If your business is merchandising or manufacturing, most likely you have inventory. Inventory represents goods which the company resell, or materials used for the productions of finished goods. But how do we initially account inventories in business? What accounting methods are applicable? In this topic, we are going to discuss the two types of inventory system and related accounting terms for better understanding.

2 TYPES OF INVENTORY SYSTEM

Perpetual Inventory System – In this system, every purchase of inventory is directly recorded into inventory, which is an asset account. The monitoring of inventory accounts in a continuous manner where every movement of inventory is directly recorded in the inventory account. It provides better control thru the use of stock cards which are filled throughout the accounting period. In using this method, there is no need to set up for ending inventory amounts since it is reflected outright. However, inventory counts may still be conducted for verification and accuracy purposes. Purchase returns and allowances, purchase discounts and Freight charges are recorded against Inventory account.

Sample entries under Perpetual Inventory System:

Periodic Inventory System – An inventory system that is commonly used in manufacturing and merchandising businesses where every purchase of inventory is recorded as expense through “purchases account”. Periodic inventory does not use any stock cards for inventory recording, it only measures inventory thru physical count every end of the period. Companies may facilitate inventory counts on a monthly, quarterly, or an annual basis depending on the need for evaluation and financial statement preparation. Since this system does not have continuous monitoring throughout the period, a closing entry at the end of the period is necessary to reflect the actual inventory count. Purchase returns and allowances, purchase discounts and Freight charges are recorded on its own temporary account which are later closed to Inventory at the end of the period.

Sample entries under Periodic Inventory System:

DISCOUNTS

Cash Discounts – These are discounts or deductions that are granted to the buyer in buying a certain product. These are offers or inducements to captivate customers in buying the product. Cash discounts are usually offered in order to motivate customers to pay at an earlier date covered by the discount period. Below are some example of Cash Discount:

1. 4/10, N/30 – the term means that there is a four (4%) discount if the item is paid within 10 days from the date of receipt. While, there is no discount is paid after 10 days until the 30^th day.
2. 4/10, 2/20, N/30 – the term implies that four percent (4%) discount if the item is paid within 10days from the date of receipt, two percent (2%) discount if paid on the 20^th day, and no discount if paid on the 21^st until the 30^th day.
3. 4/10, EOM – this means that four percent (4%) discount is available if the item is paid within 4 days from date of receipt. The total amount is due on the end of the month.

Trade Discounts – Trade discounts on the other hand are outright discounts or spot discounts being deducted from the list price to arrive at the invoice price.

The difference between the two discount options is that cash discounts are recorded in the books while trade discounts do not. You can offer both discounts but the amount recorded is only up to the extent of the amount of discount.

Example:

Breezy Company bought Premium T-shirt Items which will be later sold again for his business. The Premium T-Shirt has a list price of ₱ 30,000 and has a discount terms of 2%, 4/10, N/30. Assuming that he paid on the discount period, how much is the amount of inventory in his accounting records?

Answer:

List Price	30,000.00
Less: Trade Discount (2%)	(600.00)
Invoice Price	29,400.00
Less: Discount Price (4%)	(1,176.00)
Cost of Inventory Paid	28,224.00

FREIGHT IN AND FREIGHT OUT

This accounting term is used for cost associated with the delivery of inventory. Freight In is the cost of delivering inventory into the company while Freight Out is the cost of delivering inventory to the customers. As mentioned earlier, Freight In is part of the cost of the inventory, and therefore must be capitalizable. While freight Out is recorded as an outright expense for the delivery in conducting a sale transaction. It is a business expense and is also known as transportation out.

Freight ownership may also be determined by either of the following:

• F.O.B. Shipping Point – the ownership is passed from the seller to the buyer the moment the item is loaded at the “point of origin”. Impliedly the cost of shipping is shouldered by the buyer.
• F.O.B Destination – the ownership is transferred from buyer to seller the moment the item reaches the “point of destination”. The cost of shipping is shouldered by the seller.

These are widely used in determining the true amount of inventory at the end of the period which is sometimes understated because of certain cut-off.

CREDIT AND DEBIT MEMOS

Credit and Debit Memos may be issued to adjust amount previously invoiced due to defective, incorrect, or damaged merchandise inventory. A credit memorandum is a notification from the seller to the buyer on the reduction of amount, while a debit memorandum, is a notification from the buyer to the seller. Adjusting entries shall be made to reflect the accurate value of inventory, either at point of return (perpetual inventory system), or at the end of the period (periodic inventory system).

In running a business, especially in merchandising and or manufacturing entities, it is important that we learn how to account for inventory and understand the terms associated with it to maintain accurate record.