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