The value of inventory is a line in the balance sheet and a line in the income statement at the same time: what remains is an asset, what leaves is cost of sales. Which is why overstating inventory raises both profit and assets — one of the best-known routes to dressing up a set of accounts.
1 Two systems for tracking inventory
| Aspect | Perpetual | Periodic |
|---|---|---|
| The book balance | Updated with every movement | Calculated at period end |
| Cost of sales | Recorded with every sale | Derived by formula at period end |
| Detecting a shortage | Immediately, by comparison | Buried inside cost of sales |
| What it requires | A system and discipline in recording | Simple and inexpensive |
| Suits | Most businesses today | Many items of very low value |
The hidden flaw in the periodic system
Under the periodic system cost of sales is derived as a difference: opening inventory + purchases − closing inventory. Which means that everything lost, damaged or stolen slips inside cost of sales and never appears as a line of its own — so nobody is held to account for it, simply because nobody can see it.
2 The physical count and its forms
Full count
Every item once a year with movement frozen
Cycle count
Some items each day in rotation, without stopping
Surprise count
A sample with no prior notice
Handover count
On transferring custody or changing storekeeper
Cycle counting catches the error while it is small, instead of a year-end surprise
- Count without a balance sheet in hand: whoever sees the book figure tends to confirm it rather than count.
- Double counting for high-value items, by two independent teams.
- Freeze movement during the count, or document it precisely.
- Whoever issues does not count — and an independent party attends.
- Goods in transit and on consignment are handled through separate schedules, not by counting.
- Signed minutes of the differences before any adjustment is posted.
3 Inventory costing methods
Purchases: 100 units at 10, then 100 units at 14. And 120 units were sold:
| Item | First-in first-out | Weighted average |
|---|---|---|
| Unit cost applied | 10 then 14 | 12 |
| Cost of sales | 1,280 | 1,440 |
| Closing inventory (80 units) | 1,120 | 960 |
| Difference in profit | Higher by 160 | Lower by 160 |
The same goods, the same sales, and a different profit. In a period of rising prices, first-in first-out shows a higher profit and an inventory value closer to current prices, while the weighted average produces a smoother result.
The method is chosen once and applied consistently
The accounting standards permit first-in first-out and the weighted average, and do not permit last-in first-out. More importantly, the method must be applied consistently across similar items and from one year to the next; changing it without justification is manipulation of the result.
4 Measurement and differences
Inventory is measured at the lower of cost and net realisable value. So if the expected selling price falls below cost — through obsolescence, damage or a falling market — inventory is written down to the lower amount and the loss is recognised immediately.
| Situation | Treatment |
|---|---|
| Shortage within normal limits | Charged to cost of sales |
| Abnormal shortage | A separate expense, with its causes investigated |
| A surplus at the count | Investigated first — usually a recording error, not a gain |
| Damaged or expired | Disposal minutes by a committee, then a loss entry |
| Slow-moving or obsolete | A write-down provision against inventory |
A surplus at the count is bad news too
A surplus means a movement was never recorded, or an issue was recorded that never happened, or two similar items were confused. Adjusting it without investigation hides the error rather than fixing it, and it will return at the next count — as a shortage this time.
Lesson summary
- The perpetual system updates the balance continuously; the periodic one calculates it at period end.
- Under the periodic system, shrinkage vanishes inside cost of sales and is never seen.
- Cycle counting catches the error while it is small instead of a year-end surprise.
- Counting is done without the book figures, and with a party independent of the storekeeper.
- The costing method changes the profit, is applied consistently, and last-in first-out is not permitted.
- Inventory is measured at the lower of cost and net realisable value.
- A surplus at the count is investigated exactly as a shortage is.
5 Test your understanding
Three quick questions
Pick the answer you believe is correct and you will see the result immediately.
1. A business uses the periodic system and loses goods to theft. Where does the loss appear?
Cost of sales under the periodic system is derived as a difference, so it swallows every shortfall whatever its cause.
2. An item costs 100 and its expected net realisable value is 70. It is carried at:
The rule prevents inventory being shown above what is expected to be recovered from it, and the loss is recognised at once.
3. The count shows a surplus over the book balance. The proper action:
A surplus is evidence of a recording failure just as a shortage is, and adjusting it without investigation only defers the problem.