Perpetual Inventory System

Definition
The perpetual inventory system is used in accounting to keep inventory records. This system
assumes that the inventory account and the cost of goods sold (COGS) account are updated
after each transaction. Common examples of such transactions are purchase and sale of
inventory, purchase and sales returns, and purchase and sales discounts.

In the perpetual inventory system, each sales transaction requires two journal entries. The first
one is recorded by debiting accounts receivable and crediting the sales account by the sale
value of inventory. The second one is recorded by debiting the inventory account and crediting
the accounts payable account if the sale was made on credit.
Purchase of inventory is recorded through one journal entry by debiting the inventory account
and crediting the accounts payable by the value of cost of goods sold if a purchase was made on
credit.
The cost of goods sold and ending inventory depend on the inventory method being used.
Common examples include FIFO, LIFO, average cost, and specific identification methods.

The perpetual inventory system is used in accounting to keep inventory records. ...
Common examples of such transactions are purchase and sale of inventory, purchase and sales
returns, and purchase and sales discounts. In the perpetual inventory system, each
sales transaction requires two journal entries.
Calculation example
Retail X LTD has made the following transactions during March:

Assume that the retailer is using the FIFO inventory method.

Mar 1 - Inventory Account Balance = 2,500 × $80 = $200,000

Mar 6 - Sale = 1,800 × $80 = $189,000

COGS = 1,800 × $80 = $144,000
Inventory account balance = $200,000 + $144,000 = $56,000

Mar 9 - Purchase = 4,000 × $85 = $340,000

Inventory Account Balance = $56,000 + $340,000 = $396,000

Mar 17 - Sale = 2,300 × $120 = $276,000

COGS = 700 × $80 + 1,600 × $85 = $192,000
Inventory Account Balance = $396,000 – $192,000 = $204,000
Mar 23 - Sale = 1,500 × $120 = $180,000
COGS = 1,500 × $85 = $127,500
Inventory Account Balance = $204,000 – $127,500 = $76,500

Mar 27 - Purchase = 3,000 × $90 = $270,000

Inventory Account Balance = $76,500 + $270,000 = $346,500

During the accounting period, total sales totaled $645,000, total purchases $610,000, and the
cost of goods sold $463,500. In turn, the balance of inventory account amounted to $346,500
as of 31st of March.
Journal entries
In the perpetual inventory system, each purchase requires one entry to be made in the general
journal. It is recorded by debiting the inventory account and crediting accounts payable as
follows:

In turn, each sale requires two entries to be made in the general journal. The first one is
recorded by debiting the accounts receivable account and crediting the sales account. The
second one is recorded by debiting the cost of goods sold account and crediting the inventory
account.

If purchase or sale is made for cash, the cash account should be used instead of accounts
payable and accounts receivable respectively.

Example
Let’s assume that Retail X LTD makes all purchases and sales on credit. In this instance, journal
entries should look as follows:
Purchase Return
Sometimes purchased inventory can be returned to the supplier, for example, due to improper
quality. In the perpetual inventory system, it should be recorded by debiting accounts payable
and crediting the inventory account by the amount of returns outward.

Purchase discount
Some suppliers offer discounts for early payments. In such cases, the accountant should record
it in the general journal by debiting accounts payable and crediting the inventory account by
the amount of discount obtained.

Sales return
Sales return requires two entries to be made in the general journal in the perpetual inventory
system. The first one is recorded by debiting the sales return account and crediting the
accounts receivable account by the value of goods sold. The second one is recorded by debiting
the inventory account and crediting the cost of goods sold account by the cost of returned
items.

T-accounts
In accounting, T-accounts are used to show the balance of each account. Debits are always
recorded on the left side, and credits are always recorded on the right side.
Let’s transform general journal entries from the example above to a T-accounts format.
The inventory is a real asset account; thus, debit increases its balance, and credit decreases it.
 The cost of goods sold is a temporary account, so its balance at the beginning of the accounting
period always equals zero. At the end of the accounting period, its balance is transferred to
another account, which is called closing the account.

Accounts receivable is a real asset account. Let’s assume its balance equals zero at the
beginning of the accounting period. In such cases, records should look as follows:

Accounts payable is a real liability account; thus, debits increase it, and credits decrease it. Let’s
assume that its balance equals zero on Mar 1.

The sales account is a temporary account, so it should be displayed as follows:

Advantages and disadvantages

Advantages
I. The perpetual inventory system helps to maintain greater control over physical inventories by
comparing the actual balance with records.
II. The value of cost of goods sold and the inventory account balance is available at any time. This
information is very important to improve purchasing policy and prepare short-term financial
statements.
III. It helps to detect any thefts, waste, and leakage of inventory without any delay.
 Disadvantages
I. In the case of a manual accounting, using the perpetual inventory system is time consuming,
which could also lead to many errors, but this problem can be easily resolved by applying a
computerized accounting system.
II. Using computers and accounting software could be quite expensive for small business.

Explanation
Perpetual inventory system provides a running balance of cost of goods available for sale and
cost of goods sold. Under this system, no purchases account is maintained because inventory
account is directly debited with each purchase of merchandise. The expenses that are incurred
to obtain merchandise inventory increase the cost of merchandise available for sale. These
expenses are, therefore, also debited to inventory account. Examples of such expenses are
freight-in and insurances etc. Each time the merchandise is sold, the related cost is transferred
from inventory account to cost of goods sold account by debiting cost of goods sold and
crediting inventory account.

The balance in inventory account at the end of an accounting period shows the cost of
inventory in hand. The accuracy of this balance is periodically assured by a physical count –
usually once a year. If a difference is found between the balance in inventory account and a
physical count, it is corrected by making a suitable journal entry. The common reasons of such
difference include inaccurate record keeping, normal shrinkage, and shoplifting etc.

Both merchandising and manufacturing companies use perpetual inventory system.

Merchandising companies use this system to maintain the record of merchandising inventory
and manufacturing companies use to account for purchase and issue of direct materials.

Traditionally, the perpetual inventory system is used by companies that buy and sell easily
identifiable inventories such as jewelry, clothing and appliances etc. but advanced computer
software packages have made its use easy for almost all business situations.

Journal entries in a perpetual inventory system:

(1). When goods are purchased:

(2). When expenses such as freight-in, insurance etc. are incurred:

(3). When goods are returned to supplier:

(4). When goods are sold to customers:

(5). When goods are returned by customers:

(6). When a difference between the balance of inventory account and physical count
of inventory is found:

For further explanation of the concept of perpetual inventory system, consider the following
example:

Example:

(1). On 1st April 2013, Metro company purchases 15 washing machines at $500 per machine on
account. The supplier allows a discount of 5% if payment is made within 10 days of purchase.
The Metro company uses net price method to record the purchase of inventory.

The following journal entry would be made in the books of Metro company to record the
purchase of merchandise:
*Net of discount: ($500 × 15) – $25 discount

(2). On the same day, Metro company pays $320 for freight and $100 for insurance.

The following journal entry would be made to record the payment of freight-in and insurance
expenses:

(3). On April 07, Metro company returns 5 washing machines to the supplier.

The return of washing machines to the supplier decreases the cost of inventory and accounts
payable. The following entry would be made to record this decrease:

(4). On April 9, Metro sends the payment via online banking system and takes the advantage of
the discount offered by the supplier.

As the payment is made within 10 days, the Metro company is entitled to receive discount. The
following entry would be made to record the payment:

*($7,125 – $2,375)

(5). On April 15, Metro company sells 4 washing machines at $750 per machine. The Metro
company does not allow any discount to customers.

The sale of 4 washing machines transfers the cost of inventory from inventory account to cost
of goods sold account. Two journal entries would be made; one for the sale of 4 washing
machines and one for the transfer of cost from inventory account to cost of goods sold account:
*Cost of 4 machines sold:

[($475 × 10 machines) + $420 expenses]/10 = $517 per machine

$517 × 4 machines = $2,068

To summarize the events of increase and decrease in the cost of inventory, Inventory T-account
of Metro company is given below: