Most companies still use a physical inventory system that only reconciles inventory to actual physical counts at the end of the fiscal year. This system is called “Periodic Inventory System”. A physical inventory count can be eliminated if accurate perpetual inventory records are available. “Perpetual Inventory System” is a manual or automated inventory tracking system in which a new inventory balance is computed continuously whenever new transactions occur. This post shows you journal entries made for both inventory systems.

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The Sale and Purchase of Products

Perpetual inventory systems show all changes in inventory in the “Inventory” account. “Purchases” accounts are not used in a perpetual inventory system. Periodic inventory systems keep the inventory balance at the same value that it was at the beginning of the year. At year end, the inventory balance is adjusted to a physical count. To account for inventory purchases in a periodic inventory system, an account called “Purchases” is used rather than debiting “Inventory“. Let’s construct one example….

Example:

Lie Dharma Putra Mart, a wholesaler shows the following information:

[1]. Beginning inventory = 100 units at $6 = $ 600
[2]. Purchases = 900 units at $6 = $5,400
[3]. Sales = 600 units at $12 = $7,200
[4]. Ending inventory = 400 units at $6 = $2,400
(Unit cost is held constant to avoid the necessity of a using a cost flow assumption)

 

If Lie Dharma Putra Mart uses perpetual inventory system, the transaction flow and its journal entries will be as follows:

[1]. Beginning inventory 100 units at $600
Inventory account shows $600 in inventory.

[2]. Purchase of 900 units at $6 per unit
[Debit]. Inventory = 5,400
[Credit]. Account Payable = 5,400

[3]. Sale of 600 units at a selling price of $12 per unit. A couple of journal entry is made:

[Debit]. Account Receivable = 7,200
[Credit]. Sales = 7,200
And;

[Debit]. Cost of Goods Sold = 3,600
[Credit]. Inventory = 3,600

[4]. End-of-period entry for inventory adjustment. No entry needed. The ending balance of inventory shows $2,400.

 

But, using periodic inventory system, the transaction flow and its journal entries will be as follows:

[1]. Beginning inventory 100 units at $600. Inventory account shows $600 in inventory.

[2]. Purchase of 900 units at $6 per unit:

[Debit]. Purchases = 5,400
[Credit]. Acc. Payable = 5,400
(Note: it uses “Purchase” account, instead of inventory)

[3]. Sale of 600 units at a selling price of $12 per unit. Periodic inventory system makes a single journal entry only [a cost of goods sold account hasn’t been used yet]. Cost Of goods sold will be recorded through adjustment entry at the end of period [we will discuss this on the next section]. Here is the journal entry:

[Debit]. Account Receivable = 7,200
[Credit]. Sales = 7,200

[4]. Period-end entry for inventory adjustment is made after a physical count:

[Debit]. Inventory = 1,800
[Debit]. Cost of Goods Sold = 3,600
[Credit]. Purchases = 5,400

Note: The periodic inventory adjustment in transaction 4 adjusts inventory to the physical count, closes out any purchase accounts, and runs any difference through cost of goods sold. Let’s talk about cost of goods sold in a periodic inventory system specifically. Read on…

 

Cost of Goods Sold in Perpetual and Periodic Inventory System

Perpetual inventory systems record cost of goods sold and keep inventory at its current balance throughout the year. Therefore, there is no need to do a year-end inventory adjustment unless the perpetual records disagree with the inventory count. In addition, a separate cost of goods sold calculation is un-necessary since cost of goods sold is recorded whenever inventory is sold.

The inventory account in a periodic inventory system keeps its beginning balance until the end of period adjustment to the physical inventory count. Therefore, a separate cost of goods sold calculation is required. The following calculation shows the calculation for the preceding example.

Beginning Inventory = 600
Plus: Net Purchases = 5,400
Equal: Goods Available for Sale = 6,000
Minus: Ending Inventory Balance = 2,400
Equal
: Cost of Goods Sold = 3,600

Note: Ending inventory balance is discovered through a physical count at the period-end, and cost of goods sold could be determined. An adjustment entry would be required to record the cost of goods sold.

 

Purchase Returns and Allowances and Purchase Discounts

Purchases” account has a normal debit balance in a periodic inventory system since it replaces the debit to “Inventory” [in a perpetual system]. It has two contra accounts known as “Purchase Discounts” and “Purchase Returns and Allowances” (Purchase R&A) that reduce it to determine “Net Purchases“. The balance of these two contra accounts is a credit because “Purchases” is a debit. Contra accounts always have a normal balance that is opposite to what they are contra to. Purchase-type accounts are temporary accounts [i.e., they are closed at year end] and only appear in a periodic inventory system. They simply serve to replace the corresponding inventory portion of an entry that exists in a perpetual inventory system.

For better understanding, let’s construct some examples:

Lie Dharma Putra Mart returned $600 of damaged merchandise to its supplier, and received a price reduction allowance of $100 on the portion of the merchandise they retained.

If Lie Dharma Putra Mart uses perpetual inventory system, the following journal would be made:

[Debit]. Account Payable = 700
[Credit]. Inventory = 700

Using periodic inventory system:

[Debit]. Account Payable = 700
[Credit]. Purchase Return and Allowance = 700

In a previous transaction, Lie Dharma Putra Mart purchased merchandise on account at a cost of $1,000. The credit terms were 2/10, n/30. Lie Dharma Putra paid for the merchandise within the discount period.

 

Using perpetual inventory system, the journal entry will be:

[Debit]. Account Payable = 1,000
[Credit]. Inventory = 20
[Credit]. Cash = 980

 

Using periodic inventory system, Lie Dharma Putra will record the transaction with the following journal entry:

[Debit]. Account Payable = 1,000
[Credit]. Purchase Discount = 20
[Credit]. Cash = 980
(Note: It uses “Purchase Discountinstead ofInventory“)

How if the company received sales return and provide allowance and sales discount? Let’s discuss about these. Read on…

 

Sales Returns and Allowances and Sales Discounts

Sales” account has two contra accounts known as “Sales Discounts” and “Sales Returns and Allowances” that reduce it. The normal balance for these two contra accounts is a debit. Sales and its contra accounts may appear with either a perpetual or periodic inventory system. The following examples better illustrate the accounts in perpetual and periodic inventory systems [Note: the entries assume the gross method]:

Lie Dharma Putra Mart received $600 of damaged merchandise from their customers. They also gave a $100 allowance for some of the damaged merchandise that customers retained. The original cost of the merchandise returned to Lie Dharma Putra Mart was $400.

 

Using perpetual inventory system, Lie Dharma Putra Mart would make the a couple of journal entry:

[Debit]. Sales Return and Allowance = 700
[Credit]. Account Receivable = 700

And;

[Debit]. Inventory = 400
[Credit]. Cost of Goods Sold = 400

 

But if Lie Dharma Putra uses periodic inventory system instead, it would make a single journal entry only:

[Debit]. Sales Return and Allowance = 700
[Credit]. Account Receivable = 700

Next, Lie Dharma Putra Company received a customer payment for a prior sale on account of $1,000 subject to credit terms of 2/10, n/30. The customer made payment within the discount period.

 

Using perpetual inventory system, the journal entry would be:

[Debit]. Cash = 980
[Debit]. Sales Discount = 20
[Credit]. Account Receivable = 1,000

Using periodic inventory system, the journal entry would be the same as if Lie Dharma Putra uses perpetual system.

 

Perpetual Or Periodic Inventory System [which one is better]?

I would personally recommend perpetual inventory system. While the Controllers of companies who implement periodic inventory system need a reliable approach for organizing the inventory in preparation for a count, creating and managing counting teams, and properly using counting forms and inventory release teams to ensure that counts have been completed as accurately as possible. A physical inventory count can be eliminated if accurate perpetual inventory records are used. Many steps are required to implement such a system, requiring considerable effort. The accountant should evaluate a company’s resources before embarking on a perpetual inventory system to ensure that they are sufficient to set up and maintain this system.

Despite the major effort needed to implement an accurate perpetual system, it is still a most worthwhile project. Once completed, the accounting staff can incorporate accurate inventory records into its inventory valuations, external auditors can review the system at any time, because there is no need to conduct a year-end physical inventory count, and the material planning staff can utilize the inventory database with confidence. Which one is your preference? Let me know your thoughs through below comment form.