There are two basic methods of accounting for merchandise inventories which are called Periodic and Perpetual. Just the definition of the terms perpetual and periodic should trigger a pretty good idea of what the two basic methods actually are. Periodic means occasionally and perpetual means continually. Periodic Inventory System-Simple method for keeping up with products and calculating the cost of products that were sold in a period. An actual count is periodically performed in order to determine the value of the inventory. Perpetual Inventory System-Method for keeping up with products and calculating the cost of products that were sold in a period. Up-to-date inventory records are continually maintained at all times. A detailed record (subsidiary ledger record) is maintained for each product that keeps up with the quantities and cost of each purchase and the quantities and cost associated with each sale. An actual count is usually done at the end of the year in order to check the accuracy and correct any errors in the detailed records. Periodic Method The periodic method of accounting for inventory is a system that requires a physical count at specified times normally the end of an accounting period and at the very least a count must be made at the end of your accounting year in order to be able to calculate the cost of items sold and the cost of items still on hand. Taking The Inventory You've probably heard people use the phrase "taking the inventory". What they are talking about is actually performing the physical count of the inventory. They may have even used some four letter adjectives with the phrase. Why would they do this ? The time, cost, planning, and effort involved in taking an accurate inventory can be enormous. In other words it's a hassle, but it needs to be done. As I was always told as a kid, "a job worth doing is a job worth doing right". How much time, cost, planning, and effort is required ? It depends. Mom and Pop Shops that maintain a small selection and quantity of items on hand don't require as much as say a company like General Motors. Is there any way to help minimize the effort required ? Many businesses take an inventory at a time when the amount of stock on hand is at a low point. Makes sense to me. The less I have to the count, means less time, cost, planning , and effort is required. When do I do the count ? Some businesses are able to count during normal business hours while others might count at night or during closed times or even close down to take their inventory. Again it depends on your type of business and the effort required. Some businesses even hire inventory service businesses to do the count for them. You've probably seen these people with their machines in grocery stores. Are there any special forms I should use ? Yes, a count sheet and possibly a cost calculation form but you can design them yourself. What information should I include on my count sheets ? General Information Department/Area Counted By Sheet Number/Reference Date of Inventory Extended By Stock/Item Number Description of Item Bin/Location Unit Of Measure Quantity On Hand (Counted) Costing Method Unit Cost Extended Cost Or Reference to Cost Calculation Sheet Notes/Comments- such as condition of items Total Sheet Cost Do I need to take any special precautions ? Only the goods that actually belong to the business should be counted. Merchandise that you have on consignment does not belong to the business and should not be included as a part of your businesses inventory although the supplier may require you to count these items and report the count to them. For those that don't know, a consignment occurs when a supplier maintains title/ownership of the goods but you have custody of the goods and are allowed to sell them and pay for the goods as they are sold. On the other hand, if you have supplied other businesses with consigned goods you need to count or make arrangements to have a count performed and include your consigned goods in your inventory. Merchandise that has been sold but not yet delivered is a sale and should not be included in your count. Merchandise that you have received and have title to but have not processed such as goods waiting to be unloaded or in a holding area waiting to be processed in should be processed and included in your inventory count. A procedure for identifying what has and has not been counted such as tags on the merchandise counted or any other method or procedure that tells you whether the goods have been counted should be used. This makes sure that goods aren't omitted from the count or included more than once. Assigning Costs To Inventory Counting our inventory is only half the battle. We also need to assign costs to all the items we still have on hand. If all our purchases of a specific item were made at the same unit cost, we could easily arrive at the cost to use for valuing our inventory. We all know though that this is normally not the case. So our problem becomes what cost do I use to value my inventory when my business has made purchases of the same item at different costs. Example Product: Super Widget Purchases: Quantity Unit Cost 100 $10.00 300 $9.00 200 $11.00 Do I use $10.00, $9.00, $11.00 ,an average or what to assign cost to my ending inventory ? Don't jump the gun and get excited yet. This problem will be discussed in our next lesson. I just wanted you to be aware that coming up with the proper cost to use in valuing your ending inventory requires your business to make some assumptions regarding costs. Detailed Records Required and Maintained With A Periodic System No Detail Subsidiary Inventory Ledger (stock records) are required; however, as you will see in Lesson 2 where you learn to assign costs, strong consideration should be given to at least maintaining detail records regarding your purchases. Count and Costing Sheets used when performing a physical inventory count. Source Documents Used To Maintain The Inventory: Purchase Orders and Invoices from Suppliers are used to determine the cost of items. Accounting and Bookkeeping Procedures For Periodic Inventory System Sale of Products-Recording of Revenue Earned and Associated Taxes Of course when we sell a product we need to record the increase in our assets either Cash or Accounts Receivable and the corresponding increase in our revenue Sales and the increase to our Sales Tax Liability. Recording the revenue and associated tax liability is done the same way if we used the Perpetual Inventory Method of maintaining our Retail Inventory. No entry is made at the time of sale to the Cost of Goods Sold Account or Merchandise Inventory Account. Can you tell me why ? The answer was given in the prior Detailed Records Required and Maintained With A Perpetual Inventory Section. Without maintaining detail records, we simply don't know at the time of sale what the cost of the item(s) sold are. Entry Needed To Record The Transaction: Assumptions: Sale of merchandise inventory in the amount of $900 was made Sales Tax Rate of 10% DESCRIPTION DEBIT CREDIT Cash or Accounts Receivable 1,000       Sales   900     Sales Tax Payable   100 Journal Used: Cash Sale would be recorded in the Cash Receipts Journal as a debit to our Cash Account, a credit to our Sales Account, and a credit to our Sales Tax Liability Account Charge(On Account) Sale would be recorded in the Sales Journal as a debit to our Accounts Receivable Control Account, a credit to our Sales Account, and a credit to our Sales Tax Liability Account Purchase Items The Purchase Account is an account used only to record the cost of merchandise bought to be sold to your customers. The Purchase Account is a temporary account that is adjusted at the end of an accounting period (month/year). Actually, you could record your Purchases of Products for Resale directly in your Products For Resale Inventory Account but by using the Purchases Account it provides you with a quick total of the amount you spent buying products during a period. Since purchasing products to sell is probably the biggest expenditure a business that sells products will incur during a period (month/year), we accountants (bean counters) feel it is worthy of an account of its own named Purchases. Entry Needed To Record The Purchase Transaction: Assumptions: Purchase of merchandise inventory for resale in the amount of $600 was made DESCRIPTION DEBIT CREDIT Purchases 600       Cash or Accounts Payable   600 Journal Used: Cash Purchase would be recorded in the Cash Disbursements Journal as a debit to our Purchases Account and a credit to our Cash Account Charge(On Account) Purchases would be recorded in the Purchases Journal as a debit to our Purchases Account and a credit to our Accounts Payable Control Account. Determine Cost Of Products Sold and Ending Inventory Values The Cost Of Goods Sold is a special account that records the cost of the goods that were sold to your customers. When you use the Periodic Inventory System, no entry is made to this account or the Merchandise Inventory Account at the time of sale. This Account and the Merchandise Inventory Account are adjusted with adjusting journal entries after counting and determining the ending inventory value (cost). Of course your Inventory for Resale Account using the periodic inventory system reflects your beginning of the year balance and the actual value (cost) of the inventory on hand can only be determined after counting and pricing the goods still on hand as of the end of the period (year). Hint:This should alert you that the difference between the two inventory methods, Perpetual and Periodic, results from the timing, methods, and procedures that are used to track and account for the value of the Inventory On Hand and the Cost of Goods Sold. A simple equation is used to calculate the cost of the items sold. The cost of the items sold is determined by first adding the cost of the items on hand at the beginning of a period (Beginning Inventory Account) to the cost of the items purchased during the period (amount recorded in the Purchases Account resulting in the Total Cost of the Items Available to be Sold. After performing (taking the physical inventory) and arriving at the quantities and total cost assigned to the Goods On Hand (Ending Inventory) at the end of the period, this ending inventory amount is subtracted from the Total Cost of the Items Available to be Sold to arrive at the Cost of Goods Sold amount for the period. All we're actually doing is using a little bit of logic mixed in with some simple Algebra. If we have so much to start (Beginning Inventory) with and we add some more (Purchases) and we only have so much left (Ending Inventory), then the difference went out the door (Cost Of Goods Sold). Stating the above steps in an equation form results in the following simple mathematical calculations. Two Step Approach: Beginning Inventory + Purchases = Total Cost of Goods Available for Sale Total Cost of Goods Available for Sale - Ending Inventory = Cost of Goods Sold Combined Approach: The above steps combined into one equation: Beginning Inventory + Purchases - Ending Inventory = Cost Of Goods Sold Let's use a Simple Worksheet and the following assumptions to help us see how all the pieces fit together. Assumptions: Beginning Inventory Valued at a cost of $10,500 and obtained from our Inventory Account Purchases at a cost of $70,000 were made during the period and obtained from our Purchases Account Ending Inventory was counted and valued at a cost of $8,000 as of the end of the period Beginning Inventory Value 10500 Add:Purchases (Transfer To Inventory Account From Purchases Account) 70000 Total To Account For-Available For Sale After Purchase Transfer 80500 Subtract:Ending Inventory Value (Based On Our Count) 8000 Cost of Goods Sold During The Period (Transfer to Cost Of Goods Sold Account From Inventory Account) 72500 An Adjusting Entry derived from our count, valuation, and calculations (work sheet) must be made to adjust our Merchandise Inventory Account to our calculated value (cost) and record the Cost of the Items Sold during the period in our Cost of Goods Sold Account. The General Journall is used to record the Inventory and Cost of Goods Sold adjusting entries when the Periodic Inventory Method is used. Entries Needed To Record (Adjust) Merchandise Inventory and Cost Of Goods Sold The first entry will transfer the balance from our Purchases Account to our Merchandise Inventory Account. DESCRIPTION DEBIT CREDIT Merchandise Inventory 70,000       Purchases   70,000 The second entry will adjust our Ending Inventory Balance in our Merchandise Inventory Account and record our Calculated Cost of Good Sold amount in our Cost Of Goods Sold Account. DESCRIPTION DEBIT CREDIT Cost Of Goods Sold 72,500       Merchandise Inventory   72,500 Perpetual Method If you use the Perpetual Method you have to maintain detail records pertaining to each and every purchase and sale of inventory. A grocery store is an example of a business that often uses a perpetual inventory system. As you may or may not be aware most grocery store products have what is called a bar code (code that identifies the product description, price, cost, etc.). This code allows purchases to be scanned in when delivered to the store. As goods are sold, the fancy check out counters now have scanners that scan the products and automatically update the sales and inventory records. Thank goodness for automation ! Can you imagine trying to do this by hand with manual inventory cards ? Many types of businesses are almost "forced" to maintain a perpetual inventory system in order to properly serve their customers. A business that I'm familiar with is a John Deere dealership. When your mower breaks a belt and you call the dealer to see what part you need and whether they have it which dealer would you rather deal with ? The one who can call it up on their computer and determine immediately if they have any and give you the price or the dealer that puts you on hold and has to look around his store and try to physically locate the item and determine the price. Don't get me wrong, even the dealer with a perpetual inventory should after looking it up on their records should verify that they actually do have the part. Perpetual Inventory Systems are only as good as the people who maintain it. Detailed Records Maintained With A Perpetual System Merchandise Inventory Subsidiary Ledger is maintained on Inventory Stock Record Cards (Manual System) or Computer Software that monitors your inventory or a complete computer accounting/bookkeeping software product that includes Inventory Management. The total costs of all the subsidiary ledger cards should equal the balance maintained in the Merchandise Inventory-Control Account. Count and Costing Sheets used when performing a Physical Inventory Count Wait a minute, why do I need to actually count my inventory when I'm using the Perpetual Inventory System ? Shucks the answer is easy. We're human and unfortunately we make mistakes (not me). As I stated earlier our Perpetual Inventory System is only as good as the people who maintain it. We use the physical count to verify the accuracy of our perpetual records and make any required adjustments resulting from errors. Source Documents Used To Maintain The Inventory: Purchase Orders and Invoices from Suppliers are used to record (update our detail stock records) the quantities and the cost of the items received Our Sales Invoices along with information from our subsidiary ledger cards (cost information) are used to record (update our detail subsidiary ledger (stock records) ) the quantities and costs of the items sold Accounting and Bookkeeping Procedures For Perpetual Inventory System Sale of Products-Recording of Revenue Earned and Associated Taxes and Cost Of Goods Sold Of course when we sell a product we need to record the increase in our assets either Cash or Accounts Receivable and the corresponding increase in our revenue Sales and the increase to our Sales Tax Liability. Recording the revenue and associated tax liability is done the same way as if we had used the Periodic Inventory Method of maintaining our Retail Inventory. What's different from the Periodic Inventory System is that we also record the Cost of the Goods Sold and the resulting decrease in our Merchandise Inventory Account at the same time (time of the Sale). Entries Needed To Record The Transaction: Assumptions: Sale of merchandise inventory in the amount of $900 was made Sales Tax Rate of 10% Cost of items sold is $600 arrived at from the inventory detail records maintained The first entry records the asset acquired (received) and the revenue earned. DESCRIPTION DEBIT CREDIT Cash or Accounts Receivable 1,000       Sales   900     Sales Tax Payable   100 The second entry records the decease in the merchandise inventory and the cost of the items sold. DESCRIPTION DEBIT CREDIT Cost Of Goods Sold 600      Merchandise Inventory    Control   600 Journal Used: Cash Sale would be recorded in the Cash Receipts Journal as a debit to our Cash Account, a credit to our Sales Account, and a credit to our Sales Tax Liability Account Charge(On Account) Sale would be recorded in the Sales Journal as a debit to our Accounts Receivable Control Account, a credit to our Sales Account, and a credit to our Sales Tax Liability Account To record the Cost of the Items Sold and the reduction in the value of the Merchandise Inventory, you can use the Cash Receipts or Sales Journal where you recorded the revenue resulting from the sale to record the cost portion of the entry or create a Special Cost Of Goods Sold Journal and use it to record the cost of the items sold. Purchase Items The Merchandise Inventory Control Account is the account used to maintain a summary of the cost of merchandise bought to be sold (Purchases) to your customers and the costs of the merchandise sold and transferred to the Cost of Goods Sold Account. The balance of this Control Account, after all the transactions for the period have been posted, represents the current balance of our inventory. Entry Needed To Record The Purchase Transaction: Assumptions: Purchase of merchandise inventory for resale in the amount of $600 was made DESCRIPTION DEBIT CREDIT Merchandise Inventory Control 600       Cash or Accounts Payable   600 Journal Used: Cash Purchase would be recorded in the Cash Disbursements Journal as a debit to our Inventory Control Account and a credit to our Cash Account Charge(On Account) Purchases would be recorded in the Purchases Journal as a debit to our Inventory Control Account and a credit to our Accounts Payable Control Account. Purchases using the Perpetual Method are directly charged to the Merchandise Inventory Account instead of the Purchases Account that was used for recording purchases using the Periodic Method. Of course, the Inventory Subsidiary Ledger (stock card) is also updated with the quantity received and the cost of the items received. Remember, the balance of the Merchandise Inventory Account using the Periodic Method is the balance of the inventory at the beginning of the year (period) and a physical inventory must be taken and adjusting journal entries made to adjust the account to the current balance. Determine Cost Of Products Sold and Ending Inventory Values As stated earlier, the Cost Of Goods Sold is a special account that records the cost of the goods that were sold to your customers. When you use the Perpetual Inventory System, an entry is made to the Cost Of Goods Sold Account and Merchandise Inventory Account for the cost of the items sold at the time of each sale We also need to update our detail inventory records at the time of the sale. What detail record do we need to update ? Our Subsidiary Inventory Ledger (stock card) needs to also be posted with the quantity sold and the costs assigned to the items sold. . The Cost of the Products Sold used to update our Cost Of Goods Sold and Merchandise Inventory Accounts is obtained from the Detail Inventory Records that are maintained when the Perpetual Inventory System is used. Although the Perpetual Inventory Method should maintain a current, actual inventory balance, losses from theft, obsolescence, damage, etc. may reduce the actual inventory available. As stated previously, performing Actual Physical Inventory counts and adjusting your detail records ensures the accuracy of your perpetual records and discloses areas that may require further investigation. In addition, for U.S. taxpayers, the IRS requires an annual physical inventory. Summary Of Accounting/Bookkeeping Entries For The Perpetual and Periodic Inventory Methods Transaction Type Periodic Method Perpetual Method Purchase Of Products Debit Purchases Account Debit Inventory Control Account Sale Of Product Debit Cash/Accounts Receivable Account Credit Sales Account Credit Sales Tax Payable Account No Entry Made To Record Cost Of Goods Sold and Reduce Inventory Value Debit Cash/Accounts Receivable Account Credit Sales Account Credit Sales Tax Payable Account Debit Cost Of Goods Sold Credit Inventory Control Account Adjusting Entries Debit Inventory Account Credit Purchases Account Debit Cost Of Goods Sold Account Credit Inventory Account No Adjusting Entries Needed To Record Cost Of Goods Sold and Adjust Ending Inventory Advantages & Disadvantages of Each Method Perpetual Advantages: Better Overall Control. Allows you to monitor your inventory levels and provides information for helping determine optimum inventory levels and ordering requirements. You know what you have on hand at all times-better customer service. No need to estimate or count inventory when preparing financial statements. Helps prevent stock out conditions. Information is available for determining profit by customer and product lines. Disadvantages: Detailed records required. Periodic Advantages: Simple to use. Less record keeping is required-but don't be fooled ! Disadvantages: Determining cost to assign to your ending inventory can be quite a hassle. Purchase orders and invoices normally contain many different products and their associated unit costs. Determining what cost(s) to use for valuing ending inventory may require a substantial effort. Less overall management control-theft, etc. Information is not available for determining optimal inventory levels. Stock outs may occur. Information is not readily available for determining profitable customers and product lines. Information is not readily available for preparing financial statements. As a general rule, the perpetual method should be used for high dollar value products such as jewelry, cars, boats, lawn mowers, mink coats, etc. . The periodic method is acceptable for low dollar value products and items where the cost of maintaining detail records is greater than the benefits derived. An example would be a hardware store's nuts, bolts, screws, and, nails. Observation:In the ole manual record keeping days (I know some businesses still don't use a computer), I could probably present a better case for using the Periodic and not using the Perpetual Inventory Method. Now, however, when you can purchase a computer and the necessary software for less than $1000 its difficult (except for the smallest businesses) for me to make that case. Our next lesson ,Costing Methods, covers quite a bit of material so you might want take a break and grab a soda, snack, or cup of coffee. The nice thing about self paced tutorials is that you decide how fast you want to go and not the instructor (me). But, before you go on break let's see if anything stuck to those brain cells. Quiz-Inventory Methods <--BACK        NEXT--> Introduction Lesson 1 Lesson 2 Lesson 3 Lesson 4 Lesson 5 Lesson 6 Bean Counter