Perpetual inventory system

Explanation

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 periodically assured 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 such difference include 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 use to account for purchase and issue of direct materials.

Traditionally, the perpetual inventory system is used by companies that buy and sell easily identifiable inventories such as jewelry, clothing and appliances etc. but advanced computer software packages have made its use easy for almost all business situations.

Journal entries in a perpetual inventory system:

(1). When goods are purchased:

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

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(3). When goods are returned to supplier:

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(4). When goods are sold to customers:

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(5). When goods are returned by customers:

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

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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:

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*Net of discount: ($500 × 15) – $25 discount

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

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

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(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:

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 (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:

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*($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:

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*Cost of 4 machines sold:

[($475 × 10 machines) + $420 expenses]/10 = $517 per machine
$517 × 4 machines = $2,068

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

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16 Thoughts on Perpetual inventory system

  1. affan

    Could not understand the COGS entry in the journal entry part in the end.

    1. Accounting For Management

      Hi Affan,

      Out of total 15 units, 5 units have been returned to the vendor. The direct expenses (freight + Insurance) will be apportioned to the remaining 10 units. The inventory cost of 10 units have been calculated as follows:

      Cost of 10 units:
      = (10 × $475) + 420
      = $5,170

      As 4 units are sold, their cost is immediately transferred from inventory account to cost of goods sold account. It is computed as follows:
      = ($5,170/10) × 4
      = $2,068

      Hope this helps.

  2. Shawna L

    How are you getting 2375 for the accounts payable and inventory accounts? If it is a return wouldn’t you do (5*$500) and report those numbers for each?

    So confusing!!!

  3. Accounting For Management

    @Shawna L
    The cost per machine is $500 but we have recorded our purchases using net of discount method i.e., $475 per unit. The same figure will be used to record the returns to supplier i.e., $475 × 5 machines = $2,375.

    I would suggest you to visit the following pages that can be helpful to understand net and gross method of recording purchases.

    http://www.accountingformanagement.org/exercise-5-icm/ – net method
    http://www.accountingformanagement.org/exercise-6-icm/ – gross method

    Hope this helps. 🙂

  4. Gift

    Suppose inventory were donated to a welfare and the perpetual inventory was in use. Will this reduce assets and equity?, I just want to confirm.

  5. Accounting For Management

    Yes, it will reduce both. The accounting entries should be:

    (1)
    Donation – Dr.
    Inventory – Cr.

    and

    (2)
    Income summary – Dr.
    Donation – Cr.

  6. Simphiwe

    if inventory were donated and the periodic inventory control system was in use. what will the effect of the of the transaction be on the accounting period.

  7. mohammed salam

    Would you mind to explain me ,how you got cost of goods sold ,its really confusing..why you are deducting freight and insurance cost after you return the goods ,its obvious that when we return the goods back to supplier ,the supplier will only give back the money we paid for the product ,not the transportation cost .

  8. Accounting For Management

    Cost per unit before including freight and insurance = $475*
    Cost per unit after including freight and insurance = ($475 + 42**) = $517
    Cost of goods sold = 4 × $517 = $2,068

    *500 × 0.95 – net discount
    ** 420/10 – freight and insurance allocated to 10 units, 5 have been returned.

    Hope this helps.

  9. Aykut

    Is everything true here?
    Cuz you at first day you made discount even buyer didn’t pay any cash.
    You must put 7,500 direct. And ‘If’ buyer pays cash in 10 days then you gonna make discount.

  10. tamuka

    how do you treat drawings under perpetual inventory system.the journal entries and tax .

  11. LarryWang

    What is the defination of the perpetual inventory system?

  12. JENNIFER Henson

    Larry, there’s a definition of it on Wikipedia. As I understand it, there are two basic inventory systems – perpetual and periodic.

    Under the perpetual inventory system, the records are updated every time the inventory changes. (Easier with a computer!)

    Under the periodic inventory system, the inventory is checked only periodically – when someone goes to the stockroom, for example, and physically counts how many items are in there. If you count the number of large tins of tomatoes in the stockroom once a month, for example,

    50 = Number of tins in the stockroom at end of April
    30 = Number of tins in the stockroom at end of May

    Subtract May total from April total = 20

    So in May, you sold 20 tins of tomatoes.
    Or maybe you actually sold 18 tins and someone stole 2 tins.

    Under a perpetual inventory system, you’d change the inventory every time a tin of tomatoes was sold (usually with computer software that tracks every sale.)

    30 April – 50 tins in the stockroom
    2 May – 2 tins sold. 48 tins in the stockroom
    5 May – 3 tins sold. 45 tins in the stockroom.
    and so on until the end of May.

  13. Shah shahzad

    if Purchase return is givenin the question then how The ending inventory valuation is calculated in perpetual if any transaction relate to purchase rereturn are post??

  14. MIchael

    The problems and explanations are very helpful. Thank you!

  15. Crystal Mars-Noel

    this has been very helpful , including all of the questions and answers in the previous comments , thank you !

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