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Perpetual Inventory System

By Yuriy Smirnov Ph.D.

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.

Calculation example

RetailX 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:

Purchase of inventory journal entry

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.

Sale of inventory journal entry

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 RetailX LTD makes all purchases and sales on credit. In this instance, journal entries should look as follows:

Perpetual inventory system journal entries

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.

Journal entry of purchase return in perpetual inventory system

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.

Journal entry of purchase discount in perpetual inventory system

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.

Journal entry of sales return in perpetual inventory system

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.

T-accounts in perpetual inventory system - inventory account

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.

T-accounts in perpetual inventory system - cost of goods sold 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:

T-accounts in perpetual inventory system - accounts receivable

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.

T-accounts in perpetual inventory system - accounts payable

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

T-accounts in perpetual inventory system - sales account

Advantages and disadvantages

Advantages

  1. The perpetual inventory system helps to maintain greater control over physical inventories by comparing the actual balance with records.
  2. 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.
  3. It helps to detect any thefts, waste, and leakage of inventory without any delay.

Disadvantages

  1. 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.
  2. Using computers and accounting software could be quite expensive for small business.