What is Inventory?

what-is-inventoryThere are two inventory systems, the perpetual inventory system and the periodic inventory system. With the perpetual system, a (computer) system is in place which keeps track of inventory. It is therefore possible to compare the actual inventory with the inventory according to the system. However, such a system comes at a cost. With the periodic system, inventory is not kept up to date. To find out the units that have been sold, a physical count is necessary. Choosing between the two systems involves a complex cost-benefit tradeoff. Benefits of a computerized system include having up-to-date information (and potentially better decision making) and less theft by employees. However, automated systems are not for free. Software needs to be purchased or programmed. Also, separation of duties between employees is required for making somebody accountable for missing units.

In this section, I take a firm’s choice for either system as a given and focus on the accounting implications of each system.

When the perpetual inventory system is used, the inventory T-account is updated with every purchase and every sale. When new inventory is purchased, the asset inventory is increased. When sold, the inventory is reduced and expensed as cost of goods sold. This system is therefore in line with the matching principle.

With the periodic inventory system however, no up-to-date system is in place. When inventory is purchased, it is expensed. When sold, no entry is made (as it has already been expensed when purchased). At the end of the period, a correction needs to be made, because in the income statement the cost of goods sold needs to be expensed. Purchases are generally not equal to cost of goods sold. Since beginning inventory + purchases = ending inventory + cost of goods sold, the correction that needs to be made is beginning inventory – ending inventory. This correction is added to inventory on the balance sheet, and also added to purchases, so that the income statement is expensed with cost of goods sold.


Inventory Example

The following information is available about inventory, purchases and sales:

Beginning inventory 10
Purchases 25
__
Goods available for sale 35
Cost of goods sold 17
Ending inventory (physical count) 18
__
Goods available for sale 35

Verify that beginning inventory + purchases = cost of goods sold + ending inventory

If the periodic inventory system is used, then purchases of 25 are expensed, whereas in reality the cost of the goods sold is only 17. At the same time, the T-account inventory has not been used over the year and will show an ending balance of 10, whereas it actually is 18. Thus, the journal entry of the correction needed is:

T-account Debit Credit
Inventory 8
Purchases 8

If the perpetual system were used, no such correction for inventory nor cost of goods sold would be needed. Under the perpetual system inventory is kept up-to date at all times and cost of goods sold are expensed when inventory is sold.


Inventory Explained

Key points:

– with the perpetual inventory system at all times inventory is kept up to date. This method applies the matching principle. Purchases are booked as inventory, and at time of sale inventory is reduced and recognized as cost of goods sold.

– with the periodic inventory system, purchases are expensed. As a result, at the end of year inventory as well as cost of goods sold needs to be corrected beginning inventory minus ending inventory

 

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