Any business that sells a product has inventory. The products must be accurately priced to maximize profits and to be competitive against market rivals. To do this, the value of the products and the cost to produce them must be known. Here's a look at two methods for recording and tracking this vital information--the perpetual and periodic inventory systems.
Most think of inventory as the supply of items on hand that are offered for sale. While this is true, inventory is also the name for the various accounts in which the accountant or bookkeeper records this information. A retailer that buys finished products and resells them may have a relatively simple inventory system; manufacturers will have many more accounts to track value of work in progress and the value of raw materials used in the production process.
Perpetual Inventory System
With a perpetual inventory system, all transactions are recorded to the inventory account as they happen. The account balance reflects the inventory on hand at any moment. The physical delay in recording the transactions is all that separates the balance in the account from being real time. With technological solutions such as point-of-sale scanners, this delay can be very small. Because inventory counts and values are maintained constantly, no physical count of inventory is required with the perpetual system.
Periodic Inventory System
The periodic system uses multiple accounts to record sales, purchases of new product and customer returns, among others. These accounts are maintained until the end of the inventory period--which could be monthly, quarterly or any other time frame determined by the company--then reconciled to the inventory account. At that time, the transaction accounts are zeroed out in preparation for the next inventory period. A periodic inventory system also requires a physical count of inventory at the end of the period. Any necessary adjustments to the inventory account are made, and the period is complete.
Inventory is an asset, just like cash and real estate. Like other assets, inventory can be manipulated by unscrupulous managers. The Sarbanes-Oxley Act of 2002, enacted in response to the public accounting scandals of the time, codified the requirement that the information released by a company be accurate in all material respects. Firms must verify that the internal controls in place are adequate and working, and that all financial statements are accurate. Penalties are provided for failure to comply. The act has largely restored confidence in the accuracy of information available to potential investors.
How to Choose
The major factor in deciding whether to use the periodic or perpetual system is the ability of the company to record sales data as it happens. Technology makes this more likely than ever before, so many companies will opt for the perpetual system. A company that, for whatever reason, is not equipped to do this may opt for the periodic system. In either case, the rules governing inventory accounting are subject to prevailing laws and accounting industry standards, known in the United States as Generally Accepted Accounting Principles (GAAP).