Principles of Financial Accounting: Merchandising Operations - Perpetual vs. Periodic, Inventory Systems

What It Is

A perpetual inventory system is a method of tracking inventory where each item is recorded individually as it is purchased or sold. This system provides a continuous record of inventory levels and is typically used by companies with a large number of items or high inventory turnover. If a company buys $10,000 of inventory, it will record each item individually in the perpetual inventory system.

Key Concepts & Formulas

• Perpetual Inventory System: A method of tracking inventory where each item is recorded individually as it is purchased or sold.
  • Example: A company buys 100 units of Product A for $100 each, totaling $10,000. The perpetual inventory system will record each unit individually.
• Cost of Goods Sold (COGS): The direct cost of producing or purchasing a product.
  • Formula: COGS = Beginning Inventory + Purchases - Ending Inventory
  • Example: If Beginning Inventory is $5,000, Purchases are $10,000, and Ending Inventory is $3,000, COGS would be $12,000.
• Gross Profit: The difference between Sales and COGS.
  • Formula: Gross Profit = Sales - COGS
  • Example: If Sales are $20,000 and COGS is $12,000, Gross Profit would be $8,000.
• Inventory Turnover: A measure of how quickly inventory is sold and replaced.
  • Formula: Inventory Turnover = Cost of Goods Sold / Average Inventory
  • Example: If COGS is $12,000 and Average Inventory is $6,000, Inventory Turnover would be 2.
• Periodic Inventory System: A method of tracking inventory where inventory is recorded at the end of each period.
  • Example: A company buys $10,000 of inventory, but records it all at the end of the period, rather than individually.
• Physical Count: A count of inventory on hand to ensure accuracy.
  • Example: A company conducts a physical count of inventory and finds that it is $1,000 short.

Journal Entry Examples

Perpetual Inventory System

Dr. Inventory, Product A $10,000 Cr. Accounts Payable $10,000

Explanation: The company purchases $10,000 of inventory and records it individually in the perpetual inventory system. The debit to Inventory, Product A increases the asset account, while the credit to Accounts Payable increases the liability account.

Periodic Inventory System

Dr. Inventory $10,000 Cr. Cash $10,000

Explanation: The company purchases $10,000 of inventory, but records it all at the end of the period in the periodic inventory system. The debit to Inventory increases the asset account, while the credit to Cash decreases the asset account.

Common Mistakes

• Mistake: Confusing debits and credits for expense accounts.
  • Correction: Remember that debits increase assets and expenses, while credits increase liabilities and equity.
• Mistake: Not considering the impact of inventory on COGS.
  • Correction: Remember that inventory is a key component of COGS, and changes in inventory levels can affect COGS.
• Mistake: Not conducting a physical count of inventory.
  • Correction: Remember that a physical count of inventory is essential to ensure accuracy and prevent inventory shrinkage.

Exam Tips

• Tip: Be careful when using the perpetual inventory system, as it can be prone to errors if not properly implemented.
• Tip: Remember that the periodic inventory system is typically used by companies with low inventory turnover or few items.
• Tip: Be prepared to calculate COGS and Gross Profit using the formulas above.

Quick Practice

1. A company purchases $5,000 of inventory using the perpetual inventory system. What is the adjusting entry to record the purchase? Dr. Inventory, Product A $5,000 Cr. Accounts Payable $5,000 Explanation: The company records the purchase individually in the perpetual inventory system.

2. A company has Beginning Inventory of $10,000, Purchases of $20,000, and Ending Inventory of $15,000. What is COGS? COGS = Beginning Inventory + Purchases - Ending Inventory = $10,000 + $20,000 - $15,000 = $15,000 Explanation: The company uses the formula to calculate COGS.

3. A company has Sales of $50,000 and COGS of $30,000. What is Gross Profit? Gross Profit = Sales - COGS = $50,000 - $30,000 = $20,000 Explanation: The company uses the formula to calculate Gross Profit.

Last-Minute Cram Sheet

1. Dividends are NOT an expense – they go directly to retained earnings.
2. The perpetual inventory system is typically used by companies with high inventory turnover.
3. COGS = Beginning Inventory + Purchases - Ending Inventory.
4. Gross Profit = Sales - COGS.
5. Inventory Turnover = Cost of Goods Sold / Average Inventory.
6. The periodic inventory system is typically used by companies with low inventory turnover.
7. A physical count of inventory is essential to ensure accuracy and prevent inventory shrinkage.
8. Debits increase assets and expenses, while credits increase liabilities and equity.
9. Inventory is a key component of COGS, and changes in inventory levels can affect COGS.
10. The perpetual inventory system can be prone to errors if not properly implemented.