There are two systems of inventory record keeping:
- Periodic inventory system
- Perpetual inventory system
Inventory valuation methods can be used in either of the above-mentioned inventory record keeping systems. Application of FIFO valuation method in both periodic and perpetual systems is explained with examples in our chapter “First in, First out method (FIFO)”. Similarly, application of LIFO and weighted average valuation methods in both periodic and perpetual systems is explained in our chapters “Last in, First out method (LIFO)” and “Weighted average valuation method”.
Let’s briefly discuss the periodic system and perpetual system of inventory record keeping.
Periodic inventory system
In periodic inventory system, inventory account is not updated continuously. No entry is made in the inventory account when materials are purchased. A separate purchases ledger is created and all purchases and purchase returns, if any, are recorded in the purchases ledger. At the end of the period (e.g. month, quarter, year etc.), two steps are done to work out the cost of goods sold:
- total of purchases account is transferred to the inventory account and from there to cost of goods sold account; and
- closing inventory determined by physical stock count and application of relevant cost flow assumptions (FIFO, LIFO or weighted average) is subtracted from the cost of goods sold account.
As the name suggests, in periodic system of inventory, cost of goods sold is calculated at the end of the period using the following formula:
Cost of goods sold (bal.) = Opening inventory + Purchases – Closing inventory
|Opening inventory balance||xxx|
|Total inventory balance available||xxx|
|Less: Closing inventory balance||(xxx)|
|Cost of goods sold||xxx|
Perpetual inventory system
In perpetual inventory system, inventory account is updated continuously, and all receipts and issuance of inventory are recorded in the inventory account as and when they occur. Purchases are debited and purchase returns are credited in the inventory account. There is no need for a separate purchases ledger as all purchases and purchase returns are recorded directly in the inventory account.
For sales, cost of goods sold is credited in the inventory account. Each issue of inventory is given a cost, either the actual cost if it is possible or using any valuation method (FIFO, LIFO, weighted average etc.).
Hence at any time, inventory account can give the information about the inventory available and cost of goods sold. Unlike periodic inventory system, physical stock count is not required in perpetual inventory system to calculate cost of goods sold. However, an entity using perpetual inventory system should conduct stock counts periodically to ensure the accuracy of the inventory records.