O Level Principles of Accounts Inventory Costing Quiz

O-Level Principles of Accounts Quiz - Inventory Costing

Answer Key and Marking Scheme

Total Marks: 40

Section A: Short Answer (10 marks)

1. State the accounting concept that requires inventory to be valued at the lower of cost and net realisable value. Explain why this concept is applied to inventory valuation. (2 marks)

Concept: Prudence concept (1 mark)

Explanation: The prudence concept states that assets and profits should not be overstated, and liabilities and expenses should not be understated. Inventory is valued at the lower of cost and NRV to ensure that inventory is not overstated in the statement of financial position and that any potential loss is recognised immediately in the income statement. This prevents the business from reporting profits that may not be realised. (1 mark for clear explanation linking concept to inventory valuation)

2. Distinguish between the First-In-First-Out (FIFO) method and the Weighted Average Cost (AVCO) method of inventory valuation. (2 marks)

FIFO: Assumes that the earliest (first-in) inventory items are sold first. Closing inventory is valued at the most recent purchase prices. (1 mark)

AVCO: Calculates a weighted average cost per unit after each purchase by dividing total cost of inventory by total units. Both cost of sales and closing inventory are valued at this average cost. (1 mark)

3. A business has closing inventory that cost $8,000. Due to damage, the inventory can now only be sold for$6,500 after incurring selling costs of $300. Calculate the value at which the inventory should be stated in the financial statements. (2 marks)

Working: Net Realisable Value (NRV) = $6,500 −$300 = $6,200 *(1 mark for correct NRV calculation)* Lower of Cost ($8,000) and NRV ($6,200) =$6,200

Value: $6,200 (1 mark for correct answer)

4. Explain how an overstatement of closing inventory affects the gross profit and net profit of a business. (2 marks)

Effect on Gross Profit: Gross profit will be overstated because cost of sales will be understated (Closing inventory is deducted in the cost of sales calculation: Opening inventory + Purchases − Closing inventory. If closing inventory is overstated, cost of sales is lower, so gross profit is higher). (1 mark)

Effect on Net Profit: Net profit will also be overstated by the same amount as the overstatement of gross profit, assuming no other changes to expenses. (1 mark)

5. State two reasons why a business might choose to use the FIFO method instead of the AVCO method for inventory valuation. (2 marks)

Reason 1: FIFO reflects the actual physical flow of goods for many businesses, especially those selling perishable items where older stock is sold first. (1 mark)

Reason 2: Under FIFO, closing inventory is valued at the most recent purchase prices, which provides a more current valuation of inventory on the statement of financial position. (1 mark)

(Accept other valid reasons such as: FIFO is simpler to understand and apply; FIFO may result in higher reported profit in times of rising prices which may be preferred for external reporting.)

Section B: Calculation (18 marks)

6. Calculate the cost of sales for the year ended 31 December 2025. (3 marks)

Working:

	$
Opening inventory	12,000
Add: Purchases	85,000
Add: Carriage inwards	2,500
Less: Purchase returns	(1,800)
Net purchases	85,700
Cost of goods available for sale	97,700
Less: Closing inventory	(14,500)
Cost of Sales	83,200

Marking: 1 mark for correct net purchases, 1 mark for correct cost of goods available for sale, 1 mark for correct cost of sales.

Cost of Sales: $83,200

7. Using your answer from Question 6, calculate the gross profit. (1 mark)

Working: Gross Profit = Revenue − Cost of Sales = $150,000 −$83,200 = $66,800

Gross Profit: $66,800 (1 mark for correct answer; award mark even if based on incorrect cost of sales from Q6, provided calculation is correct)

8. FIFO (perpetual) method. (5 marks: 3 for cost of sales, 2 for closing inventory)

(a) Cost of Sales Working:

Mar 15 sale (250 units):

• 200 units × $5.00 =$1,000 (from opening inventory)
• 50 units × $5.50 =$275 (from Mar 8 purchase)
• Cost of Mar 15 sale = $1,275 (1 mark)

Remaining after Mar 15 sale: 250 units from Mar 8 purchase @ $5.50

Mar 28 sale (350 units):

• 250 units × $5.50 =$1,375 (remaining from Mar 8 purchase)
• 100 units × $6.00 =$600 (from Mar 22 purchase)
• Cost of Mar 28 sale = $1,975 (1 mark)

Total Cost of Sales: $1,275 +$1,975 = $3,250 (1 mark)

(b) Closing Inventory Working: Remaining after Mar 28 sale: 300 units from Mar 22 purchase @ $6.00 Closing inventory = 300 ×$6.00 = $1,800 (2 marks: 1 for identifying remaining units, 1 for correct valuation)

Closing Inventory Value: $1,800

9. AVCO (perpetual) method. (5 marks)

Working:

After Mar 8 purchase: Total cost = (200 × $5.00) + (300 ×$5.50) = $1,000 +$1,650 = $2,650 Total units = 500 Weighted average cost =$2,650 ÷ 500 = $5.30 per unit (1 mark)

Mar 15 sale: 250 units × $5.30 =$1,325 (1 mark) Remaining: 250 units @ $5.30 =$1,325

After Mar 22 purchase: Total cost = $1,325 + (400 ×$6.00) = $1,325 +$2,400 = $3,725 Total units = 250 + 400 = 650 Weighted average cost =$3,725 ÷ 650 = $5.73 per unit (rounded to 2 d.p.) (1 mark)

Mar 28 sale: 350 units × $5.73 =$2,005.50 (1 mark)

Cost of Sales: $1,325 +$2,005.50 = $3,330.50

Remaining: 300 units × $5.73 =$1,719.00

Closing Inventory Value: $1,719.00 (1 mark)

Note: Accept minor rounding differences if consistent method is shown.

10. Calculate the estimated value of inventory destroyed by the fire. (4 marks)

Working: Step 1: Calculate Cost of Sales from 1 Jan to 15 Apr 2026 Gross profit margin = 20% on sales Gross profit = 20% × $90,000 =$18,000 Cost of Sales = Sales − Gross Profit = $90,000 −$18,000 = $72,000 (1 mark)

Step 2: Calculate Cost of Goods Available for Sale Opening inventory + Purchases = $25,000 +$60,000 = $85,000 (1 mark)

Step 3: Calculate Estimated Closing Inventory (before fire) Estimated closing inventory = Cost of goods available for sale − Cost of sales = $85,000 −$72,000 = $13,000 (1 mark)

Step 4: Inventory destroyed Assuming all inventory was destroyed, estimated inventory destroyed = $13,000 (1 mark)

Estimated Inventory Destroyed: $13,000

Marking: Award marks for correct method even if arithmetic errors are present. 1 mark each for correct gross profit/cost of sales, cost of goods available, estimated closing inventory, and final answer.

Section C: Application and Analysis (12 marks)

11. Kenji Enterprise inventory analysis. (6 marks)

(a) Inventory Turnover Ratio: Average inventory 2024 = ($18,000 +$22,000) ÷ 2 = $20,000 Inventory turnover 2024 =$140,000 ÷ $20,000 = 7 times (1 mark)

Average inventory 2025 = ($22,000 +$28,000) ÷ 2 = $25,000 Inventory turnover 2025 =$180,000 ÷ $25,000 = 7.2 times (1 mark)

(b) Days Sales in Inventory: 2024: 365 ÷ 7 = 52.14 days (1 mark) 2025: 365 ÷ 7.2 = 50.69 days (1 mark)

(c) Comment: The inventory turnover has improved slightly from 7 times to 7.2 times, and days sales in inventory has decreased from 52.14 days to 50.69 days. This indicates that Kenji Enterprise is managing its inventory slightly more efficiently in 2025, converting inventory into sales more quickly. However, the improvement is marginal, and the business should continue to monitor inventory levels to ensure they are not holding excessive stock. (2 marks for a reasoned comment that refers to the calculated ratios and discusses efficiency)

12. Priya Retailers changing from FIFO to AVCO in a period of rising prices. (3 marks)

(a) Effect on Closing Inventory: Closing inventory value will be lower under AVCO compared to FIFO. Under AVCO, closing inventory is valued at an average cost which includes older, lower costs, whereas FIFO values closing inventory at the most recent, higher purchase prices. (1 mark)

(b) Effect on Cost of Sales: Cost of sales will be higher under AVCO compared to FIFO. AVCO uses an average cost that is higher than the older costs used in FIFO for cost of sales, resulting in a higher cost of sales figure. (1 mark)

(c) Effect on Gross Profit: Gross profit will be lower under AVCO compared to FIFO. Since cost of sales is higher under AVCO, the resulting gross profit will be lower. (1 mark)

13. Recommendations to improve liquidity. (3 marks)

Recommendation 1: Offer discounts or promotions to clear slow-moving inventory. This will convert inventory into cash or accounts receivable more quickly, improving the quick ratio by increasing liquid assets. (1.5 marks for valid recommendation and justification)

Recommendation 2: Implement tighter inventory control and reduce future purchase orders for slow-moving items. This prevents further build-up of illiquid inventory and frees up cash that would otherwise be tied up in inventory, improving overall liquidity. (1.5 marks for valid recommendation and justification)

(Accept other valid recommendations such as: selling obsolete inventory at a discount, returning excess inventory to suppliers, or improving demand forecasting.)

14. Impact of FIFO vs AVCO on financial statements during rising prices. (2 marks)

Statement of Financial Position: Under FIFO, closing inventory is valued at more recent, higher prices, resulting in a higher current asset value and a stronger statement of financial position. Under AVCO, closing inventory is valued at an average cost, which is lower than FIFO, resulting in a lower inventory value. (1 mark)

Income Statement: Under FIFO, cost of sales is lower (using older, cheaper costs), leading to higher gross profit and net profit. Under AVCO, cost of sales is higher (using average costs), leading to lower gross profit and net profit. (1 mark)

15. Decrease in inventory turnover ratio. (2 marks)

Cause 1: Accumulation of obsolete or slow-moving inventory that is not being sold. (0.5 marks)

Cause 2: A decline in sales volume while inventory purchases have remained constant or increased. (0.5 marks)

Action: Conduct a review of inventory to identify slow-moving items and implement a discount or clearance sale to reduce excess stock levels. (1 mark for a practical and relevant action)

(Accept other valid causes such as: overstocking due to poor demand forecasting, supply chain disruptions leading to early purchases, or a change in product mix. Accept other valid actions such as: revising inventory purchasing policies, improving sales and marketing efforts, or writing off obsolete inventory.)

Section D: Extended Response (10 marks)

16. Importance of the lower of cost and net realisable value rule. (3 marks)

The lower of cost and net realisable value (LCNRV) rule is fundamental to inventory valuation as it ensures that inventory is not overstated in the financial statements. This rule aligns with the prudence concept, which requires that assets and income are not overstated, and liabilities and expenses are not understated. By valuing inventory at the lower of its historical cost or its net realisable value, any potential losses from damaged, obsolete, or slow-moving inventory are recognised immediately in the income statement through a higher cost of sales or a write-down. For example, if a business holds inventory that cost $10,000 but due to market changes can only be sold for$8,000 after selling costs, the LCNRV rule requires the inventory to be valued at $8,000. This provides a more faithful representation of the business's financial position and performance, preventing the overstatement of assets and profits. (3 marks for a comprehensive discussion covering the rule, its link to prudence, and a clear example.)

17. Comparison of FIFO and AVCO effects on gross profit during rising prices. (2 marks)

During a period of rising prices, FIFO results in a higher gross profit compared to AVCO. Under FIFO, the cost of sales is based on older, lower inventory costs, while closing inventory is valued at more recent, higher prices. This leads to a lower cost of sales and consequently a higher gross profit. In contrast, AVCO smooths out price fluctuations by using a weighted average cost for both cost of sales and closing inventory. Since the average cost is higher than the oldest costs but lower than the most recent costs, the cost of sales under AVCO is higher than under FIFO, resulting in a lower gross profit. Therefore, FIFO yields a higher gross profit during inflationary periods. (2 marks for a clear comparison and correct identification of FIFO as the method resulting in higher gross profit with explanation.)

18. Advantages of a perpetual inventory system. (2 marks)

Advantage 1: A perpetual inventory system provides real-time, up-to-date information on inventory levels and cost of sales. This allows management to make timely decisions regarding reordering, pricing, and identifying slow-moving items, leading to better inventory control and reduced risk of stockouts or overstocking. (1 mark)

Advantage 2: It facilitates the preparation of interim financial statements without the need for a physical inventory count, as the inventory and cost of sales figures are continuously updated. This saves time and reduces disruption to business operations. (1 mark)

(Accept other valid advantages such as: enhanced accuracy through continuous tracking, better detection of theft or shrinkage, or improved customer service through accurate stock availability information.)

19. Effect of inventory valuation on current ratio and quick ratio. (2 marks)

Inventory valuation directly affects the current ratio because inventory is a significant component of current assets. An overstatement of inventory will inflate current assets and overstate the current ratio, giving a misleading impression of liquidity. The quick ratio, however, excludes inventory from current assets because inventory is not always readily convertible to cash. Therefore, the quick ratio is considered a more conservative measure of liquidity as it focuses only on the most liquid assets (cash, accounts receivable, and short-term investments). It provides a stricter assessment of a business's ability to meet its short-term obligations without relying on the sale of inventory, which may be slow-moving or difficult to liquidate quickly. (2 marks for explaining the impact on both ratios and justifying why the quick ratio is more conservative.)

20. Calculation of cost of sales using LCNRV and explanation. (1 mark)

Working: Closing inventory at lower of cost ($25,000) and NRV ($22,000) = $22,000 Cost of Sales = Opening inventory + Purchases − Closing inventory =$30,000 + $120,000 −$22,000 = $128,000

Cost of Sales: $128,000 (0.5 marks for correct calculation)

Explanation: This approach provides a more faithful representation of the business's financial performance because it recognises the loss in value of inventory immediately. By using the lower NRV, the cost of sales is higher, which reduces gross profit and reflects the economic reality that the inventory cannot be sold for its original cost. This prevents the overstatement of assets and profits, adhering to the prudence concept and providing users of financial statements with more reliable information. (0.5 marks for a clear explanation linking to faithful representation and the prudence concept)

END OF ANSWER KEY