While management of a company may consider whether using periodic or perpetual inventory system—in the aim of getting inventory system that fits into their operation, accountants would need to be familiar with inventory journal entries in both periodic and perpetual system. The journal entries for the perpetual inventory system should seem familiar to all of you—as perpetual system has been assumed in all other posts in this site (except a discussion in the periodic system).

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The only downside of using perpetual inventory system is the costs and investments (dollar and time) that are required to operate and maintain the system—to updating the inventory records each time a purchase and sale are made.

The advancement in the information technology over the last 2 decades, however, has lowered the costs. As a result, more businesses have adopted perpetual systems so that they can more closely track inventory levels. An obvious example of this trend is in the supermarket business. Two decades ago, the checkout clerk typed the price of each item on a cash register. After the customers walked out of the store with their groceries, the store knew the total amount of the sale but did not know which individual items had been sold. This was a periodic inventory system. Now, with laser scanning tool connected with the supermarket’s computer system, most supermarkets operate under a perpetual system. The store manager knows exactly what were sold and exactly how many of each item should still be left on the store shelves.

However, many companies, in real business practices, see the necessity of using periodic system. Therefore accountants are supposed to be familiar (and are ready to deal) with both perpetual and periodic inventory systems—as they are expected to be so.

As a start, let’s have a look at a running case example.

 

Example of Journal Entries in the Perpetual Vs Periodic System

For easier understanding about the differences in bookkeeping procedures between a business using a perpetual inventory system and one using a periodic inventory system, let’s construct a case example using Lie Dharma Putra Store, a clothing store—just purchase a merchandise (finished good), and then sells the merchandises in the store for profit, in a full inventory cycle.

 

1. Purchases

With a perpetual system, all purchases are added (debited) directly to Inventory. With a periodic system, the inventory balance is only updated using an inventory count at the end of the period; inventory purchases during the period are recorded in a temporary holding account called Purchases. As will be illustrated later, at the end of the period, the balance in Purchases is closed to Inventory in connection with the computation of cost of goods sold.

a. Lie Dharma Putra Store purchased 1,000 shirts at a cost of $10 each for a total of $10,000.

Using perpetual system, the journal entry would be as follows:

[Debit]. Inventory = 10,000
[Credit. Accounts Payable = 10,000

And periodic system would be:

[Debit]. Purchases = 10,000
[Credit]. Accounts Payable = 10,000

b. Another purchase of 300 pairs of pants at a cost of $18 each for a total of $5,400.

Using perpetual system, the journal entry would be as follows:

[Debit]. Inventory = 5,400
[Credit]. Accounts Payable = 5,400

And, using periodic system would be:

[Debit]. Purchases = 5,400
[Credit]. Accounts Payable = 5,400

 

2. Transportation Costs

The cost of transporting the inventory is an additional inventory cost. Sometimes, as with the pants in the Lie Dharma Putra Store, the shipping cost is already included in the purchase price, so a separate entry to record the transportation costs is not needed. When a separate payment is made for transportation costs, it is recorded as follows. Let say that paid cash for separate shipping costs on the shirts purchased in (a), $970. The supplier of the pants purchased in (b) included the shipping costs in the $18 purchase price.

Using perpetual system, the journal entry would be as follows:

[Debit]. Inventory = 970
[Credit]. Cash = 970

And, using periodic system would be:

[Debit]. Freight In = 970
[Credit]. Cash = 970

With a perpetual inventory system, transportation costs are added directly to the inventory balance. With a periodic inventory system, another temporary holding account, Freight In, is created, and transportation costs are accumulated in this account during the period. Like the purchases account, Freight In is closed to Inventory at the end of the period in connection with the computation of cost of goods sold.

 

3. Purchase Returns

With a perpetual system, the return of unsatisfactory merchandise to the supplier results in a decrease in Inventory. In addition, since no payment will have to be made for the returned merchandise, Accounts Payable is reduced by the same amount. With a periodic system, the amount of the returned merchandise is recorded in yet another temporary holding account called Purchase Returns. Purchase Returns is a contra account to Purchases and is also closed to Inventory as part of the computation of cost of goods sold.

For example, Lie Dharma Putra Store returned 30 of the shirts (costing $300) to the supplier because they were stained.

Using perpetual system, the journal entry would be as follows:

[Debit]. Accounts Payable = 300
[Credit]. Inventory = 300

And, using periodic system would be:

[Debit]. Accounts Payable = 300
[Credit]. Purchase Returns = 300

If the returned merchandise had already been paid for, the supplier would most likely return the purchase price. In this case, the debit would be to Cash instead of to Accounts Payable.

 

4. Purchase Discounts

Sellers sometimes offer inducements for credit customers to pay quickly. In this example, Lie Dharma Putra Store takes advantage of purchase discounts to save money on the payment for the shirts. The amount of the purchase discount is $194 (=$9,700 x 0.02), so the total payment for the shirts is $9,506 (=$9,700 – $194). The amount recorded for inventory should reflect the actual amount paid to purchase the inventory. With a perpetual inventory system, this is shown by subtracting the purchase discount amount from the inventory account. With a periodic inventory system, another holding account is created to accumulate purchase discounts taken during the period.

For example, Lie Dharma Putra Store paid for the shirt purchase. A 2% discount was given on the $9,700 bill [=(1,000 purchased – 30 returned) x $10] because of payment within the 10-day discount period (payment terms were 2/10, n/30).

Using perpetual system, the journal entry would be as follows:

[Debit]. Accounts Payable = 9,700
[Credit]. Inventory = 194
[Credit]. Cash = 9,506

And, using periodic system would be:

[Debit]. Accounts Payable = 9,700
[Credit]. Purchase Discounts = 194
[Credit]. Cash = 9,506

Next, Lie Dharma Putra Store paid $5,400 for the pants purchase. No discount was allowed because payment was made after the discount period.

Using perpetual system, the journal entry would be as follows:

[Debit]. Accounts Payable = 5,400
[Credit]. Cash = 5,400

And, using periodic system would be:

[Debit]. Accounts Payable = 5,400
[Credit]. Cash = 5,400

Note that the payment for the pants is made after the discount period, so the full amount must be paid. Since this transaction had no impact on Inventory, the entry is the same for both the perpetual and the periodic system.

In terms of journal entries, you should recognize that the difference between a perpetual and a periodic inventory system is that all adjustments to inventory under a perpetual system are entered directly in the inventory account; with a periodic system, all inventory adjustments are accumulated in an array of temporary holding accounts: Purchases, Freight In, Purchase Returns, and Purchase Discounts.

 

5. Sales

Lie Dharma Putra Store sold 600 shirts at a price of $25 each for a total of $15,000.

Using perpetual system, the journal entry would be as follows:

[Debit]. Accounts Receivable = 15,000
[Credit]. Sales (600 x $25) = 15,000
And;
[Debit]. Cost of Goods Sold = 6,000
[Credit]. Inventory (600 x $10) = 6,000

And, using periodic system would be:

[Debit]. Accounts Receivable = 15,000
[Credit]. Sales = 15,000

Next, Lie Dharma Putra Store sold on 200 pairs of pants at a price of $40 each for a total of $8,000.

Using perpetual system, the journal entry would be as follows:

[Debit]. Accounts Receivable = 8,000
[Credit]. Sales (200 x $40) = 8,000
And;
[Debit]. Cost of Goods Sold = 3,600
[Credit]. Inventory (200 x $18) = 3,600

And, using periodic system would be:

[Debit]. Accounts Receivable = 8,000
[Credit]. Sales = 8,000

These entries reflect the primary difference between a perpetual and a periodic inventory system—with a periodic system, no attempt is made to recognize cost of goods sold on a transaction-by-transaction basis. In fact, with a periodic system, Lie Dharma Putra Store would not even know how many shirts and how many pairs of pants had been sold. Instead, only total sales of $23,000 (=$15,000 + $8,000) would be known.

For simplicity, we have recorded the cost of goods sold for the shirts as $10 each. The actual cost per shirt, after adjusting for freight in and purchase discounts, is $10.80, computed as follows:

Total purchase price (1,000 shirts) = $10,000
Plus: Freight in                                          =           970
Less: Purchase returns (30 shirts)    =       (300)
Less: Purchase discounts                      =        (194)
Total cost of shirts (970 shirts)          = $10,476

(Note: Total cost $10,476/970 shirts = $10.80 per shirt)

In practice, it is unlikely that a firm using a perpetual inventory system would bother to adjust unit costs for the effects of freight cost and purchase discounts on an ongoing basis. The cost of doing these calculations could easily outweigh any resulting improvement in the quality of cost information.

 

6. Sales Returns

Dissatisfied customers sometimes return their purchases. For example, Lie Dharma Putra Store accepted return of 50 shirts by some dissatisfied customers.

Using perpetual system, the journal entries to record the return of 50 shirts are as follows:

[Debit]. Sales Returns (50 x $25) = 1,250
[Credit]. Accounts Receivable = 1,250
And;
[Debit]. Inventory (50 x $10) = 500
[Credit]. Cost of Goods Sold = 500

And, using periodic system would be:

[Debit]. Sales Returns = 1,250
[Credit]. Accounts Receivable = 1,250

Under the perpetual system, not only are the sales for the returned items canceled, but the cost of the returned inventory is also removed from Cost of Goods Sold and restored to the inventory account.

 

7. Closing Entries

After all of the journal entries are posted to the ledger of the Lie Dharma Putra Store accounting system, under the perpetual system, balances of Inventory and Cost of Goods Sold balance, would appear as follows:

Inventory
(a) 10,000 [on the debit side]
(b) 5,400 [on the debit side]
(c) 970 [on the debit side]
(d) (300) [on the credit side]
(e) (194) [on the credit side]
(g) (6,000) [on the credit side]
(h) (3,600) [on the credit side]
(i) 500 [on the debit side]
Inventory Balance = $6,776

Cost of Goods Sold
(g) 6,000 [on the debit side]
(h) 3,600 [on the debit side]
(i) (500) [on the credit side]
Cost of Goods Sold Balance = $9,100

These numbers, after being verified by a physical count of the inventory, would be reported in the financial statements—the $6,776 of Inventory in the balance sheet and the $9,100 of Cost of Goods Sold in the income statement.

Review all journal entries under the “periodic inventory system” and notice that none of the amounts have been entered in either Inventory or Cost of Goods Sold. As a result, both of these accounts will have zero balances at year-end. Actually, the inventory account would have the same balance it had at the beginning of the period, which, in this example, we will assume to be zero.

With a periodic inventory system, the correct balances are recorded in Inventory and Cost of Goods Sold through a series of closing entries. Two entries are made:

1. Transfer all the temporary holding accounts to the inventory account balance. At this point, the inventory account balance is equal to the cost of goods available for sale (beginning inventory plus the net cost of purchases for the period).

2. Reduce Inventory by the amount of Cost of Goods Sold. At this point, the inventory account balance is equal to the ending inventory amount, and the appropriate cost of goods sold amount is also recognized.

To illustrate, the information for Lie Dharma Putra Store will be used. The entry to transfer all the temporary holding accounts to the inventory account is as follows:

[Debit]. Inventory = 15,876
[Debit]. Purchase Returns = 300
[Debit]. Purchase Discounts = 194
[Credit]. Freight In = 970
[Credit]. Purchases = 15,400
(Closing of temporary inventory accounts for periodic system)

The inventory debit of $15,876 is the amount of net purchases for the period. Notice that, after this entry has been posted, the balances in all the temporary holding accounts will have been reduced to zero. As mentioned, after the addition of net purchases, the inventory account balance represents cost of goods available for sale (the sum of beginning inventory and net purchases). Remember that, in this example, beginning inventory is assumed to be zero.

The second closing entry involves the adjustment of Inventory to its appropriate ending balance and the creation of the cost of goods sold account. This cost of goods sold account would be closed when other nominal accounts (e.g., Sales Salaries, Interest Expense, etc.) are closed. If the year-end physical count indicates that the ending inventory balance should be $6,776, the appropriate entry is as follows:

[Debit]. Cost of Goods Sold = 9,100
[Credit]. Inventory ($15,876 – $6,776) = 9,100
(Adjustment of inventory account to appropriate ending balance.)

In this example, the values for both ending inventory ($6,776) and cost of goods sold ($9,100) are the same with either a perpetual or a periodic inventory system.

 

So, as a conclusion in term with journal entries, what is the practical difference between the two systems?

  • First, a perpetual system can tell you the inventory balance and the cumulative cost of goods sold at any time during the period. With a periodic system, on the other hand, you must wait until the inventory is counted at the end of the period to compute the amount of inventory or cost of goods sold.
  • Second, with a perpetual system, you can compare the inventory records to the amount of inventory actually on hand and thus determine whether any inventory has been lost or stolen. As described in the next section, this comparison is not possible with a periodic system.

 

In other words: With a perpetual inventory system, the amount of inventory and cost of goods sold for the period are tracked on an ongoing basis. With a periodic inventory system, inventory and cost of goods sold are computed using an end-of-period inventory count. With a periodic system, inventory-related items are recorded in temporary holding accounts that are transferred to the inventory account at the end of the period.