In this chapter we describe two methods of accounting for inventory: "periodic" and "perpetual". In addition, we describe "specific identification", a variation of the perpetual method. In this chapter, the words periodic and perpetual are used to refer to the inventory methods, and should not be confused with the ways that amounts are presented in NewViews.
Companies that sell large volumes of low cost per unit merchandise generally use the periodic inventory method. Purchases of merchandise are continually recorded in a cash or payables account, posting to a purchases account. Sales are continuously recorded in a cash or receivables account, posting to sales. The recording of a purchase or sale has no effect on inventory accounts.
Only by a detailed count of the merchandise on hand can the value of inventory be determined. A count of inventory is taken at the end of accounting periods, usually once per fiscal year as a minimum. The value of inventory is determined using one of several possible costing methods: last in first out (LIFO), first in first out (FIFO), weighted average, replacement value, and so on.
An adjusting transaction is added to the inventory account, posting to a change to inventory account on the income statement (contra-purchases), bringing the inventory to the current value as determined by the physical count and the selected costing method. Purchases less (plus) the increase (decrease) in inventory equals the cost of goods sold for a period. The cost of goods sold is subtracted from sales to determine gross profit for a period.
In the periodic method, inventory and cost of goods sold are accurate only after a physical count or estimate is made and the adjustment to inventory is recorded. Therefore, inventory must be counted or estimated, and adjusted on a monthly basis if accurate monthly determinations of inventory, gross profit and income are required.
In contrast to the periodic inventory method, inventory accounts in the perpetual method continuously reflect the value of goods on hand. However, physical inventory is still counted from time to time to identify discrepancies. The perpetual method is used when a company sells a small volume of high cost per unit merchandise or when the current value of inventory is continuously required.
Purchases are recorded by adding transactions to cash or payables accounts, posting directly to inventory. A purchases account is not used. Two transactions are required to record a sale. The first is added as a transaction detail (invoice) to a cash or receivables account, posting sales items to appropriate sales accounts. The amounts of sales items equal the selling price of the merchandise. When Sales accounts are linked to inventory and cost of goods sold accounts, the second transaction is automatically added to cost of goods sold, posting directly to appropriate inventory accounts, reducing their balances. The items of this transaction equal the rolling average cost of the merchandise sold.
In the periodic method, the cost of goods sold is determined only when inventory is counted or estimated. In the perpetual method, the inventory balance should continuously equal the current value of inventory and the income statement continuously reports the correct value of cost of goods sold. To accomplish this, cost is determined continuously as sales are recorded and merchandise is shipped.
Previous examples used single accounts to illustrate the periodic and perpetual inventory methods. In practice inventory is maintained by product or product category and information available from inventory can be used to report gross profit by product. Inventory accounts can also be grouped by warehouse on the inventory report when multiple warehouses are managed.
Debit and credit amounts can be selected on inventory reports to display the flows in and out for any period. Debit amounts report purchases and credit amounts report the cost of goods sold. Therefore purchases are also available by product for the perpetual inventory method even though purchase accounts are not used. This also eliminates the need for more than one purchases account in the periodic inventory method unless gross profit is reported by product.
Levels of inventory for each product can be seen immediately on the analysis view of the inventory report. However, it is also important to report the difference between current levels and minimum acceptable levels for each product. For this purpose, minimum levels can be entered into budget amounts on the inventory accounts and then compared to current levels. Products that are below (or above) the minimum are identified at a glance. Inventory planning is also integrated with sales and purchase order management.