ACCOUNTING CH 8

Question 1

1 Define the term ‘trading firm’.

Answer 1

A trading firm is a firm that purchases goods in order to resell them at a profit.

Question 2

2 Define the term ‘stock’.

Answer 2

Stock refers to goods purchased by a trading firm for the purpose of resale at a profit.

Question 3

3 Explain how stock should be classified in the Balance Sheet.

Answer 3

Stock should be classified as a current asset because it is a resource controlled by the entity from which future economic benefit is expected to flow to the entity within the next 12 months.

Question 4

4 State two reasons why stock is important to a trading firm.

Answer 4

• Stock is a firm’s main source of revenue, and thus the key to its ability to earn profit.
• Stock is likely to be one of the most significant assets the firm controls.

Question 5

5 State three reasons why stock is considered to be a vulnerable asset.

Answer 5

Stock is susceptible to:
•	damage
•	spoilage
•	theft
•	changes in tastes and fashions.

Question 6

1 Explain the role of the Stock Control account.

Answer 6

The Stock Control account summarises all movements of stock in a firm in the General Ledger.

Question 7

2 Identify two transactions that would appear on the debit side of the Stock Control account.

Answer 7

• cash purchases
• credit purchases
• stock gain

Question 8

3 Identify four transactions that would appear on the credit side of the Stock Control account.

Answer 8

• cash sales
• credit sales
• drawing of stock
• advertising of stock
• stock loss

Question 9

1 Explain the relationship between the Stock Control account and the stock cards.

Answer 9

The Stock Control account is used to summarise all transactions affecting stock, with information relating to individual lines of stock, including details of stock transactions, recorded in stock cards.

Question 10

2 Identify four details that will be provided in the top portion of a stock card but not in the Stock Control account.

Answer 10

• a description of the item
• the stock code
• the location of the item
• the name of the supplier

Question 11

3 Identify three details that are provided when transactions are recorded in the stock card but are not provided in the Stock Control account.

Answer 11

• the source document
• the quantity of stock
• the unit cost of stock

Question 12

4 State how many stock cards a typical trading firm would require. Beware: This is a trick question!

Answer 12

A typical trading firm would require a stock card for every line of stock, including one for every different colour and for every different size. Therefore, the number of stock cards depends on how many lines of stock a trading firm possesses.

Question 13

1 Explain why GST does not affect the valuation of a stock purchase.

Answer 13

GST does not affect the valuation of stock because it does not affect the economic benefit derived from the stock. Instead, the GST is an additional amount collected or paid on behalf of the ATO and will only affect the GST owed to the ATO.
 

Question 14

2 State the effect on the balance of a transaction recorded in the:

Answer 14

• In column – increases the balance

* Out column – decreases the balance.

Question 15

3 Explain why the cost price is not shown on the source document that provides the evidence of a sale.

Answer 15

The cost price is not revealed as this protects the gross profit on the sale; customers who are aware of the mark-up have a tendency to haggle harder for price reductions.

Question 16

4 Explain how the stock card is used to determine the Cost of Sales for each transaction.

Answer 16

The amount recorded in the ‘Out’ Cost Value column represents the cost of sales for the transaction. This is determined by applying the First In, First Out (FIFO) approach using the cost price of the units remaining in the Balance column of the previous transaction

Question 17

5 State three reasons why a small business might choose to value its stock using the FIFO (First In, First Out) assumption.

Answer 17

• It is not possible for some types of stock to label every item to identify its cost price; for example, petrol.
• For other items of stock it may be possible, but not practical: a fruit shop would find it impractical to label each grape, for example.
• Even where identifying the cost is both possible and practical, the owner may still decide it is not worth the time, effort and cost to label every item of stock.

Question 18

6 Explain the FIFO assumption as it applies to stock cards.

Answer 18

Under this assumption, the business assumes that the stock that was purchased first will be sold first, even though the business may have no way of knowing for certain. Without marking stock, there is no way of knowing the cost price of the stock that has been sold, making FIFO an acceptable and necessary assumption.

Question 19

7 Identify three transactions to which the FIFO assumption must be applied.

Answer 19

• sales
• drawings (of stock)
• advertising (of stock)
• stock losses

Question 20

1 Explain the importance of stock cards when sales are recorded in the special journals.

Answer 20

The amounts in the Value column of the Out section of the stock card represent the cost price of the sale. These amounts represent the Cost of Sales and they will be recorded in the Cost of Sales column in the special journals.

Question 21

2 Explain the importance of stock cards when purchases are recorded in the special journals.

Answer 21

The amounts in the Value column of the In section of the stock card represent the cost price of the purchase. These amounts will be recorded in the special journals.

Question 22

3 Identify two means of verifying the amounts recorded in the Cost of Sales account in the General Ledger.

Answer 22

• the Cost of Sales column of the Sales Journal (for credit sales)
• the Cost of Sales column of the Cash Receipts Journal (for cash sales)

Question 23

1 Define the term ‘stocktake’.

Answer 23

A physical count of the number of units of each line of stock on hand.

Question 24

2 Explain the role of a stocktake.

Answer 24

The role of a stocktake is to verify the accuracy of the stock cards and, in the process, detect any stock losses and stock gains.

Question 25

1 Explain why a stock loss is classified as an expense.

Answer 25

Stock loss is an expense because it is an outflow of an economic benefit (Stock) in the form of a decrease in assets (Stock Control), leading to a decrease in owner’s equity.

Question 26

2 Identify three reasons for a stock loss.

Answer 26

•	theft
•	damages/breakages
•	undersupply from a supplier
•	oversupply to a customer
 

Question 27

3 Explain how the cost price of a stock loss is determined.

Answer 27

The cost price of a stock loss is determined by comparing the stocktake figure of the units on hand with the stock card figure of the units on hand and establishing that there is stock missing. Multiply the number of units missing with the unit cost in the Balance column of the stock card (remembering to apply the FIFO assumption).

Question 28

4 Show the General Journal entries necessary to record a stock loss.

Answer 28

Stock Loss Debit

Stock Control Credit

Question 29

5 State the effect of a stock loss on the accounting equation.

Answer 29

Assets Decrease (Stock Control)
Liabilities No effect
Owner’s Equity Decrease (Stock loss expense decreases Net Profit)

Question 30

1 Explain why a stock gain is classified as a revenue.

Answer 30

Stock gain is a revenue because it is an inflow of an economic benefit (Stock) that increases assets (Stock Control), leading to an increase in owner’s equity.

Question 31

2 Identify two reasons for a stock gain.

Answer 31

• oversupply from a supplier

* undersupply to a customer

Question 32

3 Explain how the cost price of a stock gain is determined

Answer 32

The cost price of a stock gain is determined by comparing the stocktake figure of the units on hand with the stock card figure of the units on hand and determining that there is stock gained. Multiply the number of units gained with the lowest unit cost price still on hand in the Balance column of the stock card.

Question 33

4 Show the General Journal entries necessary to record a stock gain.

Answer 33

Stock Control Debit

Stock gain Credit

Question 34

5 State the effect of a stock gain on the accounting equation.

Answer 34

Assets Increase (Stock Control)
Liabilities No effect
Owner’s Equity Increase (Stock gain revenue increases Net Profit)

Question 35

1 State two reasons why a small business may use stock for advertising purposes.

Answer 35

• to use as display purposes

* to donate stock to local community organisations

Question 36

2 Explain why stock used for advertising purposes is classified as an expense.

Answer 36

It is an expense because it is an outflow of an economic benefit (Stock) in the form of a decrease in assets (Stock Control), leading to a decrease in owner’s equity.

Question 37

3 Explain how the cost of stock used for advertising purposes is determined.

Answer 37

It must be recorded in the Out column of the stock card and valued according to FIFO.

Question 38

4 Show the General Journal entries necessary to record stock used for advertising purposes.

Answer 38

Advertising Debit

Stock Control Credit

Question 39

5 State the effect of stock used for advertising purposes on the accounting equation

Answer 39

Assets Decrease (Stock Control)
Liabilities No effect
Owner’s Equity Decrease (Advertising Expense decreases Net Profit)

Question 40

1 Define the term ‘Cost of Goods Sold’.

Answer 40

Cost of Goods Sold is used to describe all costs incurred in getting goods into a condition and location ready for sale.

Question 41

2 State two reasons why Cost of Goods Sold may be greater than Cost of Sales.

Answer 41

• customs duty/import duties
• freight in/delivery from suppliers
• modifications
• packaging
• buying expenses

Question 42

3 Explain why it is important to identify Gross Profit in the Income Statement.

Answer 42

It is important to identify Gross Profit to allow the owner to assess the adequacy of the firm’s mark-up, because Gross Profit expresses the relationship between selling prices and cost prices.

Question 43

4 Explain why it is important to identify Adjusted Gross Profit in the Income Statement.

Answer 43

It is important to identify Adjusted Gross Profit to allow the owner to isolate the stock loss or gain and bring it to the attention of the owner, so that strategies may be developed to address any problems that are identified.

Question 44

1 Explain the operation of the perpetual system of stock recording.

Answer 44

The perpetual system involves recording individual stock transactions in the stock cards as they occur, then conducting a physical stocktake at the end of the Reporting Period to verify the balances of those stock cards. In the process, any stock losses or gains will be detected.

Question 45

2 Explain the benefits of the perpetual system of stock recording.

Answer 45

• Reordering of stock is assisted by maintaining a continuous record of the number of units of stock on hand, enabling the business to avoid lost sales.
• Stock losses and gains can be detected by comparing the balances of the stock cards against the physical stocktake.
• Fast and slow moving lines of stock can be identified so that stock can be rotated or the stock mix adjusted.