Comprehensive Guide to Periodic and Perpetual Inventory Systems

Selection Criteria for Inventory Systems

• The Choice of System: The primary reason for choosing a periodic inventory system is when it is not possible or practical to use a perpetual inventory system.

• Characteristics for Perpetual Inventory: A company should ideally use a perpetual system if:

  • Items can be easily identified as they move through the company.

  • The value of the items is high enough to justify the tracking effort.

  • The volume of sales is relatively low.

• Characteristics for Periodic Inventory: A periodic system is chosen under the following conditions:

  • The business sells thousands of identical items that cannot be individually identified.

  • The individual value of the inventory items is low.

  • The time and cost required to follow each item throughout the process do not justify the benefit (low value/high volume).

Characteristics of the Periodic Inventory System

• Limited Use of Inventory Account: Under the periodic system, the inventory account is barely used during the financial period.

• Lack of Continuous Tracking: The system does not track the cost price of every individual sale as it happens.

• Requirement for Physical Counts: Since the inventory account is not updated with every sale, the only way to determine the value of inventory on hand is to perform a physical inventory count.

• Formula-Based Cost of Sales: Because cost price isn't tracked per sale, the cost of sales must be determined at the end of a period using a specific formula.

The Cost of Sales Formula and Logic

• Conceptual Metaphor (The Storeroom Example):

  • Imagine a store room that started the year with inventory valued at $100\,R$.

  • During the year, the business purchased an additional $200\,R$ worth of inventory and placed it in the warehouse.

  • Trading occurred throughout the period, but the business did not keep track of what left the warehouse.

  • At the end of the period, a physical count was performed, revealing $50\,R$ of inventory remaining.

  • Determination by Elimination: If the business started with $300\,R$ ($100\,R + 200\,R$) and ended with $50\,R$, then $250\,R$ must have been sold (or otherwise removed). Thus, the cost of sales is determined to be $250\,R$.

• Mathematical Formula:

  • $\text{Cost of Sales} = \text{Opening Balance} + \text{Purchases} - \text{Closing Balance}$

• Broadening the Components of the Formula:

  • Additions (Cost of Purchases): This includes the invoice price of the goods plus all costs incurred to get the inventory to its current location and condition ready for sale (e.g., transport/freight costs and insurance).

  • Reductions (Items Not Sold): Anything that was not sold to a customer must be deducted from the total inventory available to find the true cost of sales. This includes:

    • Donations (inventory given away).

    • Withdrawals/Drawings (inventory taken by the owner for personal use).

    • Returns (inventory sent back to suppliers).

    • Closing Balance (inventory still physically present in the warehouse).

Comparison of Accounting Procedures

• Initial Inventory Recognition:

  • Perpetual: No specific journal entry is needed for opening or closing balances because the inventory account is updated continuously; the info is already there.

  • Periodic: A journal entry is required to move the opening balance out of the inventory account and into the cost of sales account at the start of the period ($\text{Debit Cost of Sales}$, $\text{Credit Inventory}$).

• Recording Purchases:

  • Perpetual: Purchases are debited directly to the Inventory account.

  • Periodic: Purchases are debited to a separate Purchases account. Transportation and insurance costs are also debited to their own specific expense accounts throughout the month or year. At the end of the period, these accumulated totals are transferred to the cost of sales account.

• Recording Sales:

  • Both Systems: Must record the selling price ($\text{Debit Bank/Debtors}$, $\text{Credit Sales}$, $\text{Credit VAT}$).

  • Perpetual Only: Must simultaneously record the movement of cost price ($\text{Debit Cost of Sales}$, $\text{Credit Inventory}$).

  • Periodic Only: The cost price is ignored at the time of sale. It is only dealt with at the end of the period via the formula.

• Handling Returns and Non-Sale Reductions:

  • Periodic System: When inventory is returned or donated, it is credited directly out of the Cost of Sales account (or the related purchases account) to ensure the final calculation is accurate. These are recorded at cost price.

Case Study: Jungle Gyms June Transactions

• Background Data:

  • The business is registered for VAT at a rate of $15\%$.

  • Opening inventory value (from physical count at end of May): $9,000\,R$.

  • Closing inventory value (from physical count at end of June): $26,580\,R$.

• Purchase Events (Periodic):

  • Invoice price: $57,500\,R$.

  • Trade discount: $10\%$.

  • Calculation of payment: $(57,500 - 10\%) = 51,750\,R$.

  • Additional costs: Transport ($5,000\,R$) and Insurance ($2,300\,R$).

  • Total Credit to Bank: $59,800\,R$ (including VAT).

  • Initial Recognition: Debit Purchases ($45,000\,R$), Debit Transport ($5,000\,R$), Debit Insurance ($2,000\,R$), Debit VAT ($7,800\,R$).

  • Period-End Transfer: The Purchases, Transport, and Insurance accounts are closed by crediting them and debiting Cost of Sales.

• Sales Events:

  • Sale Amount: $48,000\,R$.

  • Journal Entry: $\text{Debit Bank}$ for total, $\text{Credit Sales}$ for the revenue portion, $\text{Credit VAT}$ for the $15\%$ levy.

  • Note: The cost price of this sale is ignored in the journal entries during the month.

• Closing Procedures:

  • The closing inventory value ($26,580\,R$) must be recorded. Since it wasn't sold, it is removed from the cost of sales ($\text{Credit Cost of Sales}$) and recognized as an asset ($\text{Debit Inventory}$).

  • The final balancing figure in the Cost of Sales account ($30,600\,R$ in this example) is transferred to the Trade Account ($\text{Debit Trade Account}$, $\text{Credit Cost of Sales}$).

Key Internal Controls and Differences

• Process Differences: While the debits and credits differ throughout the period, both systems should arrive at the same final figures for the financial statements (Statement of Comprehensive Income).

• Control Advantage of Perpetual: Perpetual is the preferred system because it provides a baseline for comparison. One can compare what the inventory account says should be there versus what was actually counted.

• Periodic Limitation: In a periodic system, the business relies solely on the physical count. There is no independent accounting record to compare against to identify theft, loss, or waste.

• Important Examination Note: Even if a question states that "closing journal entries are not required," students are still expected to provide the entries to finish the Cost of Sales account—specifically transferring the closing inventory to the inventory account and transferring the final cost of sales balance to the trade account.