There are two different bookkeeping methods for inventories: the perpetual and periodic methods. Both methods lead to the same results, so the choice mainly depends on the sophistication of the firm’s accounting system.
the perpetual method, all inventory acquisitions are recorded as asset
purchases. The cost of goods sold is not recorded until the inventory is
actually sold.This method requires the business to track the specific physical inventory flow from acquisition to sale. This is easy if the business has a relatively modest amount of discrete inventory. It is more difficult if there are large amounts of inventory or if the inventory is fungible. Fungible inventory consists of physically indistinguishable products like chemicals and commodities.
Example. Janis operates a firm that sells silicon gel used in cosmetic implants called Bust Buy. Janis’ gel is fungible. Assume that Janis purchases for cash 70 ounces of compound at $250 per ounce on February 15 and sells 30 ounces for $500 per ounce on February 28. This is the entry for the acquisition under the perpetual method:
An asset account, Inventory, is increased, while another asset, Cash, is decreased. Under the perpetual method of accounting, two entries need to be made when Janis sells 30 ounces of product. The recording of the sale is straightforward:
Next the cost of the product sold needs to be recorded.
An expense (a reduction in equity) is increased, while an asset is decreased.
The alternative to the perpetual recording system is the periodic method. Using this approach inventory purchases are first recorded as an expense. At the end of the accounting period, inventory on hand is counted and an adjustment is made to reflect this ending inventory as an asset.
When Janis purchased her initial product the entry using the periodic method would be:
When Janis sells her product in February no adjustment to Inventory or Cost of Goods Sold is made. So the sale entry is simply the same as the entry used in the perpetual method:
In order to properly reflect the correct ending inventory at the end of February and reflect the correct cost of goods sold for the period, the following entry is made:
The correct inventory figure is the amount on hand times the purchase price. Assuming that no one dipped into the inventory Janis should have 40 ounces of compound on hand at the end of the month, since she purchased 70 ounces and sold 30 ounces. This last entry insures that the amount of inventory and cost of sales is properly reflected.
Notice that under both methods the cost of goods sold and ending inventory amount are the same. Ending inventory is $10,000 and cost of goods sold is $7,500.
Businesses that use the periodic method of recording inventory do not generally have an accounting system in place that can accurately track the flow of inventory. To accurately reflect the cost of goods sold and ending inventory at the end of the accounting period, such firms need to perform an accurate count of inventory on hand. Performing such a count can be expensive and time consuming, but is indispensable in arriving at an accurate accounting of cost of goods sold.
You might think that businesses with the ability to maintain a perpetual record of inventory would be able to dispense with the time consuming and expensive end of period physical counts of ending inventory. Think again. Tracking inventory on a perpetual and continuing basis entails faithfully increasing the inventory account when purchases are made, and decreasing the account when inventory is sold. In the real world stuff happens. Customers shoplift goods off the shelf. Employees help themselves to product. Or products become spoiled or damaged.