There are two types of systems of inventory accounting, which are briefly discussed below:
(1) Periodic Inventory System – Definition and Explanation:
When the periodic inventory system is employed inventory account is not debited or credited on account of purchase or sale of goods. Consequently, inventory is not determined through movements of purchases or sales rather it is determined through a complete physical inventory count only at the end of an accounting period or at specified intervals.
Advantages of Periodic Inventory System:
(i) Much time and even labor costs are saved as continuous records need not be maintained.
(ii) A generally simpler system to administer as compared with the perpetual inventory system.
Disadvantages of Periodic System:
(i) As inventory take generally involves additional time, cost and disruption to normal business routines. This usually prevents a physical inventory being taken more frequently.
(ii) As inventory value is only determined at the end of the period so there is very little control over inventory movements. The value of lost, stolen or spoiled goods therefore is difficult to ascertain. This may significantly affect profits and net worth.
(iii) Short term (monthly or quarterly) profit and loss statements cannot be prepared unless an inventory count is taken at the end of each period.
(2) Perpetual Inventory System – Definition and Explanation:
A perpetual inventory method is one whereby records of inventory held are maintained on a continuous basis. This provides a continuous record of the inward and outward movement of goods, so that the quantity and book value of the inventory which ought to be on hand may be seen by inspection of the record; in other words, a perpetual balance of inventories on hand is kept.
The discrepancies between the two balances may be due to clerical errors, theft, wastage or other causes. Irrespective of the reason for the difference, the inventory records must be brought into arrangement with the physical inventory count and any discrepancies written off by charging them in the income statement according to the nature of the difference.
Advantages of Perpetual Inventory System:
(i) There is great control over inventories through periodical comparison of inventory records with physical inventory.
(ii) Short term financial statements can be prepared as the values of cost of sales and inventory balances are readily available.
(iii) The inventory ledger cards help to maintain optimum level of inventories, ensuring that the business is never out of inventory or have too much money tied up in inventories.
Disadvantages of Perpetual Inventory System:
(i) Continuous maintenance of record for inventory movements involves additional cost.
(ii) In case of use of a manual accounting system, maintenance of inventory ledger cards is a very time consuming job. However, this may not be such a disadvantage for firms with a computer.
Due to growth in use of computers in business, the perpetual inventory system is becoming more widely used.
Solved Example – Periodic, Perpetual Inventory Methods and Calculation of Net Profit:
Ranjit Bali commenced business of mobile phones on 1st February 2015. During the first four weeks of trading, his transactions were:
Expenses for the period were $2100. All transactions were on cash basis.
(b) Calculate the closing inventory value on 28 February 2015, using both the FIFO and AVCO methods of inventory valuation by using periodic method.
(c) Calculate the net profit February 2015, using FIFO and AVCO inventory values as calculated in “a” part.
Solution (Part “a”):
Calculation of Closing Inventory FIFO (Perpetual)
Calculation of Closing Inventory AVCO (Perpetual)
Solution (Part “b”):
Solution (Part “c”):
Calculation of Net Profit
For the month ended 28 February 2015