Question

1:Jim’s accountant insisted that he should use a perpetual inventory system instead of a periodic inventory system and the average cost method for valuating the inventory. Do you agree with this advice (justify your answer)? Would the balance of the inventory at the end of the month be the same? And the net income?

Answer 1

The periodic system relies upon an occasional physical count of the inventory to determine the ending inventory balance and the cost of goods sold, while the perpetual system keeps continual track of inventory balances. There are a number of other differences between the two systems, which are as follows:

• Accounts. Under the perpetual system, there are continual updates to either the general ledger or inventory ledger as inventory-related transactions occur. Conversely, under a periodic inventory system, there is no cost of goods sold account entry at all in an accounting period until such time as there is a physical count, which is then used to derive the cost of goods sold.

• Computer systems. It is impossible to manually maintain the records for a perpetual inventory system, since there may be thousands of transactions at the unit level in every accounting period. Conversely, the simplicity of a periodic inventory system allows for the use of manual record keeping for very small inventories.

• Cost of goods sold. Under the perpetual system, there are continual updates to the cost of goods sold account as each sale is made. Conversely, under the periodic inventory system, the cost of goods sold is calculated in a lump sum at the end of the accounting period, by adding total purchases to the beginning inventory and subtracting ending inventory. In the latter case, this means it can be difficult to obtain a precise cost of goods sold figure prior to the end of the accounting period.

• Cycle counting. It is impossible to use cycle counting under a periodic inventory system, since there is no way to obtain accurate inventory counts in real time (which are used as a baseline for cycle counts).

• Purchases. Under the perpetual system, inventory purchases are recorded in either the raw materials inventory account or merchandise account (depending on the nature of the purchase), while there is also a unit-count entry into the individual record that is kept for each inventory item. Conversely, under a periodic inventory system, all purchases are recorded into a purchases asset account, and there are no individual inventory records to which any unit-count information could be added.

• Transaction investigations. It is nearly impossible to track through the accounting records under a periodic inventory system to determine why an inventory-related error of any kind occurred, since the information is aggregated at a very high level. Conversely, such investigations are much easier in a perpetual inventory system, where all transactions are available in detail at the individual unit level.

This list makes it clear that the perpetual inventory system is vastly superior to the periodic inventory system.

The Accountant's advice of use of Perpetual system instead of periodic sysytem is appropriate but use of Average cost method for valuaing the inventory is not appropriate. Under perpetual system the details of every incoming and outgoing of inventory is recorded. Hence instead of using average cost method the company should use FIFO method as under FIFO method the closing stock will include the recent purchase stock which are inline with the current market cost.

Hence using of FIFO method under Perpetual system is appropriate.

-Balance of inventory and net income will not be same under perpetual system and under periodic system, because COGS will be different under both the method.Under the perpetual system, there are continual updates to the cost of goods sold account as each sale is made. Conversely, under the periodic inventory system, the cost of goods sold is calculated in a lump sum at the end of the accounting period, by adding total purchases to the beginning inventory and subtracting ending inventory.

-If the prices of inventory are increasing then value of inventory under periodic system will be more as compared to perpetual system,because under periodic system the most recent price will be taken to value the inventory dut to which net income will be more. Reverse will happen in case of decreasing price of the inventory.