One of the key determinations in accounting for inventory is the actual quantities of items on hand from time to time. A number of celebrated cases of fraudulent or misleading financial statements have involved the overstatement of inventory quantities on hand. Overstating inventory normally translates into a corresponding overstatement of income.
In determining the amount of inventory on hand, consideration must be given to the legal ownership of inventory as compared to its physical location. For example, goods in
transit may be included in inventory when title has been transferred to the 138
purchaser even though the goods have not arrived. Goods that have been shipped to a consignee under a consignment arrangement should be included in the inventory of the consignor.
There are two primary techniques for determining physical inventory quantities. These are the periodic inventory system and the perpetual inventory system.
1. PERIODIC INVENTORY SYSTEM
The periodic inventory system employs a periodic physical count of the inventory on hand from time to time. This count will usually be performed at the end of the accounting period although some businesses may conduct more frequent counts particularly where inventory is highly valuable. A separate count is made of each type, size, or other component of the inventory.
To illustrate how the periodic inventory system works and how cost of goods sold ( i.e., the amount to be deducted from the sales revenue recognized for the goods sold) is determined under this system, assume that a business started the year with 75,000 units on hand and that each unit costs $1. At the end of the year, the business conducts an inventory count and determines that there are now 80,000 units on hand at a cost of $1 per unit. The ending inventory that should be included in the balance sheet for the current year will be $80,000.
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To determine cost of goods sold under this system, one more item of information is necessary. The business will have maintained a temporary account during the year called
“Purchases” (assuming that we are dealing with a retail or wholesale operation) and all the purchases of inventory items during the year will have been recorded in that account.
Assume that the balance in the Purchases account for the year is $400,000 (i.e., 400,000 units were purchased during the year at a cost of $1 per unit). A summary journal entry for all of the inventory purchase transactions for the year would be as follows:
Purchases $400,000
Accounts Payable (or Cash) $400,000
In order to determine the cost of goods sold for the year under the periodic inventory system, you first determine the total inventory that was available for sale during the year (the beginning inventory plus the purchases for the year). You then subtract from the goods available for sale the amount of the ending inventory. The difference is the amount of the inventory that was sold (or otherwise lost) during the year. For the example discussed above, the calculation would be as follows:
Beginning Inventory $ 75,000
Purchases 400,000
Goods Available for Sale 475,000
Less Ending Inventory (80,000)
Cost of Goods Sold $395,000
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An accounting entry is made at the end of the year to update the inventory account, close out the purchases account, and enter the appropriate amount in the cost of goods sold account. That entry would be as follows:
Inventory (Ending) $ 80,000
Cost of Goods Sold $395,000
Inventory (Beginning) $ 75,000
Purchases $400,000
This entry returns the purchases account to a zero balance, corrects the inventory to be reported in the balance sheet to the appropriate end of the year amount, and records cost of goods sold for the year.
One disadvantage of the periodic inventory system is that there is no way to determine the cost of goods sold at interim points during the accounting period since the inventory currently on hand is not known until the end of the year. Businesses that rely solely on the periodic inventory system use various estimating techniques to estimate ending inventory and cost of goods sold for interim periods and other purposes.
2. THE PERPETUAL INVENTORY SYSTEM
As noted above, one problem with the periodic inventory system is that it does not provide information about the inventory on hand until completion of the periodic inventory count. This system also does not permit interim determination of the cost of
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goods sold. The perpetual inventory system addresses these problems. Under the perpetual system, the business maintains a continuous record of the goods on hand during the year. The accounting records show not only the purchases that occur during the year but they also record the number and cost of the items sold each time a sale occurs. Conceptually, the entries to record the purchase and sale of inventory items are made directly to the inventory account. Thus, a purchase of inventory at a cost of
$30,000 would be recorded as follows:
Inventory $30,000
Accounts Payable (or Cash) $30,000
The sale of inventory with a cost of $25,000 for $30,000 would be recorded as follows:
Accounts Receivable $30,000
Sales Revenue $30,000
Cost of Goods Sold $25,000
Inventory $25,000
The gross profit on this sale is immediately determinable as $5,000 ($30,000 minus
$25,000). Similar entries are made for all purchases of, and sales from, inventory throughout the year.
Under this system, at any time during the year, the business knows its cost of goods sold and its current inventory balance. As compared to the periodic
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system, this provides much more timely information not only for purposes of financial reporting but also for operational purposes such as inventory control, reordering procedures, and other operational needs. Particularly with the extensive use of such technology as point of sale terminals, scanning equipment, and high speed computers, many businesses are able to update their inventory records on an immediate and continuous basis.
For companies that use the perpetual inventory system, it is still necessary to conduct periodic inventory counts to confirm the accuracy of the perpetual inventory records.
These counts may be conducted at the end of the year or they may occur on a test basis with respect to different parts of the inventory throughout the year. Any corrections necessitated by the results of the count are recorded in the inventory and cost of goods sold account before the books are closed for the year.