Companies maintain inventory systems using either periodic or perpetual inventory systems. The perpetual inventory system maintains a real-time inventory balance. The periodic inventory system only updates the inventory balance when a physical count is taken. Perpetual inventory systems require a physical inventory count to be done annually, while a periodic inventory system performs physical inventory counts more often. For both systems, the difference between the physical inventory count and the quantity reported in the inventory system is adjusted through an inventory adjustment.
Inventory adjustments require a physical inventory count to take place so that the accountant can compare it to the inventory balance recorded in the system. All activity must cease during the physical inventory count to maintain the integrity of the count. Company employees manually count and record every unit contained in the warehouse during the physical inventory.
Under the periodic inventory system, the business owner records an inventory change when he physically counts the inventory. He compares the current recorded inventory balance to the inventory count he just made. The difference is recorded as an inventory adjustment. The inventory adjustment journal entry includes a debit to Cost of Goods Sold, a credit to Purchases and either a debit or credit to Inventory. The owner determines the purchases amount based on the accumulation of purchases made throughout the month. The inventory amount is calculated based on the difference between the physical inventory count and the inventory balance in the system. If the inventory amount represents an increase in the inventory balance, the account is debited. If the inventory amount represents a decrease, the account is credited. The Cost of Goods Sold amount is determined by calculating the number required to balance the entry.
In a perpetual inventory system, purchases and sales transactions impact the inventory balance at the time of transaction. The ending inventory recorded in a perpetual inventory system theoretically should match the physical inventory count. The accountant compares the physical inventory to the inventory system balance. The accountant records the discrepancy as an inventory adjustment. The amount of discrepancy is charged to Cost of Merchandise Sold with the other portion of the entry charging Inventory. If the physical inventory count shows a higher balance than the inventory system, the accountant debits Inventory and credits Cost of Merchandise Sold. If the physical inventory count shows a lower balance than the inventory system, the accountant debits Cost of Merchandise Sold and credits Inventory.
Some inventory adjustments occur as a result of normal business activity, such as inventory spoiling or data entry errors. The accountant needs to analyze large inventory adjustments to determine why the large adjustments are occurring. Frequent errors in data entry require retraining or restructuring responsibilities. Large unexplained inventory adjustments may be a result of theft, indicating that security needs to increase.