Chapter 6.2® - Types of Merchandising Inventory Systems - Perpetual & Periodic Inventory Systems & Journal Entries for Merchandise Purchases – Perpetual Inventory System

• Part 6.1 - Accounting for Merchandising Activities, Balance Sheet Representation of Inventory, Perpetual & Periodic Inventory Systems & Merchandise Purchases
• Part 6.2 - Types of Merchandising Inventory Systems - Perpetual & Periodic Inventory Systems & Journal Entries for Merchandise Purchases – Perpetual Inventory System
• Part 6.3 - Transfer of Ownership, FOB Shipping & FOB Destination Points - Accounting for Transportation Costs of Merchandise Inventory
• Part 6.4 - Accounting for Merchandise Sales, Sales Discounts, Sales Returns & Allowances & Shrink – Perpetual Inventory System
• Part 6.5 - Sales Returns & Allowances & Shrink (Merchandise Adjusting Journal Entries) - Continued from Accounting for Merchandise Sales– Perpetual Inventory System
• Part 6.6 - Glossary of Merchandise Accounting Terms

i) Perpetual Inventory System

A perpetual inventory system, as the name suggests, gives a continuous record of the amount of inventory on hand. A perpetual inventory system adds up all the merchandise purchases in the Inventory account, and removes them from this account when an item is sold, and transfers it to Cost of Goods sold. Therefore, a merchandise piece sits as Inventory on the balance sheet of Costco when it is not sold. However as soon as it is sold, it is moved from the Inventory account to Cost of goods sold, an expense item on the Income statement. The advantage of using a perpetual inventory system is that at any given point in time, we can see the amount of merchandise inventory on hand without doing any calculations. The perpetual inventory system has become popular due to advancements in computer technology that continually post inventory transactions and keep an updated account. Doing this on paper or by hand using human accountants is impossible, especially for a large company such as Costco Wholesale. Perpetual inventory systems therefore provide more timely information to investors, are currently widely used across all businesses and will be the focus of our tutorials here.

ii) Periodic Inventory System

A periodic inventory system, as the name suggests, provides a periodic balance of the inventory account only at the end of an accounting period such as March 31st, 2009 which is the end of first quarter for most large corporations. Periodic inventory system does not update the inventory account after every transaction. The cost of new purchases of merchandise is recorded in a temporary expense account known as Purchases. When merchandise is sold, revenue is recorded but the cost of the merchandise sold is not yet recorded as cost. When financial statements are prepared at the end of the year, the company takes a physical inventory count of its entire warehouse(s). Each item on this physical inventory count is assigned a cost, and total inventories are tabulated.
Periodic inventory systems were largely used by large hardware, drug & department stores that sold large quantities of low-value items such as shampoo, soap, toothpaste, etc. Without today’s Point of Sale (POS) scanners, computers and cameras, it was not feasible enough for accounting systems to track such small items.

Accounting for Merchandise Purchases – Perpetual Inventory System

i) Purchase of Inventory

Any purchase of merchandise is debited to the Merchandise Inventory account and creates an accounts payable liability or cash payment entry. Consider Binti Kiziwi Corp. records a purchase of $1,500 Sony camera on credit on September 14th, 2009.

ii) Purchase Returns & Allowances

Purchase returns are merchandise received by a buyer but returned to the supplier due to reasons such as incorrect size, color, defective merchandise, etc. This triggers a purchase return and a purchase allowance entry is made to reduce the cost of merchandise purchased. For example, consider the camera bought from Sony was defective but still able to be sold. Here are the set of journal entries made to record the initial purchase of the camera, and the defective return.

Assume on October 9th, 2009, the defective camera is returned to Sony. The journal entry made to record this is:

If this merchandise was bought for cash, then the journal entry will look like:

iii) Purchase Discounts

Merchandise that is bought on credit requires a clear statement of expected amounts & dates of future payments as well as terms of credit. Credit terms are a listing of the amounts & timing of payments between a buyer and a seller, and the discount percent if the payment is made within a certain time period. The equation for setting up the terms is: n/10 = EOM. The EOM means “end of month” and most invoices are due for payment in 30 days, thus making the EOM 30 days. The “n” in this case means the discount percent if the payment is made within 10 days. Thus, the following equation means
2.5/10 = 30 days -> 2.5% discount if invoice is paid within 10 days, otherwise the invoice is due in 30 days.

A seller offering a cash discount when the credit period is long is encouraging the buyer to make prompt payment. The buyer thus views this as a purchase discount. In the eyes of the seller, this is a sales discount. To illustrate these concepts, let’s do a journal entry. Consider Binti Kiziwi Corp. records a purchase of $1,500 Sony camera on credit on September 14th, 2009, for terms of 2/10 n30 days.

Now consider that Binti Kiziwi Corp. takes advantage of this discount offering, and pays the invoice by September 20th, 2009. Here is the journal entry we record in our books: