Among various methods of accounting for inventories, there are two main methods which are very popular in accounting world. Both methods are having some advantages and dis advantages which I will focus on later. The two popular methods are as follows:
- Perpetual Method
- Periodic Method
1. Perpetual method:
Under the perpetual method, inventory records are updated each time a transaction involving inventory takes place. Thus, up-to-date information about the quantity and cost of inventory on hand will always be available, enabling the entity to provide better customer service and maintain better control over this essential asset. This system is more complicated and expensive than the periodic method but, with the advent of user-friendly computerized accounting packages and point-of-sale (POS) machines linked directly to accounting records, most businesses today can afford to and do use the perpetual method.
The perpetual method requires a subsidiary ledger to be maintained, either manually or on computer, with a separate record for each inventory item detailing all movements in both quantity and cost. This subsidiary record is linked to the general ledger account for inventory, and regular reconciliations are carried out to ensure the accuracy and completeness of the accounting records.
2. Periodic method
Under the periodic method, the amount of inventory is determined periodically (normally annually) by conducting a physical count and multiplying the number of units by a cost per unit to value the inventory on hand. This amount is then recognized as a current asset. This balance remains unchanged until the next count is taken. Purchases and returns of inventory during the reporting period are posted directly to expense accounts. Cost of sales during the year is determined as follows:
Cost of sales = Opening inventory + Purchases + Freight inwards – Purchase returns – Cash discounts received – Closing inventory
Accounting for inventory using the periodic method is cost effective and easy to apply, but its major disadvantage is that the exact quantity and cost of inventory cannot be determined on a day-to-day basis, and this might result in lost sales or unhappy customers. Additionally, it is not possible to identify stock losses or posting errors, resulting in accounting figures that might be inaccurate or misleading.