Inventory records are kept using either one of the following systems:
a. Perpetual Inventory System
Perpetual means continuous. This is a system where a business keeps continuous, moment-to-moment records of the number, value and type of inventories that it has at the business.
A computerized accounting system – where each item of inventory is linked to the electronic accounting records – creates a perpetual system. Products that have barcodes are automatically recorded as having been sold at tills in a supermarket when they are ‘swiped.’ Inventory levels are automatically decreased as soon as the invoice has been entered and completed at the till.
b. Periodic Inventory System
Where one does periodic inventory counts (such as once a month, or at the beginning and end of each year), and does not have an accurate record of the inventories in between these points – well, this is a periodic system.
This system does not keep continuous, moment-to-moment records of inventories.
Accurate records are only kept periodically – meaning, at certain points in time – in this case, when the actual counts are done.
Many small businesses still only have a periodic system of inventory.
Journal Entries During the Year: Periodic Inventory
Now what do these two systems mean in terms of journal entries? Let’s look at the periodic inventory system (b) first.
If we have a periodic inventory system and purchase more inventories during the year, we record the following:
This isn’t very complicated – we’ve been doing this already in previous lessons.
When we sell these inventories on the periodic system we record:
Again, we’ve gone through this journal entry before, so nothing new.
Journal Entries During the Year: Perpetual Inventory
Now, with the perpetual inventory system it’s a bit different.
When we purchase more inventories during the year, we say:
Why do we use the “inventories" (asset) account here and not “purchases" (expense)? The answer is that where we are keeping perpetual records of inventory, we can continuously adjust the inventories account when we get more inventories. Where we are not keeping perpetual records of our inventory, it is inappropriate to adjust the inventories account (there are no continuous, accurate records of our inventory levels), so we use the “purchases" account. When we next do a physical inventory count (and thus have an accurate record of inventories once again) we can then adjust our “inventories" account to the newly-counted level. We’ll look at how this adjustment is done pretty soon.
FYI, in the examples in previous lessons, we used the periodic inventory system and so debited the “purchases" account when buying inventories (not the “inventory" account).
When we use a perpetual inventory system and sell inventories we record:
Thus we are left with a sales figure of $1,500 that can be matched against an expense – cost of goods sold – of $1,000, to give us $500 gross profit. We also have $500 in our bank account ($1,500 – $1,000). The balance of inventories is $0 ($1,000 – $1,000).
End of Year Adjustments: Periodic Inventory
Let’s look at the periodic inventory system again. There was no entry regarding cost of goods sold using this system. So how does cost of goods sold fit in? At the end of the period (when we do a physical inventory count) we adjust our “inventory" and “cost of goods sold" accounts again.
Let’s look at our example of the periodic system again to see how this works. We’ll use the same figures above, but now let’s also say that the business had $200 worth of inventories at the beginning of the year (opening inventories). At the beginning of the year our inventories T-account would have looked as follows:
At the end of the period we count $100 worth of inventory.
At the end of the period we make the following adjustments:
The above closing entries (entries at the end of the year) are in line with the formula for the calculation of cost of goods sold:
Our inventories account would look like this at the end of the year:
Inventories (already at $200) are adjusted to the counted figure of $100 only at the end of the year (when counted). This is done in two steps (cancel the $200 and then add the $100), but can be done in one step.
The contra account is always “cost of goods sold." One way of looking at why we do this is that the difference between the $200 (opening inventories) and $100 (closing inventories) must have been sold, and the value of these goods that were sold ($100) is thus added to the “cost of goods sold" expense.
The “cost of goods sold" account would look like this at the end of the year:
End of Year Adjustments: Perpetual Inventory
Let’s look at what we did with the perpetual system again:
When we purchased more inventories during the year, we said:
When we sold these inventories we recorded:
Cost of goods sold and inventories are thus adjusted continuously throughout the year – after each and every sale. Additionally, unlike the periodic system, at the end of the year cost of goods sold and inventories do not have to be adjusted at all. This is because the adjustments have already been done throughout the year.
And that represents the big difference between perpetual and periodic systems – continuous adjustment or adjustment only at certain periods.