Inventory Systems
& Stock Valuations
How businesses record and value their stock - the two systems, three methods, and what happens when stock goes missing.
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Book Now →Imagine two different tuck shops. The first one records every single sale as it happens - scan the item, cost of sales recorded immediately. The second one just sells all day and only counts what's left at closing time to figure out what was sold. The first is perpetual. The second is periodic. Both work - they just update their records at different times.
Perpetual System
- ✓ Cost of Sales recorded on EVERY sale
- ✓ Stock balance accurate at all times
- ✓ Regular stock counts (better control)
- ✓ Purchases go to TRADING STOCK account (asset)
- ✓ Carriage on purchases: Trading Stock account
- ✓ Best for: high-value items (cars, electronics)
Periodic System
- ✓ Cost of Sales calculated ONCE at year-end
- ✓ No Cost of Sales account exists mid-year
- ✓ Stock count done at year-end only
- ✓ Purchases go to PURCHASES account (expense)
- ✓ Carriage on purchases: Carriage on Purchases account
- ✓ Best for: low-value bulk goods (grocery store)
In the perpetual system, carriage goes to the Trading Stock account (it becomes part of the cost of the asset). In the periodic system, carriage goes to a separate Carriage on Purchases expense account. This is a common exam question - know which account each one uses.
The Trading Account is used in the PERIODIC inventory system to calculate GROSS PROFIT. It brings together Sales, Cost of Sales and all the components needed to calculate COS. It stops at Gross Profit - nothing below Gross Profit belongs in the Trading Account. Operating expenses, interest and tax all appear further down in the Income Statement.
Gross Profit = Sales minus Cost of Sales. The Trading Account only deals with items ABOVE this line. Carriage on sales, bad debts, salaries, depreciation - these are all operating expenses that appear BELOW Gross Profit. They must NEVER be included in the Trading Account.
The Trading Account Format
| Trading Account for the year ended ... | |
|---|---|
| Dr (Debit side) | Cr (Credit side) |
| Opening stock XXX | Sales XXX |
| Purchases XXX | Less: Debtors allowances (XXX) |
| Less: Returns to suppliers (XXX) | Net Sales XXX |
| Net Purchases XXX | Closing stock XXX |
| Carriage on purchases XXX | |
| Import duties / customs XXX | |
| Gross Profit (balancing) XXX | or Gross Loss if Dr > Cr |
| Total XXX | Total XXX |
6-Step Method for Preparing the Trading Account
Follow these steps in order every single time. Never jump straight to writing the account - the preparation work is where the marks are.
Journal Entries: Perpetual vs Periodic Side by Side
The same transaction is recorded differently depending on which system the business uses. Know both versions.
| Transaction | Perpetual System | Periodic System |
|---|---|---|
| Buy stock on credit R10 000 | Dr Trading Stock R10 000 Cr Creditors R10 000 Stock asset updated immediately |
Dr Purchases R10 000 Cr Creditors R10 000 Goes to expense account |
| Sell stock for cash R6 000 (cost R4 000) Debtors allowance = sales return |
Dr Bank R6 000 Cr Sales R6 000 Dr Cost of Sales R4 000 Cr Trading Stock R4 000 Two entries - COS recorded now |
Dr Bank R6 000 Cr Sales R6 000 One entry - COS calculated at year-end only |
| Return stock to supplier R1 000 | Dr Creditors R1 000 Cr Trading Stock R1 000 Stock reduced immediately |
Dr Creditors R1 000 Cr Purchases Returns R1 000 Deducted from Purchases in the Trading Account |
| Debtors allowance (return from customer) R800 - cost R500 | Dr Sales Returns R800 Cr Debtors R800 Dr Trading Stock R500 Cr Cost of Sales R500 Reverses the original sale entry |
Dr Debtors Allowances R800 Cr Debtors R800 Deducted from Sales in the Trading Account |
| Carriage on purchases R500 | Dr Trading Stock R500 Cr Bank R500 Becomes part of stock cost |
Dr Carriage on Purchases R500 Cr Bank R500 Separate expense account |
Accounting Equation Impact - Perpetual vs Periodic
Every transaction changes the accounting equation (Assets = Liabilities + Owners Equity). Know which direction each account moves and how it hits the equation.
| Account | Type | Normal Balance | Increases on | Effect on Equity | System |
|---|---|---|---|---|---|
| Trading Stock | Asset | Debit | Debit side | No direct effect | Perpetual |
| Cost of Sales | Expense | Debit | Debit side | Reduces equity | Perpetual |
| Purchases | Expense | Debit | Debit side | Reduces equity | Periodic |
| Purchases Returns | Income adj. | Credit | Credit side | Increases equity | Periodic |
| Carriage on Purchases | Expense | Debit | Debit side | Reduces equity | Periodic |
| Sales | Income | Credit | Credit side | Increases equity | Both |
| Debtors Allowances (Sales Returns) |
Income adj. | Debit | Debit side | Reduces equity | Both |
Accounting Equation: Two Worked Transaction Examples
Assets: Trading Stock +R10 000 | Liabilities: Creditors +R10 000 | Equity: No change. The equation stays balanced because an asset increased and a liability increased by the same amount.
Assets: No immediate change | Liabilities: Creditors +R10 000 | Equity: Purchases expense -R10 000 (reduces profit). The equation still balances because liabilities went up and equity went down by the same amount.
The Trading Account ends at Gross Profit. If an item does not help calculate Gross Profit (Sales minus Cost of Sales), it does not belong in the Trading Account. Carriage on SALES is an operating expense - it goes below Gross Profit. Carriage on PURCHASES is a cost of getting stock - it goes INTO the Trading Account as part of COS.
You buy apples at different prices throughout the year - R5 in January, R7 in June, R9 in December. At year-end you have 10 apples left. What are they worth? It depends which method you use. Specific ID: depends which actual apples are left. FIFO: assume the R9 ones (bought last) are the ones remaining. Weighted Average: calculate one blended price for all apples bought.
Specific Identification
- Each item tracked individually
- Each item has its own specific cost
- COS = cost of items actually sold
- Closing stock = cost of items NOT sold
- ✓ Best for: jewellery, cars, phones
- (high-value, unique items)
FIFO
First In, First Out
- OLDEST stock assumed sold first
- Closing stock valued at MOST RECENT prices
- Work BACKWARDS from latest purchases
- If prices rising: higher closing stock
- If prices rising: higher gross profit
Weighted Average
One average cost for all units
- Blends ALL purchase prices together
- One average price per unit
- Smooths out price swings
- If prices rising: moderate closing stock
- If prices rising: moderate gross profit
FIFO Step-by-Step
FIFO gives HIGHER closing stock (valued at recent high prices), which means LOWER Cost of Sales and HIGHER Gross Profit. Weighted Average smooths everything out and gives a moderate result in between. This is why a business might want to switch to FIFO when prices are rising - and why that switch is restricted.
Both methods use the same Cost of Sales formula. The ONLY thing that changes is the closing stock value. A higher closing stock means lower Cost of Sales means higher Gross Profit. A lower closing stock means the opposite. The valuation method directly affects how profitable the business appears.
| FIFO (prices rising) | Weighted Average (prices rising) | |
|---|---|---|
| Closing Stock value | HIGHER (recent high prices) | LOWER (blended average) |
| Cost of Sales | LOWER | HIGHER |
| Gross Profit | HIGHER | LOWER |
FIFO Advantages
- ✓ Based on actual purchase prices
- ✓ Closing stock at most recent prices
- ✓ More realistic balance sheet value
FIFO Disadvantages
- ✗ More admin (track each batch separately)
- ✗ Drastic price changes = big profit swings
Weighted Average Advantages
- ✓ Smooths out price fluctuations
- ✓ One simple price for all units
- ✓ Less volatile profit figures
Weighted Average Disadvantages
- ✗ Unit cost not based on most recent prices
- ✗ Can be less meaningful in fast-changing markets
Cost of Sales, Sales, Gross Profit and Mark-up % all feed off each other. Remember: Sales = Units sold x Selling price. Gross Profit = Sales - Cost of Sales. Mark-up % = (Gross Profit / Cost of Sales) x 100. The only input that changes between methods is your closing stock figure.
At the end of the day, a tuck shop owner counts 80 pies on the shelf. But according to the records, there should be 90. Ten pies are missing. That is a deficit - stock that should be there but is not. Now flip it: the count shows 95 pies but records say 90. Five extra pies appeared. That is a surplus. Both need to be recorded.
Opening Units + Units Purchased - Units Returned - Units Sold = Units that SHOULD be on hand.
Compare this to units ACTUALLY counted on hand. The difference is your deficit or surplus.
Trading Stock Deficit
Fewer units on hand than expected. Stock has gone missing or been stolen.
Should have > Actually have
EXPENSES in SCIReduces profit
Trading Stock Surplus
More units on hand than expected. Over-delivery or counting error.
Actually have > Should have
OTHER INCOME in SCIIncreases profit
Common Causes of a Surplus
Valuing the Deficit or Surplus
Deficit = EXPENSES. Surplus = OTHER INCOME. Both appear in the Statement of Comprehensive Income (SCI). This is asked almost every time this topic appears. Write it without hesitation.
NO - not freely. A change in valuation method requires SARS approval and cannot be made simply to show a more favourable result. This is one of the most common ethics questions in the inventory topic.
Why a Sudden Change is NOT Allowed - State All Three Reasons
Consequences of Manipulating the Method
Internal Controls for Stock
Step 1: State what the owner is trying to do. Step 2: Say it is NOT allowed. Step 3: Name the three principles violated (Consistency, Comparability, Integrity) and explain each briefly. Step 4: State the consequences. This structure earns full marks every time.
Stock is often the largest asset on a company's balance sheet. How it is valued directly affects Cost of Sales, Gross Profit, and the value of assets shown to the world. Getting it wrong - or manipulating it - has real consequences for investors, banks, SARS, and the business itself.
Quick Reference
The Rules to Never Forget
Perpetual
COS recorded on every sale. Purchases: Trading Stock (asset).
Periodic
COS at year-end only. Purchases: Purchases account (expense).
FIFO (rising prices)
Higher closing stock. Lower COS. Higher GP.
Deficit
Missing stock. EXPENSES in SCI. Reduces profit.
Surplus
Extra stock. OTHER INCOME in SCI. Increases profit.
Method Change
NOT allowed freely. SARS approval + Consistency + Integrity.
Need to work through
the calculations?
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