Not only measurement basis and cost flow assumptions have an effect on inventory valuation but also the way entity is managing the records will greatly affect inventory’s value at the year end.
Typically entity uses either of the following two systems to record changes in inventory:
- Periodic inventory system
- Perpetual inventory system
1 Periodic Inventory System
Under periodic system inventory records are maintained/updated in intervals like at the end of every week or month, accountant will sit down and determine the inventory at hand.
Under periodic inventory system, entity maintains temporary accounts like purchases, purchases returns, sales and sales return. At the end of the period the amounts in these temporary accounts are added to determine the amount of inventory available for sale. Inventory still at hand is usually found by physically counting the units. The number of units at hand are deducted from inventory available for sale to compute cost of goods sold and hence the formula:
CGS = Opening inventory + [Purchases – Purchases returns] – Closing inventory
But it must be understood that purchases account and Inventory account are two different things. If entity chooses to regularly update purchases account it does not necessarily tell how much inventory entity holds at a particular time. Under periodic system it is the inventory account which is updated at intervals. Accounting of periodic inventory system will be discussed later.
To emphasize again, physical inventory count (also called stock taking) at the period end is mandatory under periodic system. Without such count, cost of sales (or cost of goods sold) cannot be determined therefore, entities have to conduct this activity at least once a year or at every period end.
2 Perpetual Inventory System
Under perpetual system, inventory record is updated on run-time basis i.e. regularly after every transaction. As every purchase, return or sale transaction is being recorded directly in inventory account, management will know the amount of inventory at hand and cost of goods sold at any given point in time as opposed to periodic inventory system where they have to wait until the end of the period.
Under perpetual inventory system, transactions are recorded directly in inventory account and no separate or temporary accounts like purchases and purchases returns are maintained. Every purchase, purchase return, sale or sales return is recorded in inventory account as and when transaction takes place.
Unlike periodic inventory system, physical inventory count is not required as inventory record can tell the number of units at any given time.
3 Difference between Perpetual and Periodic Inventory System
| Perpetual Inventory System | Periodic Inventory System | |
| Recording | Inventory records are updated regularly | Inventory records are updated periodically |
| Determination of ending inventory | Ending inventory is determined on the basis of inventory records | Ending inventory is determined on the basis of physical stock count |
| Stock count | Done to confirm if units held are as per records | Done to determine cost of goods sold |
| Control on inventory | High level of control as management knows the quantity at any given time | No control as management is unaware of quantity until the end of the period |
| Temporary accounts | No temporary accounts are maintained. Recording is done directly in inventory account | Temporary accounts like purchases, returns and sales are maintained that are closed at the period end. |
| Cost | Expensive to maintain. Need dedicated trained personnel | Cheaper to maintain as it requires less work and workforce |
A detailed discussion on accounting under both inventory systems will be done in another section, however, for understanding purposes lets go through a simple example that explains the difference in record keeping under both inventory systems
Example Perpetual Vs Periodic Inventory System
“Marvel” sell different products including “Deadpool”. The following information is provided about transactions that took place during the period:
| Inventory at the start of the year: | 200 units @ $10/unit |
| Purchases during the year: | 1000 units @ $10/unit |
| Sales during the year: | 500 units @ $20/unit |
| Purchases return during the year: | 25 units @ $10/unit |
| Inventory at the end of the year: | 675 units @ $10/unit |
Required: Show records of Marvel’s inventory under Perpetual and Periodic inventory system
Solution:
| Periodic Inventory System | Perpetual Inventory System |
| Starting inventory | |
| Inventory account with debit balance of 2000 | Inventory account with debit balance of 2000 |
| Purchase of 1000 units @ $10/unit | |
| Debit: Inventory a/c 10,000 Credit: Trade payables a/c 10,000 |
Debit: Purchases a/c 10,000 Credit: Trade payables a/c 10,000 |
| Sales of 500 units @ $20/unit | |
| Debit: Trade Receivable a/c 10,000 Credit: Inventory a/c 10,000Debit: Cost of Goods sold a/c 5,000 Credit: Inventory a/c 5,000 (Cost of 500 units sold @ $10/unit |
Debit: Trade receivable a/c 10,000 Credit: Sales a/c 10,000[No entry relating cost of goods sold] |
| Purchases returns of 25 units @ $10/unit | |
| Debit: Trade payables a/c 250 Credit: Inventory a/c 250 |
Debit: Trade payables a/c 250 Credit: Purchases returns a/c 250 |
| Closing Entries at the end of the period – 675 units @ $10/unit | |
|
[No entries required] Cost of goods sold account and inventory account are already complete CGS and Ending inventory value can be determined from the balance of respective accounts CGS: 5000 |
– Physical count will be done – Following closing entry will be made:Debit: Inventory a/c 6750 Debit: Cost of Goods sold a/c (b/f) 5000 Debit: Purchases return a/c 250 Credit: Purchases a/c 10,000 Credit: Inventory (opening) a/c 2000Cost of Goods sold figure will be a balancing figure of Inventory’s account |
It is important to note however, that it is not always the case that ending inventory value and cost of goods sold figure is same under both systems. Under certain circumstances the combination of cost flow assumptions, inventory recording system and measurement basis may change the values.