Perpetual inventory system provides a running balance of cost of goods available for sale and cost of goods sold. Under this system, no purchases account is maintained because inventory account is directly debited with each purchase of merchandise. The expenses that are incurred to obtain merchandise inventory increase the cost of merchandise available for sale. These expenses are, therefore, also debited to inventory account. Examples of such expenses are freight-in and insurances etc. Each time the merchandise is sold, the related cost is transferred from inventory account to cost of goods sold account by debiting cost of goods sold and crediting inventory account.

The balance in inventory account at the end of an accounting period shows the cost of inventory in hand. The accuracy of this balance is assured periodically by a physical count – usually once a year. If a difference is found between the balance in inventory account and a physical count, it is corrected by making a suitable journal entry. The common reasons of the difference are inaccurate record keeping, normal shrinkage, and shoplifting etc.

Both merchandising and manufacturing companies use perpetual inventory system. Merchandising companies use this system to maintain the record of merchandising inventory and manufacturing companies to account for purchase and issue of raw materials.

Traditionally, the perpetual inventory system is used by companies that buy and sell easily identifiable inventories such as jewelery, clothing and appliances etc. but advanced computer softwares has made its use easy for almost all companies.

Journal entries in a perpetual inventory system:

(1). When goods are purchased:

Inventory xxxx
     Accounts payable xxxx

 (2). When expenses such as freight-in, insurance etc. are incurred:

Inventory xxxx
     Cash xxxx

(3). When goods are returned to supplier:

Accounts payable xxxx
     Inventory xxxx

(4). When goods are sold to customers:

Accounts receivable xxxx
     Sales xxxx
Cost of goods sold xxxx
     Inventory xxxx

(5). When goods are returned by customers:

Sales xxxx
     Accounts receivable xxxx
Inventory xxxx
     Accounts receivables xxxx

(6). When a difference between the balance of inventory account and physical count of inventory is found:

Inventory over and short xxxx
     Inventory xxxx

For further explanation of the concept of perpetual inventory system, consider the following example:

Example:

(1). On 1st April 2013, Metro company purchases 15 washing machines at $500 per machine on account. The supplier allows a discount of 5% if payment is made within 10 days of purchase. The Metro company uses net price method to record the purchase of inventory.

The following journal entry would be made in the books of Metro company to record the purchase of merchandise:

Inventory 7,125*
     Accounts payable 7,125*

*Net of discount: ($500 × 15) – ($500 × 15 × 0.05)

(2). On the same day, Metro company pas $320 for freight and $100 for insurance.

The following journal entry would be made to record the payment of freight-in and insurance expenses:

Inventory 420
     Cash 420

(3). On April 07, Metro company returns 5 washing machines to the supplier.

The return of washing machines to the supplier decreases the cost of inventory and accounts payable. The following entry would be made to record this decrease:

Accounts payable 2,375
     Inventory 2,375

 (4). On April 9, Metro sends the payment via online banking system and takes the advantage of the discount offered by the supplier.

As the payment is made within 10 days, the Metro company is entitled to receive discount. The following entry would be made to record the payment:

Accounts payable 4750*
     Cash 4750*

*($7,125 – $2,375)

(5). On April 15, Metro company sells 4 washing machines at 750 per machine. The Metro company does not allow any discount to customers .

The sale of 4 washing machines transfers the cost of inventory from inventory account to cost of goods sold account. Two journal entries would be made; one for the sale of 4 washing machines and one for the transfer of cost from inventory account to cost of goods sold account:

Accounts receivables 3,000
     Sales 3,000
Cost of goods sold 2,028
     Inventory 2,028

To summarize the events of increase and decrease in the cost of inventory, Inventory T-account of Metro company is given below:

perpetual-inventory-t-account