Periodic inventory system VS. Perpetual inventory system

A perpetual inventory system is theoretically always up-to-date. If you need to know the balance of inventory, you simply look in the inventory ledger account.

A periodic system is updated periodically, hence the name. If you need to know the balance of inventory, you must perform a calculation. 

The purchase of inventory, the sale of inventory, and the payment for inventory are three separate events. A company may purchase and sell inventory before it pays for it, which is great cash flow management! In this case, revenue and cost of goods sold would be reported on the income statement and an outstanding payable would still be on the balance sheet for the inventory that was sold.

The seller always has two entries to record the sales price and record the cost of goods sold. Likewise, if a customer returns inventory, the seller still has two entries to record the return and the resulting increase in inventory. However, the purchaser has one entry to record the inventory and cash payment or payable. It may be helpful to provide seller and purchaser journal entries side-by-side for a series of transactions.

Students can see how the transactions affect both companies and identify related accounts for both companies. For example, a receivable for one is a payable for the other; a sales return for one is a purchase return for the other. When computing cash discounts, don’t forget to record any returns before calculating the required payment. A discount can’t be taken on inventory already returned! The only way to ensure a correct inventory balance is to take a physical count. Every company should take a physical count at least once a year, even those using the perpetual inventory method. Transactions can take place that are not recorded, such as theft, damage, and errors.   

Students may be surprised to see the dollar amount differences between gross profit and net income. Just because a company has gross profit doesn’t mean it will have net income. It must price its products to have enough revenue to cover the cost of the product and any other expenses incurred. In addition, operating income is a better indicator of day-to-day operations than net income. Net income and cash flow are different concepts when using the accrual method. Just because a company has net income doesn’t mean it has positive cash flow.