O Level Principles of Accounts Practice Paper 3

TuitionGoWhere Practice Paper - Principles of Accounts O-Level

Answer Key and Marking Scheme

Version: 3 of 5
Subject: Principles of Accounts
Topic: Inventory Costing

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Section A: Multiple Choice and Short Concepts [10 Marks]

1. C
Reasoning: The Prudence Concept requires assets not to be overstated. Therefore, inventory is valued at the lower of cost or NRV. [1]

2. B
Reasoning: In rising prices, FIFO assigns older (cheaper) costs to Cost of Sales, resulting in lower COGS and higher Profit. [1]

3. Net Realisable Value (NRV) is the estimated selling price in the ordinary course of business, less the estimated costs of completion and the estimated costs necessary to make the sale.
Award 1 mark for "selling price less costs to sell/complete". Award 2 marks for full definition. [2]

4. One disadvantage of AVCO:

• Calculations can be complex/time-consuming if prices change frequently (requires recalculating average after every purchase).
• OR: The cost assigned to inventory may not reflect the current replacement cost as closely as FIFO in some contexts.
  Award 2 marks for a clear, relevant disadvantage. [2]

5. **$45** *Reasoning:* Lower of Cost ($50) and NRV ($45) is$45. [1]

6. Current Asset Explanation:
Inventory is expected to be sold or consumed within one year (or the operating cycle), converting into cash or receivables.
Award 1 mark for reference to time frame (1 year) or conversion to cash. [1]

7. B
Reasoning: Switching to AVCO in inflation means higher average costs are assigned to COGS compared to FIFO (which uses older, lower costs). Higher COGS leads to lower Gross Profit. [1]

8. Periodic vs Perpetual:

• Periodic: Inventory is counted physically at specific intervals (e.g., year-end); COGS is calculated as a balancing figure.
• Perpetual: Inventory records are updated continuously after every purchase and sale.
  Award 1 mark for clear distinction. [1]

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Section B: Calculations and Applications [30 Marks]

9. Inventory Valuation (FIFO)

(a) Closing Inventory Value
Workings:
Total Units Available = 100 + 200 + 100 = 400 units
Total Units Sold = 150 + 120 = 270 units
Closing Inventory Units = 400 - 270 = 130 units

Under FIFO, closing inventory consists of the most recent purchases:

• 100 units from 15 Mar purchase @ $13.00 =$1,300
• 30 units from 5 Mar purchase @ $12.00 =$360
  (Note: The 5 Mar purchase had 200 units. 150 sold on 10 Mar left 50. Then 120 sold on 20 Mar took remaining 50 from 5 Mar batch? No. Let's trace carefully.)

Detailed Trace:

1. Op Inv: 100 @ $10
2. Buy 5 Mar: 200 @ $12. Balance: 100@$10, 200@$12.
3. Sell 10 Mar (150 units):
   • Take 100 @ $10 (Op Inv gone)
   • Take 50 @ $12 (from 5 Mar batch)
   • Remaining: 150 units @ $12.
4. Buy 15 Mar: 100 @ $13. Balance: 150@$12, 100@$13.
5. Sell 20 Mar (120 units):
   • Take 120 @ $12 (from 5 Mar batch)
   • Remaining: 30 units @ $12, 100 units @$13.

Closing Inventory:
30 units @ $12.00 =$360
100 units @ $13.00 =$1,300
Total = $1,660

Marking:

• Correct identification of remaining units: 1 mark
• Correct application of FIFO layers: 2 marks
• Final Answer $1,660: 1 mark
  [4]

(b) Cost of Sales (FIFO)
Method 1: Opening + Purchases - Closing
Opening: 100 * $10 =$1,000
Purchases: (200 * $12) + (100 *$13) = $2,400 +$1,300 = $3,700 Goods Available for Sale:$4,700
Less Closing Inventory: $1,660 Cost of Sales =$3,040

Method 2: Sum of specific costs sold
Sale 1 (150 units): (100 * $10) + (50 *$12) = $1,000 +$600 = $1,600 Sale 2 (120 units): (120 *$12) = $1,440 Total COGS =$1,600 + $1,440 =$3,040

Marking:

• Correct Working: 1 mark
• Final Answer $3,040: 1 mark
  [2]

10. Inventory Valuation (AVCO)

(a) Weighted Average Cost after 5 March Purchase
Opening: 100 units @ $10 =$1,000
Purchase: 200 units @ $12 =$2,400
Total Value: $3,400 Total Units: 300 Average Cost =$3,400 / 300 = $11.333... Rounded to two decimal places: **$11.33**
Note: For subsequent calculations, keep precision or use fraction if possible, but question asks for rounded display. We will use $11.3333 for calculation to ensure accuracy, or follow strict rounding rules if specified. Standard practice is to carry precision. Let's use$11.3333.

Marking:

• Correct Total Value ($3,400): 1 mark
• Correct Division and Rounding: 1 mark
  [2]

(b) Closing Inventory Value (AVCO Perpetual)

1. After 5 Mar Purchase:
   Balance: 300 units @ $11.3333 ($3,400)

2. Sale on 10 Mar (150 units):
   Cost of Sale = 150 * $11.3333 =$1,700
   Remaining Balance: 150 units @ $11.3333 ($1,700)

3. **Purchase on 15 Mar (100 units @ $13):** New Units = 150 + 100 = 250 units New Value =$1,700 + (100 * $13) =$1,700 + $1,300 =$3,000
   New Average Cost = $3,000 / 250 =$12.00

4. Sale on 20 Mar (120 units):
   Cost of Sale = 120 * $12.00 =$1,440
   Remaining Balance: 130 units @ $12.00

5. Closing Inventory:
   130 units * $12.00 = **$1,560.00**

Marking:

• Correct recalculation of average after 15 Mar purchase ($12.00): 2 marks
• Correct final valuation ($1,560): 2 marks
  [4]

11. Lower of Cost and NRV

(a) Total Inventory Value

• Jackets: Lower of $5,000 and$6,200 -> $5,000
• Shoes: Lower of $3,500 and$3,200 -> $3,200
• Hats: Lower of $1,200 and$1,100 -> $1,100
• Scarves: Lower of $800 and$950 -> $800

Total = $5,000 +$3,200 + $1,100 +$800 = $10,100

Marking:

• Correct selection for each item (0.5 mark each, total 2 marks)
• Correct Sum: 2 marks
  [4]

(b) Explanation for Shoes
The shoes are valued at $3,200 (NRV) because it is lower than the cost ($3,500). This adheres to the Prudence Concept, which ensures assets are not overstated and potential losses are recognized immediately.
Marking:

• Identification of Lower of Cost/NRV rule: 1 mark
• Reference to Prudence Concept: 1 mark
  [2]

12. Inventory Errors

(a) Corrected Net Profit
Overstated Closing Inventory -> Overstated Profit.
Correction: Subtract the error.
$45,000 -$2,000 = $43,000
Marking:

• Correct Direction (Subtract): 1 mark
• Correct Answer: 1 mark
  [2]

(b) Effect on Current Assets
Current Assets (specifically Inventory) are overstated by $2,000 in the Statement of Financial Position.
Marking:

• Correct Identification (Overstated): 1 mark
• Correct Amount: 1 mark
  [2]

(c) Effect on Following Year (2025)
The closing inventory of 2024 becomes the opening inventory of 2025.
Since 2024 closing inventory was overstated, 2025 opening inventory is overstated.
Higher Opening Inventory -> Higher Cost of Sales -> Understated Net Profit in 2025.
Marking:

• Link to Opening Inventory: 1 mark
• Correct Effect (Understated Profit): 1 mark
  [2]

13. Inventory Turnover

(a) Inventory Turnover Ratio
Average Inventory = (Opening + Closing) / 2
Average Inventory = ($15,000 +$25,000) / 2 = $20,000 Inventory Turnover = Cost of Sales / Average Inventory Inventory Turnover =$120,000 / $20,000 = 6 times
Marking:

• Correct Average Inventory: 1 mark
• Correct Ratio: 1 mark
  [2]

(b) Days Sales in Inventory
Days Sales in Inventory = 365 / Inventory Turnover
Days Sales in Inventory = 365 / 6 = 60.8 days (rounded to 1 d.p.)
Marking:

• Correct Formula/Application: 1 mark
• Correct Answer: 1 mark
  [2]

(c) Comment on Efficiency
The days sales in inventory increased from 45 days (2023) to 60.8 days (2024).
This indicates a decrease in efficiency. The business is holding inventory for a longer period before selling it. This could suggest overstocking, slower sales, or obsolete stock.
Marking:

• Identification of decrease in efficiency/slower turnover: 1 mark
• Relevant comment (e.g., overstocking/slower sales): 1 mark
  [2]

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Section C: Analysis and Evaluation [20 Marks]

14. Scenario: Choice of Inventory Method

(a) Recommendation for SmartPhones Inc.
Recommendation: Use NRV (Lower of Cost and NRV) strictly, or potentially FIFO if prices are falling, but given rapid price declines, NRV write-downs are critical. However, between FIFO and AVCO for valuation flow:
Better Answer: Recommend FIFO or AVCO?
In a falling price environment (technology):

• FIFO assigns older (higher) costs to COGS. This results in lower profit (prudent).
• AVCO smooths the cost.
• However, the most important aspect is the Lower of Cost and NRV rule.
  Let's stick to FIFO vs AVCO choice:
  Recommend FIFO.
  Reason 1: In a falling price market, FIFO results in higher Cost of Sales (using older, higher costs), which leads to lower reported profits. This is consistent with the Prudence Concept.
  Reason 2: FIFO ensures that the Closing Inventory is valued at the most recent (lower) prices, which is closer to the current NRV, reducing the need for large write-downs.
  (Alternatively, recommending AVCO for smoothing is acceptable if justified, but FIFO is often preferred in tech for reflecting current replacement costs in inventory value).

Marking:

• Clear Recommendation: 1 mark
• Reason 1 (linked to falling prices/prudence): 1.5 marks
• Reason 2 (linked to inventory valuation relevance): 1.5 marks
  [4]

(b) Comparability
Changing inventory methods affects comparability because the Cost of Sales and Inventory values will differ between years purely due to the accounting policy change, not operational performance. Stakeholders cannot easily compare profit trends unless the financial statements are restated or notes disclose the impact of the change.
Marking:

• Explanation of distortion in profit/assets: 2 marks
• Reference to need for disclosure/restatement: 1 mark
  [3]

15. Scenario: Inventory Management

(a) Interpretation of Inventory Turnover Change
The turnover decreased from 12 times to 8 times. This means inventory is sitting longer before being sold.
Suggestion: Sales may have declined, or the business is purchasing too much stock (overstocking). For perishable goods, this is risky.
Marking:

• Correct interpretation (slower sales/overstocking): 2 marks
• Contextual link (perishable nature): 1 mark
  [3]

(b) Actions to Improve Turnover

1. Reduce Selling Prices / Offer Discounts: To clear old stock quickly, especially for perishable items nearing expiry.
2. Improve Purchasing Policy: Order smaller quantities more frequently (Just-In-Time) to match sales demand and reduce holding levels.
   (Other valid answers: Improve marketing, stop selling slow-moving items).
   Marking:

• Action 1 + Explanation: 2 marks
• Action 2 + Explanation: 2 marks
  [4]

(c) Evaluation of Holding Too Much Inventory (Perishable Goods)
Financial Factors:

• Storage Costs: Higher insurance, warehousing, and electricity (refrigeration) costs reduce net profit.
• Spoilage/Waste: Perishable goods may expire, leading to direct write-offs (losses) and zero revenue from those units.
• Opportunity Cost: Cash tied up in inventory cannot be used for other investments or paying liabilities (liquidity impact).

Non-Financial Factors:

• Customer Satisfaction: Selling near-expiry or stale goods damages brand reputation.
• Space Constraints: Excess stock may clutter the store, making it difficult for customers to browse fresh items.

Conclusion:
For FreshFoods Ltd, holding too much inventory is highly detrimental due to the risk of spoilage. The financial losses from waste and storage likely outweigh any bulk-buying discounts. Efficient inventory management (high turnover) is critical for survival.

Marking:

• 2 Financial points explained: 2 marks
• 2 Non-financial points explained: 2 marks
• Evaluation/Conclusion linking to perishable context: 2 marks
  [6]

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End of Marking Scheme