Inventory Purchases and its Paradigms
By Mahaboob Ahmed, August 9, 2016
Generally people consider purchases as an expense, but if we were to take a closer look, purchases are not expenses until the purchased item is consumed. Normally, once we purchase any item, we start consuming it immediately. However when an organization purchases raw materials in bulk and consumes it over a period, then the purchased item is an Asset of the organization.
Most small financial software packages consider purchases as expenses and this type of accounting is called Periodic Inventory system. In this system, the purchases are recorded as expenses in the purchase account and each sales entry is recorded as a single journal voucher.
Major ERP systems use Perpetual Inventory System; in this system there are continuous updates to either the general ledger or inventory journal, as and when an inventory-related transaction occurs. 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.
Both these accounting systems adopt different ways of Arriving at & the Presentation of Trial balance & Profit & Loss statement.
In any ERP Implementation, where the customer is running an existing financial package, the major challenge faced by the Implementation team is to clarify the finance managers and auditors on how the ERP works using the Perpetual inventory system, its advantages while reporting, and prove its correctness during the initial period through a good reconciliation function. Also, inventory costing can be accurately followed, maintained, and tracked easily through the perpetual inventory system.
In this context, it is important to educate and train the users on the relationship of the physical inventory in real time compared to the general ledger value.
The following table helps to understand both the systems better.
In the current business world, where all the business functions are captured & integrated in a unified system, accounting and inventory should also be integrated and online.
Moreover, financial reporting in India has seen significant changes in the recent years. The revised schedule reporting also requires Cost of Materials consumed and the changes in the Finished Goods to be stated clearly in the Profit & Loss Statement, which makes integrated inventory accounting highly relevant.