There are two ways in which a company may account for their inventory. They can use a perpetual or periodic inventory system. Let’s look at the characteristics of these two systems.
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Characteristics of the Perpetual and Periodic Inventory Systems
A perpetual inventory system automatically updates and records the inventory account every time a sale, or purchase of inventory, occurs. You can consider this “recording as you go.” The recognition of each sale or purchase happens immediately upon sale or purchase.
A periodic inventory system updates and records the inventory account at certain, scheduled times at the end of an operating cycle. The update and recognition could occur at the end of the month, quarter, and year. There is a gap between the sale or purchase of inventory and when the inventory activity is recognized.
Generally Accepted Accounting Principles (GAAP) do not state a required inventory system, but the periodic inventory system uses a Purchases account to meet the requirements for recognition under GAAP. IFRS requirements are very similar. The main difference is that assets are valued at net realizable value and can be increased or decreased as values change. Under GAAP, once values are reduced they cannot be increased again.
Inventory Systems. (credit: “Untitled” by Marcin Wichary/Flickr, CC BY 2.0)
A purchase return or allowance under perpetual inventory systems updates Merchandise Inventory for any decreased cost. Under periodic inventory systems, a temporary account, Purchase Returns and Allowances, is updated. Purchase Returns and Allowances is a contra account and is used to reduce Purchases.
When a sale occurs under perpetual inventory systems, two entries are required: one to recognize the sale, and the other to recognize the cost of sale. For the cost of sale, Merchandise Inventory and Cost of Goods Sold are updated. Under periodic inventory systems, this cost of sale entry does not exist. The recognition of merchandise cost only occurs at the end of the period when adjustments are made and temporary accounts are closed.
A sales allowance and sales discount follow the same recording formats for either perpetual or periodic inventory systems.
If a physical count determines that merchandise inventory is understated in the accounting records, Merchandise Inventory would need to be increased with a debit entry and the COGS would be reduced with a credit entry. The adjusting entry is:
Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold will close with the temporary debit balance accounts to Income Summary.
Once the COGS balance has been established, an adjustment is made to Merchandise Inventory and COGS, and COGS is closed to prepare for the next period.
(Figure) summarizes the differences between the perpetual and periodic inventory systems.
|Purchase of Inventory||Record cost to Inventory account||Record cost to Purchases account|
|Purchase Return or Allowance||Record to update Inventory||Record to Purchase Returns and Allowances|
|Purchase Discount||Record to update Inventory||Record to Purchase Discounts|
|Sale of Merchandise||Record two entries: one for sale and one for cost of sale||Record one entry for the sale|
|Sales Return||Record two entries: one for sales return, one for cost of inventory returned||Record one entry: sales return, cost not recognized|
|Sales Allowance||Same under both systems||Same under both systems|
|Sales Discount||Same under both systems||Same under both systems|
There are advantages and disadvantages to both the perpetual and periodic inventory systems.
Advancements in point-of-sale (POS) systems have simplified the once tedious task of inventory management. POS systems connect with inventory management programs to make real-time data available to help streamline business operations. The cost of inventory management decreases with this connection tool, allowing all businesses to stay current with technology without “breaking the bank.”
One such POS system is Square. Square accepts many payment types and updates accounting records every time a sale occurs through a cloud-based application. Square, Inc. has expanded their product offerings to include Square for Retail POS. This enhanced product allows businesses to connect sales and inventory costs immediately. A business can easily create purchase orders, develop reports for cost of goods sold, manage inventory stock, and update discounts, returns, and allowances. With this application, customers have payment flexibility, and businesses can make present decisions to positively affect growth.
Advantages and Disadvantages of the Perpetual Inventory System
The perpetual inventory system gives real-time updates and keeps a constant flow of inventory information available for decision-makers. With advancements in point-of-sale technologies, inventory is updated automatically and transferred into the company’s accounting system. This allows managers to make decisions as it relates to inventory purchases, stocking, and sales. The information can be more robust, with exact purchase costs, sales prices, and dates known. Although a periodic physical count of inventory is still required, a perpetual inventory system may reduce the number of times physical counts are needed.
The biggest disadvantages of using the perpetual inventory systems arise from the resource constraints for cost and time. It is costly to keep an automatic inventory system up-to-date. This may prohibit smaller or less established companies from investing in the required technologies. The time commitment to train and retrain staff to update inventory is considerable. In addition, since there are fewer physical counts of inventory, the figures recorded in the system may be drastically different from inventory levels in the actual warehouse. A company may not have correct inventory stock and could make financial decisions based on incorrect data.
Advantages and Disadvantages of the Periodic Inventory System
The periodic inventory system is often less expensive and time consuming than perpetual inventory systems. This is because there is no constant maintenance of inventory records or training and retraining of employees to upkeep the system. The complexity of the system makes it difficult to identify the cost justification associated with the inventory function.
While both the periodic and perpetual inventory systems require a physical count of inventory, periodic inventorying requires more physical counts to be conducted. This updates the inventory account more frequently to record exact costs. Knowing the exact costs earlier in an accounting cycle can help a company stay on budget and control costs.
However, the need for frequent physical counts of inventory can suspend business operations each time this is done. There are more chances for shrinkage, damaged, or obsolete merchandise because inventory is not constantly monitored. Since there is no constant monitoring, it may be more difficult to make in-the-moment business decisions about inventory needs.
While each inventory system has its own advantages and disadvantages, the more popular system is the perpetual inventory system. The ability to have real-time data to make decisions, the constant update to inventory, and the integration to point-of-sale systems, outweigh the cost and time investments needed to maintain the system. (While our main coverage focuses on recognition under the perpetual inventory system, Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System discusses recognition under the periodic inventory system.)
Your company uses a perpetual inventory system to control its operations. They only check inventory once every six months. At the 6-month physical count, an employee notices several inventory items missing and many damaged units. In the company records, it shows an inventory balance of $300,000. The actual physical count values inventory at $200,000. This is a significant difference in valuation and has jeopardized the future of the company. As a manager, how might you avoid this large discrepancy in the future? Would a change in inventory systems benefit the company? Are you constrained by any resources?
Key Concepts and SummaryA perpetual inventory system inventory updates purchase and sales records constantly, particularly impacting Merchandise Inventory and Cost of Goods Sold.A periodic inventory system only records updates to inventory and costs of sales at scheduled times throughout the year, not constantly. Merchandise Inventory and Cost of Goods Sold are updated at the end of a period.Cost of goods sold (COGS) includes all elements of cost related to the sale of merchandise. The formula to determine COGS if one is using the periodic inventory system, is Beginning Inventory + Net Purchases – Ending Inventory.The perpetual inventory system keeps real-time data and the information is more robust. However, it is costly and time consuming, and physical counts of inventory are scarce.With the periodic inventory system, there are more frequent inventory counts and reduced chances for shrinkage and damaged merchandise. However, the periodic system makes it difficult for businesses to keep track of inventory costs and to make present decisions about their business.
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(Figure)Which of the following is a disadvantage of the perpetual inventory system?Inventory information is in real-time.Inventory is automatically updated.It allows managers to make current decisions about purchases, stock, and sales.It is cost-prohibitive.