Inventory is a major investment that businesses make. Controlling inventory costs and valuation is an important function when determining profitability on products sold. The selection of an inventory-valuation system is based on the company's industry and business environment, but it also should take the annual tax burden into account.
Periodic inventory is a method by which any inventory sold is physically counted at the end of an accounting period, deducted from the beginning inventory plus inventory purchases, with the difference moved to the cost-of-goods-sold (COGS) account. A complete physical counting under a periodic inventory system is usually done at specific times of the year, such as quarterly or annually, depending on the business.
Periodic inventory uses simple calculations to maintain the inventory account in the general ledger. Purchased materials are accounted for in a purchases account; no entries are made in this account to keep accurate monthly inventory. At the end of each accounting period, one entry is made to move sold materials to COGS. At the year-end accounting period, an adjustment is made to reflect the actual on-hand inventory balance.
Easy Record Keeping
The only records needed on a monthly basis for periodic inventory are the total materials purchased and total goods sold. No accounting records for inventory counts are needed because the inventory is maintained through journal entries in the general ledger. The only physical records that are kept come from the annual inventory count completed at the year-end accounting period.
Multiple Valuation Methods
Inventory-cost valuation is an important piece of the inventory process. The cost-valuation method chosen can affect COGS, thereby affecting its reported income for the accounting period. Both the Financial Accounting Standards Board (FASB) and the Internal Revenue Service (IRS) allow businesses to select certain valuation methods based on their inventory process. These are:
First-In, First-Out (FIFO): The inventory received first is the first inventory sold. Last-In, First-Out (LIFO): The inventory received last is the first inventory sold. Average: Inventory costs are an average of all purchases.
According to FASB, the inventory-valuation method selected should best match the periodic income earned through business operations.
Small businesses with homogeneous inventory and high inventory turnover can use periodic accounting systems easily. The simple calculations can maintain the inventory with few journal entries to the general ledger. It also allows businesses to focus on selling inventory, rather than using personnel to continually count the inventory for accuracy. Larger businesses can benefit from periodic inventory systems as well, although the amount of inventory will create longer annual physical counts and larger adjustments at year-end.