7.2 Perpetual and periodic inventory systems

Inventory management is crucial for businesses to track and value their goods accurately. This topic explores two main systems: perpetual and periodic. Each method has unique characteristics that impact how companies record purchases, sales, and calculate cost of goods sold.

Understanding these systems is essential for effective inventory control and financial reporting. The choice between perpetual and periodic inventory systems affects the timing of updates, accuracy of records, and overall financial statement presentation. This knowledge is vital for making informed decisions in inventory management.

Perpetual vs periodic inventory systems

• Perpetual and periodic inventory systems are two distinct methods used by businesses to track and record inventory
• The choice between these systems impacts the timing and accuracy of inventory updates, cost of goods sold calculations, and financial reporting
• Understanding the differences, advantages, and disadvantages of each system is crucial for effective inventory management and accurate financial statements in Intermediate Financial Accounting

Inventory cost flow assumptions

First-in, first-out (FIFO) method

• Assumes the first items purchased or produced are the first ones sold or used
• Ending inventory consists of the most recently acquired items
• Results in lower cost of goods sold and higher gross profit during periods of rising prices
• Provides a more realistic representation of the physical flow of goods

Last-in, first-out (LIFO) method

• Assumes the most recently purchased or produced items are the first ones sold or used
• Ending inventory consists of the oldest items
• Results in higher cost of goods sold and lower gross profit during periods of rising prices
• Matches current costs with current revenues, providing a better measure of current income
• Permitted under U.S. GAAP but not allowed under IFRS

Weighted average cost method

• Calculates the average cost of all items available for sale during the period
• Cost of goods sold and ending inventory are based on this average cost
• Smooths out the effects of price fluctuations
• Simpler to calculate and maintain compared to FIFO and LIFO

Specific identification method

• Tracks the actual cost of each individual item sold and remaining in inventory
• Most accurate method but can be impractical for businesses with large, diverse inventories
• Commonly used for high-value, unique items (artwork, jewelry)
• Allows for manipulation of income by selectively choosing which items to sell

Perpetual inventory system

Continuous inventory tracking

• Records inventory purchases, sales, and adjustments as they occur
• Maintains a real-time record of inventory quantities and costs
• Enables businesses to monitor inventory levels and make informed decisions

Real-time updates of inventory balances

• Updates inventory balances immediately upon each purchase or sale transaction
• Provides accurate, up-to-date information on inventory quantities and costs
• Facilitates better inventory control and reduces the risk of stockouts or overstocking

Cost of goods sold (COGS) recording

• Records the cost of each item sold at the time of sale
• Automatically updates the cost of goods sold account with each sales transaction
• Ensures that COGS reflects the actual cost of items sold during the period

Inventory purchases and sales journal entries

• Records inventory purchases as an increase in the inventory account and an increase in accounts payable or cash
• Records sales as an increase in accounts receivable or cash, an increase in COGS, and a decrease in inventory
• Maintains accurate and up-to-date financial records

Periodic inventory system

Physical inventory count at period end

• Requires a physical count of inventory at the end of each accounting period
• Used to determine the quantity and value of ending inventory
• Can be time-consuming and disruptive to business operations

Calculation of cost of goods sold (COGS)

• COGS is calculated at the end of the period using the formula: Beginning Inventory + Purchases - Ending Inventory
• Relies on the physical inventory count to determine ending inventory value
• May result in less accurate COGS figures compared to the perpetual system

Inventory purchases recorded as expenses

• Records inventory purchases as an expense in the period they occur
• Does not update the inventory account until the end of the period
• Can lead to distorted financial statements if purchases and sales are not evenly distributed throughout the period

Adjusting entries for inventory and COGS

• Requires adjusting entries at the end of the period to update the inventory and COGS accounts
• Adjusts the inventory account to match the physical count and the COGS account to reflect the calculated value
• Ensures that the financial statements accurately reflect the ending inventory and COGS for the period

Comparison of perpetual and periodic systems

Timing of inventory updates

• Perpetual system updates inventory in real-time, while periodic system updates inventory only at the end of the period
• Perpetual system provides more timely and accurate information for decision-making

Accuracy of inventory balances

• Perpetual system maintains accurate inventory balances throughout the period
• Periodic system relies on a physical count, which may be subject to errors or discrepancies

Cost flow assumption impact

• Cost flow assumptions (FIFO, LIFO, weighted average) can be applied in both systems
• Perpetual system applies the cost flow assumption with each transaction, while periodic system applies it only at the end of the period

Financial statement presentation

• Perpetual system generates more accurate and up-to-date financial statements
• Periodic system may result in less precise financial statements, particularly if there are significant fluctuations in inventory levels or prices

Advantages and disadvantages

Perpetual system pros and cons

• Advantages: real-time inventory tracking, accurate COGS, better inventory control, timely decision-making
• Disadvantages: higher setup and maintenance costs, requires integrated software and systems

Periodic system pros and cons

• Advantages: lower setup and maintenance costs, simpler to implement and maintain
• Disadvantages: less accurate inventory and COGS figures, potential for stockouts or overstocking, less timely decision-making

Suitability for different business types

• Perpetual system is more suitable for businesses with high inventory turnover, complex inventory management needs, or requiring real-time data
• Periodic system may be sufficient for smaller businesses with low inventory turnover or less complex inventory management requirements

Inventory valuation methods

Lower of cost or market (LCM) rule

• Requires inventory to be valued at the lower of its cost or market value
• Market value is typically defined as the current replacement cost, subject to an upper limit of net realizable value and a lower limit of net realizable value minus a normal profit margin
• Ensures that inventory is not overstated on the balance sheet and that any potential losses are recognized in a timely manner

Net realizable value (NRV) method

• Values inventory at the estimated selling price minus any costs to complete and sell the inventory
• Used when the utility of inventory is no longer as great as its cost
• Applicable in situations where inventory is damaged, obsolete, or selling prices have declined

Retail inventory method

• Estimates the cost of ending inventory by applying a cost-to-retail ratio to the ending retail value of inventory
• Commonly used by retailers with many different products and frequent price changes
• Provides an approximation of inventory cost without the need for a detailed physical count

Inventory management considerations

Inventory turnover and days sales in inventory

• Inventory turnover measures how quickly a company sells and replaces its inventory, calculated as: Cost of Goods Sold ÷ Average Inventory
• Days sales in inventory indicates the average number of days it takes to sell inventory, calculated as: 365 ÷ Inventory Turnover
• Higher inventory turnover and lower days sales in inventory generally indicate more efficient inventory management

Inventory control and shrinkage prevention

• Implementing proper inventory control procedures to minimize losses due to theft, damage, or obsolescence
• Conducting regular physical counts and reconciliations to identify and address discrepancies
• Using technology (barcodes, RFID) to track inventory movement and improve accuracy

Inventory costing and pricing strategies

• Selecting the appropriate cost flow assumption (FIFO, LIFO, weighted average) based on the company's industry, inventory characteristics, and financial objectives
• Developing pricing strategies that consider the cost of inventory, market conditions, and desired profit margins
• Analyzing the impact of inventory costing and pricing decisions on profitability and competitiveness

Financial reporting and disclosure

Inventory presentation on balance sheet

• Inventory is reported as a current asset on the balance sheet
• Classified into raw materials, work-in-process, and finished goods, if applicable
• Valuation method (FIFO, LIFO, weighted average) should be disclosed

Cost of goods sold on income statement

• Cost of goods sold is reported as an expense on the income statement
• Represents the cost of inventory sold during the period
• Directly impacts gross profit and net income

Inventory footnote disclosures

• Detailed information about inventory valuation, costing methods, and any changes in accounting policies
• Breakdown of inventory components (raw materials, work-in-process, finished goods)
• Information on inventory reserves, write-downs, or other adjustments

Inventory accounting policy disclosure

• Description of the inventory valuation method (FIFO, LIFO, weighted average) used by the company
• Explanation of any changes in inventory accounting policies and their impact on financial statements
• Consistency in the application of inventory accounting policies across periods