Physical vs Perpetual Inventory

by Brian Stupp December 17, 2015
December 17, 2015

Companies, especially merchandisers and manufacturers, use much of their working capital to obtain or produce merchandise. The decision of how to manage and account for inventoried goods can have profound effects on your cost of operations, the accuracy of your accounting data and your tax bill. You must provide the IRS with accurate valuations for the goods you have on hand and the cost of goods sold (COGS) so that it knows how to tax you properly. The method you use to count your inventory items is one of the most basic decisions you can make relative to inventory management.

IRS Requirements

What exactly does the IRS want?

  1. You must track the costs of goods on hand by practicing sound accounting methods.
  2. You must assign to your inventory account the costs of your acquired goods
  3. You must record the value of inventory items you transfer, use, or sell
  4. Calculate ending inventory’s value using the value of beginning inventory, the cost of goods acquired or manufactured during the period and the COGS.
  5. You should, at reasonable intervals, take physical counts of your inventory and use the information to update your inventory value so that it reflects reality.

Periodic Inventory

The essence of the periodic inventory system is to perform physical counts to determine your stock levels. One feature of this system is that you use a purchases account and debit it with all your inventory purchases. Once the period ends, you clear out the purchases account by adding its balance to the inventory account and resetting the purchases account to zero.

You make a physical count at the close of the period to determine the inventory on hand. This is the point where you adjust your book inventory balance to match the physical count. All sorts of discrepancies can appear, including ones arising from theft, damage, spoilage, obsolescence and sloppy record keeping.

Perpetual Inventory

Perpetual inventory systems attempt to keep track of each item from acquisition to disposition. If you have a tiny business, you can perform this task daily by hand. Larger businesses use fancy automated equipment such as point-of-sale cash registers and electronic inventory readers. The inventory receives electronic tags, either bar codes or radio frequency ID tags, which allow readers to track inventory movements.

You don’t keep an inventory purchases account under the perpetual system. Instead, you immediately update the inventory account when purchases or sales occur. This system gives you immediate information about stock levels, discounts, returns and allowances.

Comparison of Methods

If your business requires timely information about COGS and inventory on hand, you’ll find the perpetual inventory system better suited to your needs. As an added bonus, many of these systems place restocking orders automatically when counts run low. Because you track sales in real time, you always know your COGS. The better you keep detailed and accurate records, the longer you can wait to take a physical inventory, a costly and disruptive procedure. If you run a small business without the need for real-time information, you can save the cost of fancy gadgets by adopting the periodic method. And a teeny tiny business can always use the time-honored method of recording stock with pencil and paper to implement the periodic method.

Financing Your Inventory

However you account for it, you have to pay for your inventory or else you’ll have nothing to sell. When working capital is tight, turn to a convenient commercial loan to get your inventory back up to size quickly and conveniently.

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