In this video you'll find out what perpetual and periodic inventory systems are. I'll explain the differences and show you how they both work in a few simple steps. [Music] Hello there welcome back to Accounting Stuff. I'm James and in this week's video we're going to continue our inventory mini-series. Last time I showed you how to account for one unit of inventory in a merchandising business and today I'd like to expand on that idea. I want to show you how to account for many units of inventory at the same time. We do that using the perpetual and periodic inventory systems. But first some definitions… In a merchandising business inventory is the goods held by business that intends to sell to earn revenue. A perpetual system continuously updates a business's inventory account as goods are bought and sold on a unit by unit basis. Whereas a periodic system updates a business's inventory account at regular intervals. This is usually triggered by a physical inventory count that happens at the end of each accounting period it could happen after each month, quarter or at the end of a financial year. So what are the pros and cons of the perpetual and periodic inventory systems? A perpetual inventory system continuously updates your books which means ‘in theory’ that it’s possible to see your results in real-time. This system also makes it easy to track your inventory levels so you can spot stock shortages quickly. Sounds great doesn't it? Yes, but this comes at a price. It can be expensive to set up a perpetual inventory system and it's not always reliable. You can sometimes find differences between inventory levels in the system and what they are in real life. Some of your inventory might have been lost or stolen or there could be some human error involved who knows? Who knows. But this uncertainty pushes some businesses to double-check their numbers using periodic inventory counts. The advantages of the periodic system are that it’s relatively simple and set up costs tend to be lower. However since you're only checking your inventory levels periodically this can lead to delayed results. I'll explain how that works later in this video. Another problem with their system is that you have less control of your inventory. It can be hard to know what happened between each inventory count. Now I'm going to show you how the perpetual and periodic inventory systems work and help me explain we'll use an example. Imagine that you own a book shop it's the end of September and you're holding 300 books that cost you $8 per unit to buy. In October you buy another 500 books at the same price $8 per unit and you sell 450 books for $15 a unit. Notice that we're keeping the cost price exactly the same in this example. In the real world it changes and we need to make assumptions to help us value our inventory. There are three ways to do that FIFO, LIFO and Average Cost. I'm going to cover all of these in future videos in this playlist so remember to hit subscribe if you'd like to see those. But my question here is… How do you account for these transactions using the perpetual and periodic inventory systems? We’re going to do it both ways and what's your cost of goods sold in October. Let's find out. We'll begin with a calculation. At the top you have your opening inventory plus your additions for October. When you add these together you work out your cost of goods available for sale and below that if you subtract your cost of goods sold then you come to your closing inventory. Your inventory on hand at the end of the period. This calculation is going to be our foundation for the rest of the example. We'll use it to work out your closing inventory and your cost of goods sold for October using both the perpetual and periodic methods. Now I want you to pay close attention to timing. When is it that you first find out your cost of goods sold under each method? This is key to understanding the difference between the two systems. Right I put together some steps to help us work this out. We'll run through them now but you can also find them on my inventory systems cheat sheet where I summarize all of the key points I make in this video on one page. You can help support this channel by buying it on my website there should be a link to it up here and I’ll drop one in the description as well. Step one. Last period’s closing inventory becomes this period’s opening inventory. If we refer back to our calculation we're thinking about this top line. Opening inventory. This is your beginning inventory the inventory that you have on hand at the start of October. How do we know that? Well we said you closed out September with 300 books costing $8 per unit. 300 multiplied by $8 gives you $2,400. That's your closing September balance which you need to bring forward into October. Step one is exactly the same whether you’re using the perpetual or periodic system and since inventory is a normal debit account we can show this opening inventory as a debit of $2,400 on the left-hand side of your inventory T-account. Remember debits always go on the left and credits always go on the right. Always always always. Time for Step Two. And here's where we start seeing some differences between the two systems. Under the perpetual system this is where you record additions in your inventory account but under the periodic system this is where you record additions in your purchases account. In October you bought 500 books costing you $8 per unit. 500 multiplied by $8 is $4,000 that's your additions for October. Under the perpetual system you record these additions a debit to inventory of $4,000 and depending on how you settled the transaction a credit to cash or accounts payable of $4,000. But what about the periodic system? Here the journal entry is very similar however there's one subtle difference. You don't debit your inventory account you debit your purchases account instead. You debit purchases by $4,000 and you credit cash or accounts payable by $4,000. The purchases account only exists under the periodic inventory system. It holds all of the inventory that you've purchased during a period. At the end of the period this will get cleared out to zero. I'll show you how that works towards the end of this video. Which brings us on to step three. How to recognize inventory sales under the perpetual system. This is where you recognize revenue and record cost of goods sold as sales take place. But in the periodic system you only recognize your revenue as sales take place. You might remember from my last video that selling inventory triggers two journal entries. You recognize revenue in your income statement and you release cost of goods sold from your balance sheet to your income statement. Under the perpetual system you'd record this by crediting your revenue account and debiting your cash account or accounts receivable but how much revenue should you recognize? Well you sold 450 books at $15 per unit. 450 multiplied by $15 gives you $6,750 so you credit revenue by $6,750 to increase your earnings in the income statement and you debit cash or accounts receivable by $6,750 to increase your assets in the balance sheet. In the second journal entry you release the cost of goods sold from your balance sheet to your income statement you sold 450 books which you bought for $8 per unit. 450 multiplied by $8 is $3,600 and you need to release this from your balance sheet because you're no longer holding this inventory. So you credit inventory by $3,600 to release it from your balance sheet and you debit cost of goods sold by $3,600 to record the expense in your income statement. Okay but what about the periodic system? In the periodic system you only recognize your revenue as sales take place. So selling inventory only triggers one journal entry to recognize your revenue. You have no idea what your cost of goods sold are at this point because you haven't counted your inventory yet. So you credit revenue by $6,750 and debit cash or accounts receivable by $6,750 and that's it. Step four. With the perpetual method inventory is updated in real-time. At any given point you know all of the variables in this calculation so you're closing inventory balance is continuously updated. In this example your cost of goods available for sale were $6,400 and you sold 450 books costing you $3,600. That's your cost of goods sold and when we take the difference you're left with your closing inventory balance of $2,800 in October. To find your closing inventory and your cost of goods sold under the periodic system we need to fast forward to the end of October. You still have two more steps to get through. In step four you need to clear total purchases to your inventory account. What does that mean? It means that you need to post a journal to clean all of your October inventory additions out of your purchases account and transfer them to your inventory account. So you credit purchases by $4,000 and you debit inventory by $4,000. This might seem a bit silly with only one addition in this example but if you buy inventory in multiple batches throughout a period then this way of doing things is a lot cleaner. Right it's time for your inventory count. You head to your storage room where you keep all of your books and you physically count all of your inventory on hand. 350 books in total. That's your closing inventory. In step 5 you update your closing inventory and calculate your cost of goods sold. These books cost you $8 each to buy 350 multiplied by $8 is $2,800. That's your closing inventory balance which we can pop into the calculation here. But there's one final piece to this puzzle. You still need to find out your cost of goods sold and you can do that by rearranging this calculation. Your cost of goods available for sale less your closing inventory gives you your cost of goods sold. $6,400 less $2,800 is $3,600. So to recognize this in your income statement you debit cost of goods sold by $3,600 and you credit inventory by $3,600. You can see that your cost of goods sold under the periodic method is exactly the same as the cost of goods sold you calculated under the perpetual method. The difference is in the timing. In the perpetual system you were able to see your results in real time because both your revenue and your cost of goods sold were continuously updated as you sold your inventory however in the periodic system you needed to wait for the inventory count at the end of the month to find out your cost of goods sold. It took longer to find out your results. I've summarized all of this in the cheat sheet which you can find linked on my website over here. There are plenty more inventory videos coming out soon so don't forget to subscribe if you'd like to see those and I'll be popping them all in this playlist here when they're done. See you soon.