entered in the perpetual inventory record in units and dollars of cost. The cost of each
sale is also recorded on an ongoing basis. The difference between the goods available
less cost of sales is the ending inventory. Thus, the perpetual inventory model: BI + P –
COS = EI, reflects the fact that ending inventory is computed as a residual amount in
the inventory record.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing © 2011 McGraw-Hill Ryerson Limited. All rights reserved.
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8. (a) Weighted-average cost – This inventory costing method in a periodic inventory
system is based on a weighted-average cost for the entire period. At the end of the
accounting period the average cost is computed by dividing the number of units
available for sale into the cost of goods available for sale. The computed average unit
cost then is used to determine the cost of sales for the period by multiplying the units
sold by this average unit cost. Similarly, the ending inventory for the period is
determined by multiplying this average unit cost by the number of units on hand.
(b) FIFO – This inventory costing method views the first units purchased as the first
units sold. Under this method, cost of sales is measured at the oldest unit costs (since
the items purchased first are presumed to be the items sold first), and the ending
inventory is measured at the newest unit costs (since the items still on hand are
presumed to be the ones purchased most recently).
(c) Specific identification – This inventory costing method requires that each item in
the beginning inventory and each item purchased during the period be identified
specifically so that its unit cost can be determined by identifying the specific item sold.
This method usually requires that each item be marked, often with a code that
indicates its cost. When it is sold, that unit cost is the cost of sales. It often is
characterized as a pick-and-choose method. When the ending inventory is taken, the
specific items on hand, valued at the cost indicated on each item, represent the ending
inventory amount.
9. The specific identification method of inventory costing is subject to manipulation when
the units are identical. Manipulation is possible because one can, at the time of each
sale, select (pick and choose) from the shelf the item that has the highest or the lowest
(or some other) unit cost with no particular rationale for the choice. This may be done
with the objective of increasing or decreasing both the amount of profit and the
amount of ending inventory to be reported on the financial statements. To illustrate,
assume item A is stocked and three are on the shelf. One cost $100; the second one cost
$115; and the third cost $125. Now assume that one unit is sold for $200. If it is
assumed arbitrarily that the first unit is sold, the gross profit will be $100; if the
second unit is selected, the gross profit will be $85; or alternatively, if the third unit is
selected, the gross profit will be $75. Thus, the amount of gross profit (and income)
will vary significantly depending upon which one of the three is selected arbitrarily
from the shelf for this particular sale. This assumes that all three items are identical in
every respect except for their unit costs. Of course, the selection of a different unit
cost, in this case, also will influence the cost of the ending inventory, i.e., cost of the two
remaining items.
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