How to Use the
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When a company purchases product, it is immediately recorded as inventory. When the products are sold, the inventory balance is immediately reduced (credited) and recorded in cost of goods sold.
Whereas the periodic inventory system uses the purchases account and its contra accounts to record net purchases throughout the year (purchases less returns and discounts in the contra accounts), the perpetual inventory system records all transactions affecting inventory directly in the inventory account, including all purchases, sales, inventory returns and inventory discounts.
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Accounting software packages make it much simpler and cost-effective to monitor inventory levels using the perpetual inventory system throughout the year.
Monitoring adequate inventory levels is important to both meet demand and maximize sales while preventing too much inventory that can tie up cash and risk inventory obsolescence, write-downs, and price reductions that lead to lower profit margins. The inventory turnover ratio is used to monitor adequate inventory levels.
Though an inventory count should be taken once a year to measure and match inventory records, the perpetual inventory system does not depend on this count to determine cost of goods sold, but is used to verify inventory records. Therefore, a potentially costly year end count which may interfere with normal business operations is not required. Inventory counts can be made routinely throughout the year to match perpetual inventory records.
The following journal entries illustrate the perpetual inventory system. The two main differences between the perpetual inventory journal entries and the periodic inventory journal entries are that:
- The periodic inventory system uses a purchases account, whereas perpetual inventory uses the inventory account directly.
- Using perpetual inventory adds another journal entry after a sale to reduce the inventory balance, whereas the periodic inventory system adjusts the inventory balance at year end after a physical count of inventory items.
Items purchased for resale are recorded directly in the inventory account in the perpetual inventory system. Additionally, a journal entry is added to reduce the inventory balance based on the number of items sold, in this case 300 units @$15 each.
In the above example, a return of inventory directly reduces the inventory balance with a credit for the returned items. The periodic inventory system, on the other hand, reduces the purchases account with a credit to the purchase returns contra account.
Similarly, items purchased at a discount directly reduce the inventory balance with a credit to inventory. In this example, Sunny Sunglasses purchased product with a 2% discount when paid within 10 days (2/10), with full payment due within 30 days (n/30).
Discounts encourage quicker payment of items purchased on credit. The periodic inventory system, by contrast, records discounts by reducing the purchases account with a credit entry to the purchase discounts contra account.
When the inventory purchases and sales are complete for the year, the perpetual inventory and the periodic inventory systems reflect an ending balance of $5,625 for inventory and $43,200 for cost of goods sold ($38,700 + $4,500).
From the Perpetual Inventory System to the Periodic Inventory System
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