Accounting for Inventory | Periodic, Perpetual inventory

Accounting for Inventory Basic Rule: Inventory must be measured at lower of; Cost; or Net realizable value (NRV). NRV is usually higher than cost.

Accounting for Inventory Overview

Inventory costing methods

There are two methods of recording inventory (Inventory accounting):

Periodic inventory method/period end system
Perpetual inventory system

Each method uses a ledger account for inventory but these have different roles.

Methods for Recording Inventory

Methods for recording Inventory

Periodic inventory method

This system is base on the use of two ledger accounts:

Purchase Account:

It is used to record all purchases during the year. the balance on purchase account is transferred to cost of sales, clearing the purchases account to zero.

Inventory Account:

It is used to record value of inventory at the beginning/end of the year.
Opening inventory is last year’s unused purchases.

Perpetual inventory system

In cost accounting system:

A separate record is kept for each inventory item, in an inventory account. There is no purchase account.
Inventory account is used to record all purchases and other costs associated with inventory and all issue/transfers out of inventory. These transfers might be into work in progress(if inventory account is for raw material) or cost of sales (if inventory account is for finished goods).
Each issue/transfers are given a cost. This is the actual cost or cost obtained from valuation method (i,e FIFO/AVCO method).

With perpetual inventory account any time the balance on inventory account is the value of inventory currently held.

Summary of journal entries under Perpetual accounting and Period end system

Particular	Perpetual Inventory method	Periodic Inventory method
Opening inventory	Closing inventory as brought forward from last period.	Closing balance on the inventory account at the end of previous period.
Purchase of inventory	Purchases Debit Payable/cash Credit	Inventory Debit Payable/cash Credit
Freight paid	Carriage inwards Debit Payable/cash Credit (NO ENTRY IN PURCHASE A/C)	Inventory Debit Payable/cash Credit
Return of inventory to supplier	Payable Debit Purchase returns Credit (NO ENTRY IN PURCHASE A/C)	Payable Debit Inventory Credit
Sale of inventory	Receivables Debit Sales Credit (NO ENTRY IN PURCHASE A/C)	Receivables Debit Sales Credit AND Cost of goods sold Dr. Inventory Cr.
Return of goods by a customer	Sales returns Debit Receivables Credit (NO ENTRY IN PURCHASE A/C)	Sales returns Debit Receivables Credit AND Inventory Dr. Cost of goods sold Cr.
Issue of Inventory	(NO ENTRY IN PURCHASE A/C)	WIP Debit Inventory Credit
Return of unused inventory from production	(NO ENTRY IN PURCHASE A/C)	Inventory Debit WIP Credit
Normal loss	(NO ENTRY IN PURCHASE A/C)	Cost of goods sold Dr. Inventory Cr.
Abnormal loss	Abnormal loss Debit Purchases Credit	Abnormal loss Debit Inventory Credit
Closing Inventory	SOFP Dr. Cost of good sold Cr.	Balance on Inventory account (subject to physical count).

Accounting for Inventory: Inventory Valuation

Valuation of Inventory

Basic Rule:
Inventory must be measured at lower of;

Cost; or
Net realizable value (NRV)

Cost Formulas

It would be impossible to identify the actual cost for all inventory items because of the large numbers of such items.

Therefore, cost formulas are used for determining cost of group of similar items.

The following cost formulas are used:

First in, first out (FIFO)

Large and expensive items are readily recognizable but cost of similar items are impossible to identify.
To establish the cost of inventory using first in first out inventory method (FIFO) it is necessary to record:

Received			Issued
Date	Units	Price	Date	Units	Price

This approach assumes that the first inventory sold is always the inventory bought earliest date.

This means closing inventory is always assumed to be the most recent purchase.

Weighted Average cost (AVCO)

Weighted Average cost (AVCO)

This approach assumes that all units are issued at the current weighted average cost per unit.
A new average cost is calculated whenever more items are purchased and received in stores as:

Cost in store + New items cost
No. of units in stores + New units

Costing of Issues from inventory and Inflation

Inflation

As a general rule, during a period of high inflation the different methods of inventory valuation will give significantly different values for cost of sales and closing inventory.

First in, first out (FIFO)

With FIFO during a period of high inflation cost of sales will be lower than current replacement cost of materials used and the closing inventory should be close to current value, since they are the units bought most recently.
The inverse is also correct when prices are falling.

Weighted Average cost (AVCO)

With AVCO during a period of high inflation, the cost of sales will be higher and value of closing inventory lower than FIFO valuation.