Inventory systems and valuation - Periodic vs perpetual inve...

Learning Outcomes

After completing this article, you will be able to compare and explain periodic and perpetual inventory systems, describe how each method records and tracks inventory movements, and analyse how these approaches impact calculation of inventory balances, cost of sales, and the preparation of financial statements. You will also recognize the key strengths and limitations for ACCA exam requirements.

ACCA Maintaining Financial Records (FA2) Syllabus

For ACCA Maintaining Financial Records (FA2), you are required to understand how different inventory systems work, how transactions are recorded under each approach, and how these influence inventory valuation and reporting. In particular, revision should focus on:

• Explaining and distinguishing between periodic and perpetual inventory systems
• Recording inventory purchases and sales under each method
• Identifying how each system affects the calculation of cost of sales, closing inventory, and gross profit
• Understanding the adjustments and controls relevant to each system
• Evaluating the impact on accuracy, information timeliness, and error detection in the accounting system

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which inventory system updates inventory and cost of sales after every purchase or issue of goods?
   1. Periodic system
   2. Perpetual system
   3. Manual system
   4. Year-end system
2. Under the periodic inventory system, how is cost of sales determined at year-end?
   1. By running total updates after every sale
   2. By deducting closing inventory from the sum of opening inventory and purchases
   3. By counting only inventory returns
   4. By immediate calculation at the time of sale

3. True or false? The perpetual system always provides up-to-date inventory balances in the general ledger.

4. State one practical limitation of the periodic system in identifying inventory losses due to theft or error during the year.

Introduction

Inventory systems determine how businesses record, track, and value their stock throughout the accounting period. The choice between periodic and perpetual systems affects when and how transactions are entered, how readily managers can access inventory information, and the reliability of figures reported in financial statements. For FA2, you are expected to distinguish clearly between these two approaches and explain their impact on inventory valuation and financial record-keeping.

Key Term: inventory system
A set of procedures for recording and monitoring the purchase, sale, and physical movement of inventory within an entity.

The Periodic Inventory System

The periodic inventory system does not continually update inventory records after each movement. Instead, purchases are recorded in a purchases account throughout the period. The system relies on a physical inventory count at period end to determine the closing balance.

• Purchases and returns are recorded in separate accounts (e.g., Purchases, Returns Outwards).
• The total available inventory is calculated at period-end: opening inventory + purchases – returns.
• Cost of sales is determined only after adjusting for the closing inventory from the physical count.

Key Term: periodic inventory system
An inventory recording approach where stock balances and cost of sales are updated only at the period end, based on a physical count.

Example Transaction Flow

During the accounting year:

• All inventory purchases are debited to the Purchases account.
• Each sale is recognized in revenue; no direct reduction is made to the inventory account.

At year-end:

• The business counts its inventory physically.
• Cost of sales is calculated as:

  Opening inventory + Purchases – Returns – Closing inventory = Cost of Sales

Key Term: cost of sales
The expense representing the cost of goods sold during the period, calculated as opening inventory plus net purchases minus closing inventory.

Benefits and Limitations

Advantages:

• Simpler for very small businesses with infrequent transactions.
• Less administrative work during the period.

Disadvantages:

• No up-to-date inventory balance available during the year.
• Shrinkage, losses, or errors are only identified at period end.
• Delays in recognizing errors or losses.

Worked Example 1.1

A retailer starts the year with $5,000 inventory. It purchases $12,000 of goods during the year. At year-end, a physical count shows $3,500 of inventory remains. What is the cost of sales for the year?

Answer:
Cost of sales = $5,000 (opening) + $12,000 (purchases) – $3,500 (closing) = $13,500

The Perpetual Inventory System

The perpetual inventory system updates records immediately for each inventory transaction. Both the quantity and value of stock on hand are tracked continuously.

• Inventory purchases are debited directly to the Inventory (stock) account.
• Each sale records two entries: one for sales revenue, and one to reduce inventory and recognize cost of sales.

Key Term: perpetual inventory system
An inventory recording approach where inventory and cost of sales are updated in real time after every purchase or sale.

Example Transaction Flow (Perpetual)

• On purchase: Debit Inventory, Credit Payables/Cash
• On sale: Debit Cost of Sales, Credit Inventory (for the cost of the goods sold); Debit Receivables/Cash, Credit Sales (for the sale price)

Physical counts are still performed but serve mainly as a check for reconciliation, not as the main source for valuing inventory.

Advantages:

• Inventory figures in the accounts are always current.
• Errors, shortages, or theft can be detected more quickly.
• Better suited for computerized accounting and inventory management.

Disadvantages:

• Can be more complex and require computerized systems.
• More suitable for larger businesses or those with high volume transactions.

Worked Example 1.2

A company operates a perpetual system. It holds 400 units at $5 each. Purchases 200 more at $5.20 each. Sells 300 units during the month. What is the closing inventory at the end using FIFO?

Answer:
FIFO assumes oldest units sold first.

• 400 units @$5 = $2,000 (beginning)
• Add 200 units @$5.20 = $1,040
• Total available: 600 units, $3,040
• Units sold: 300 (from beginning stock at $5)
• Cost of sales: 300 x $5 = $1,500
• Remaining: 100 units @$5, 200 units @$5.20 = (100 x $5 = $500; 200 x $5.20 = $1,040), closing inventory = $1,540

Comparing Periodic and Perpetual Systems

Worked Example 1.3

A business wants to know inventory on hand at the end of April. Under the periodic system, when can it obtain an accurate figure? Under the perpetual system?

Answer:

• Periodic: Only after an end-of-period physical stock count is performed.
• Perpetual: At any time, as the system updates balances automatically after each transaction.

Exam Warning

In exam scenarios, ensure you can both distinguish between the features of each system and also recognize how entries flow through the general ledger (e.g., whether purchases are debited to Inventory or Purchases account).

Revision Tip

For multiple-choice questions, look for clues: The use of a 'Purchases' account for inventory usually signals a periodic system; regular Inventory account updates indicate a perpetual system.

Summary

The periodic and perpetual inventory systems differ in timing and method of recording stock movements and determining the cost of sales. The periodic system focuses on adjusting inventory and calculating cost of sales only at the end of the period, based on a physical count. The perpetual system continually updates the Inventory and Cost of Sales accounts, providing more timely and accurate inventory balances. For ACCA FA2, you must be able to identify, record, and contrast these systems as they affect inventory valuation and the financial statements.

Key Point Checklist

This article has covered the following key knowledge points:

• Explain the difference between periodic and perpetual inventory systems
• Identify how purchases, sales, and closing inventory are recorded under each system
• Describe impacts on cost of sales calculation and inventory reporting
• Recognize practical advantages and limitations of each system
• Apply inventory system knowledge to ACCA FA2 exam questions

Key Terms and Concepts

• inventory system
• periodic inventory system
• cost of sales
• perpetual inventory system