Inventory management is an important part of business success. In this lesson, we will discuss the two types of inventory systems used in accounting today.
After months of hard work and planning, Janie is in the final steps of opening her new business, Janie’s Boutique. She’s already filled the store with inventory, hired employees, and will be opening the doors in just a few days. But she’s run into a slight problem. She can’t quite decide how to account for her inventory. She knows that she wants to make sure that her financial statements are as accurate as possible, and that will require that her inventory costs and sales be as accurate as possible. But that she doesn’t know is what the best way to do this. Since Janie doesn’t know what to do, she decides to go see her friend Adam, who is an accountant, and get his advice.
Adam’s glad to talk with Janie about this. The first thing he tells her is that she needs to decide what inventory system to use. An inventory system is a system used to monitor the levels of inventory that a business has on hand. He tells her that she has two choices when it comes to inventory systems: periodic or perpetual. Which one is best for her needs, well, she’ll just have to decide that.
Adam explains to Janie that a periodic system is an inventory system that records inventory levels at specific points in time. These points in time are usually at the end of accounting periods. Periodic systems use physical count audits where employees actually count each and every item in the store to get an accurate inventory level. This amount is then compared to sales reports and purchase receipts to verify the amount of goods sold and to see if there are any discrepancies in numbers.
On the other hand, a perpetual system is an inventory system that records inventory into the accounting system on a continuous basis. This type of system relies heavily on automation to instantly track purchases and sales, and update the accounting system immediately. When an item is purchased, it is automatically recorded in the accounting system as an inventory item.
Janie was confused. What makes one better than the other? Adam tells her that one is not necessarily better than the other, but there are a couple of notable differences between the two.
One major difference is the account each system uses to record the acquisition of inventory-related materials. The periodic system uses the purchases account while the perpetual system uses the inventory account.
Another difference between the two systems is that the periodic system only reports the cost of goods sold at the end of the accounting period, where the perpetual system constantly updates this information at the time of each sale. The importance of the cost of goods sold is that it is the account that reports the direct costs that are attributed to the goods sold by a company. The cost of goods sold is reported on a business’ income statement, which is the financial statement that tells how much money a business made or lost in a given time period. The cost of goods sold is deducted from revenue earned from sales to get the total amount of profit or loss that a business had from sales in an accounting period.
A third difference between the two centers on closing entries. Closing entries are entries that are made at the end of the accounting period to update the balances of certain accounts. The periodic system requires closing entries to update the balances in the inventory and cost of goods sold account, where the perpetual system doesn’t need closing entries because they always update those accounts.
A fourth difference, and one that is important to business owners, is the cost of implementing either system. The perpetual system is highly technological, so it costs much more than the manual periodic system.
Janie knows that she needs to make a decision on what type of inventory system to use for the boutique. After talking with Adam, she learned that there were two types to choose from: periodic or perpetual. The periodic system is an inventory system that records inventory levels at specific points in time. The perpetual system is an inventory system that records inventory into the accounting system on a continuous basis.
She also learned that there were distinct differences between the two. One of those differences is the account that is used to record the acquisition of inventory-related items. The periodic system uses the purchases account, while the perpetual system uses the inventory account.
Another difference is the way that the cost of goods sold are reported. The cost of goods sold is the account that reports the direct costs that are attributed to the goods sold by a company. It is significant to a business because it helps determine exactly how much a company made or lost on sales for the accounting period. The cost of goods sold is reported on the income statement, which is a financial statement that tells how much money a business made or lost in a given time period. In the periodic system, the cost of goods sold are only reported at the end of an accounting period, whereas in the perpetual system, cost of goods sold is continuously updated with each new purchase or sale of inventory.
Janie also learned that if a business used the periodic system, then closing entries, or entries that are made at the end of an accounting period to update the balances in certain accounts, would be required to update the merchandise inventory and the cost of goods sold account. Since the perpetual system updates these accounts with every sale made, then it doesn’t require closing entries.
The last difference that Janie learned was that the perpetual system was more expensive to implement than the periodic system because of its heavy reliance on technology. After reviewing all the facts, Janie finally decides to use the periodic system since she has a very small business. Do you agree?
Once the lesson ends, see if you can achieve these goals:
- Determine what an inventory system is
- Compare perpetual and periodic inventory systems
- State the four differences between the two systems