Inventory Systems: Perpetual Inventory and the General Ledger and Documentation

Overview of Inventory Systems

• Definition and Types: Inventory systems define the accounting framework for recording the movement of goods. There are two primary systems:

  • Perpetual Inventory System: Also known as the continuous inventory system.

  • Periodic Inventory System.

• Function of the System: It is important to distinguish that these systems do not determine the calculation of amounts (valuation methods), but rather prescribe the accounting procedure—specifically, which accounts to debit and which to credit.

• Financial Statement Outcomes: Regardless of whether a perpetual or periodic system is selected, the final figures for Inventory (on the Balance Sheet) and Cost of Sales (on the Income Statement) will be identical, provided the information used is the same.

Characteristics of the Perpetual Inventory System

• Cost and Resource Intensity: This is considered an expensive system because it requires the entity to keep track of every single movement of inventory from the moment it is received until it is sold.

• Real-time Updates: Financial records are updated with every transaction. The Cost of Sales account is built incrementally with each individual sale made during the period.

• Criteria for Selection: The decision to use this system depends on the nature, value, and quantity of the product:

  • High Value/Low Quantity: Ideal for items like motor vehicles. A dealer does not sell hundreds of cars daily, and each unit is easily distinguishable (e.g., via a unique engine number).

  • Low Value/High Quantity: Generally not worth it for items like loaves of bread in a retail environment, where tracking individual units is impractical.

• Internal Control Benefits: At any given time, the Trade Inventory account balance reflects exactly how much stock should be on the premises. This allows for a verification process where physical counts are compared against accounting records to identify mistakes or theft.

Practical Application: Example 3a (Jungle Gyms)

• Company Profile: The company, named Jungle, sells jungle gyms as its core inventory. If the company were to sell computers instead, those would be classified as inventory rather than Property, Plant, and Equipment (PPE).

• Taxation: The company is registered for VAT at a rate of $15\%$.

• Period Information: The transactions occur for the month of June $2021$ ($06/01/2021$ to $06/30/2021$).

• Balances Provided:

  • Opening Inventory ($06/01$): $R9,600$

  • Closing Inventory ($06/30$): $R26,580$

• Accounting Note on Balances: In a perpetual system, no journal entry is necessary to record opening or closing balances. Because transactions (purchases, sales, returns) are recorded directly into the inventory account as they happen, the balance is a continuous balancing figure already present in the records.

• Transaction Assumptions: All transactions in this specific exercise were in cash, meaning the contra account for purchases and sales is Bank rather than Debtors or Creditors.

Recording Purchases and Inventory Costs

• Invoice Price vs. Cost Price: Inventory is recorded at cost price, which excludes VAT and is net of trade discounts.

  • Example: An invoice price of $R57,000$ including VAT with a $10\%$ trade discount.

  • The amount paid to the supplier (Credit Bank) is the discounted amount including VAT: $R57,000 - 10\% = R51,300$.

  • The VAT portion is debited to the VAT account ($R6,750$ in this example).

  • The portion allocated to Inventory (Debit Inventory) is the cost excluding VAT ($R45,000$).

• Capitalized Costs: All costs necessary to bring the inventory to its current location and condition for sale are added to the cost price of the inventory.

  • In a perpetual system, costs like Transport ($R5,750$) and Transport Insurance ($R2,300$) are debited directly to the Inventory account.

  • The total increase to inventory in this example was $R45,000 + R7,000 = R52,000$.

• Returns to Suppliers: If inventory is of low quality and returned, the initial entry is reversed.

  • Example: Return of goods with a cost price of $R1,900$ (excluding VAT).

  • Credit Inventory: $R1,900$ (to remove the asset).

  • Debit VAT: To reverse the portion previously claimed.

  • Debit Bank: To record the cash refund from the supplier.

Donations and Sales Transactions

• Donations of Inventory:

  • Inventory is removed from the records at cost price, never at selling price.

  • Journal Entry: Debit Donations (Expense); Credit Inventory.

  • VAT Rule (FINAG 178): In this specific course context, VAT on donations is ignored, although in practice, exceptions may apply.

• Sales of Inventory: A sale requires two separate journal entries in a perpetual system to track both the revenue and the movement of stock:

  1. Entry for Selling Price:

     • Debit Bank: Total amount received from the customer.

     • Credit Sales: Revenue excluding VAT (e.g., $R39,900$).

     • Credit VAT: Tax to be paid to the receiver.

  2. Entry for Cost Price:

     • Debit Cost of Sales (COS): To build the expense account for the period.

     • Credit Inventory: To remove the sold items from the asset account (at cost).

• Sales Returns (by Customers):

  • The sale must be reversed across both dimensions (selling price and cost price).

  • Selling Price Reversal: Debit Sales; Debit VAT; Credit Bank (refund to customer).

  • Cost Price Reversal: Debit Inventory (putting it back in stock); Credit Cost of Sales.

Closing Entries and the Trade Account

• Inventory Account Reconciliation: If all transactions are recorded correctly, the final balance of the inventory T-account should match the physical count performed at the end of the month (e.g., $R26,580$).

• Closing the Cost of Sales: The Cost of Sales account is a Profit and Loss (P&L) account and must be closed off to the Trade Account at the end of the period.

  • Important: Even if a question states that "closing entries are not required," students must still close Cost of Sales to the Trade Account to demonstrate full understanding of the inventory process.

• The Trade Account Hierarchy:

  1. Sales and Cost of Sales are closed to the Trade Account.

  2. The balancing figure in the Trade Account represents the Gross Profit (calculated as $\text{Sales} - \text{Cost of Sales} = \text{Gross Profit}$, e.g., $R36,400 - R30,600 = R5,800$).

  3. The Trade Account and all other income/expenses (e.g., Donations) are closed to the Profit or Loss account.

  4. The Profit or Loss account balance is finally closed to Retained Earnings.

• Statement of Comprehensive Income: The Trade Account reflects the top section of the income statement, showing Revenue, Cost of Sales, and the resulting Gross Profit.