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Accounting for Merchandising Businesses

Business Inventory Systems

It is important for businesses to maintain an accurate reflection of both the inventory on hand and the cost associated with goods sold to consumers. The goods on hand are identified as merchandise inventory, and the cost associated with goods sold to consumers is known as cost of merchandise sold, or cost of goods sold. To ensure the accuracy of their inventory on hand and the cost associated with the goods sold, businesses use one of two inventory systems: a periodic inventory system or a perpetual inventory system.

Periodic Inventory System

Periodic inventory systems require a physical inventory count in order to update inventory records and to calculate the cost of merchandise sold.
The periodic inventory system is an inventory system that involves a periodic physical inventory count to determine the quantity of goods on hand. Ideal for small businesses with a limited amount of inventory, the periodic inventory system is a more traditional approach to managing inventory. Businesses using periodic inventory systems do not have an accurate record of the goods on hand in real time because quantities are not updated with every transaction. Rather, they are updated periodically using a physical count— thus the system's name, the periodic system.
Regardless of the system used for maintaining inventory of a merchandising business's stock, a physical inventory is required at least once per year to verify accounting records.
Credit: Photo by Clark Street Mercantile on UnsplashLicense: CC0 Creative Commons
Conducting a physical inventory count can be costly, so most businesses using a periodic inventory system conduct a physical inventory count only quarterly or annually. A number of challenges are associated with the use of a periodic inventory system, including estimation errors, limited information between inventory counts, and increased adjustments for inventory shrinkage.

Perpetual Inventory System

Perpetual inventory systems are updated each time a transaction occurs, providing real-time information on inventory levels and cost of merchandise sold.

The perpetual inventory system is a system in which each sale and purchase transaction related to merchandise is recorded directly to the inventory account and corresponding subsidiary ledger. As one of the most widely used inventory systems, the perpetual inventory system mandates a continuous updating of inventory records with each sale and purchase. As a result, the perpetual inventory system provides the most accurate real-time reflection of inventory in that both the quantity and value of the inventory are perpetually updated.

The perpetual inventory system requires more effort on a day-to-day basis than the periodic inventory system, as each time inventory moves it must be recorded. However, advances in technology have made this process much easier. Merchandising businesses are able to track inventory items in a cost-effective manner using a computerized system that utilizes bar codes. For example, Walmart uses bar codes to account for its inventory items. Car dealerships utilize a unique vehicle identification number (VIN) to keep up with their inventory. As items' bar codes are scanned, inventory records are reduced for sold items, providing better inventory controls.

Periodic versus Perpetual Inventory System

There are a number of differences between periodic inventory systems and perpetual inventory systems, including the accuracy of real-time inventory data, the entries used to record transactions, and the required physical counts of merchandise.

The periodic and perpetual inventory systems differ in several key ways. One example is a timing difference. The perpetual inventory system records transactions as they occur. Under this system, inventory balances can be seen in real time. For example, if you were to ask a sales associate at Happy T's if they had a particular T-shirt in stock, they would be able to tell you exactly how many they have. However, if the business uses the periodic inventory system, they would not have the ability to pull up the inventory records of a particular T-shirt and know for sure what the current inventory level is because it is possible the inventory level of that T-shirt has changed since the last physical count.

The journal entries used to record transactions under each system are also different. When a sale occurs, the inventory and relevant costs are recorded under the perpetual inventory method. However, no entry is made under the periodic inventory method. Under the periodic inventory method, a physical count must be done in order to determine how much inventory is left. The beginning and ending inventory balances and purchases can then be used to determine cost of merchandise sold. The physical count and cost of merchandise sold calculations are not necessary under the perpetual inventory system because this data is recorded throughout the period each time a transaction takes place. Perpetually recording each transaction means that the ending inventory balance should be correct at the end of the period and all cost of merchandise sold should already be recorded. It is worth noting that even businesses using the perpetual inventory method must still do a physical count of their inventory from time to time, generally once a year at a minimum. The physical count is done to ensure the accounting records are accurate.