What is the difference between the journal entry of purchases in periodic and perpetual inventory system?

Image source: Getty Images

As a child, one of my favorite days of the year was when I would go to work with my dad on a Saturday to count inventory. He managed a box plant, and the massive rolls of paper that would later become boxes needed to be counted for that period’s inventory accounting.

About 10 of us would walk through the warehouse and scan the barcode on each roll. My favorite part, not surprisingly, was when a roll was too high up, and we called over the forklift driver to bring it down to be scanned.

The scanner communicated with a computer in the office, where the accountants reconciled the count with their spreadsheets and worked on the balance sheet for the quarter.

This method, known as the periodic inventory system, is not as prominent as it once was due to technological advances in accounting software. However, it could still be the best method for your business. Read on to learn about periodic inventory and its younger brother, the perpetual inventory system.

What is periodic inventory?

Companies that use periodic accounting do all necessary journal entries and bookkeeping at the end of each accounting period. As part of their period-ending work, they count inventory and then use that number on the balance sheet and to calculate cost of goods sold.

Let’s take a look at how periodic inventory accounting would work:

Beginning and ending inventory as well as purchases are used to calculate cost of goods sold. Image source: Author

Imagine at the end of the first quarter, inventory is $50,000. This figure becomes the beginning inventory for the second quarter. Purchases during the quarter amounted to $18,000, and at the end of the quarter, inventory was counted at $42,000. We can calculate the cost of goods sold using this information.

Start with the total cost of inventory, which is the beginning inventory plus purchases ($50,000 + $18,000 = $68,000). Subtract out the inventory remaining, and you’re left with the cost of inventory that was sold, or cost of goods sold ($68,000 - $42,000 = $26,000).

One advantage of the periodic inventory system is that counting inventory allows you to identify shrinkage (inventory that is lost, stolen, or damaged). Inventory that is only managed on the cloud can more easily disappear and end up being sold out of the back of a truck somewhere.

Keep a budget of expected gross margin each period to compare with the actual margin. Shrinkage will automatically be included in the cost of goods sold, so if the numbers vary by a large amount, it’s time to investigate.

What is perpetual inventory?

Some companies don’t wait until the end of an accounting period to track inventory. Instead, they use the perpetual inventory method. This approach involves an integrated point-of-sale system. Inventory is tracked instantaneously when purchased or when sales are made.

Under the perpetual inventory system, new units are added directly to the inventory account instead of a purchases account, and the cost of goods sold is calculated based on the inventory accounting method used, usually LIFO or FIFO.

Let’s work through an example purchase with this inventory history:

Inventory purchases are added to the inventory account when the purchase is made. Image source: Author

Using proper internal controls, for each purchase, an employee will enter a purchase order into the accounting software that is then approved by a manager. When the inventory is received, along with the invoice from the vendor, payment is approved, and the cash and inventory accounts are updated accordingly.

At the time of sale, two journal entries would be made: one to recognize the sale, and one to move the inventory to cost of goods sold:

Cash and revenue are increased and inventory is decreased by the cost of goods sold following a sale. Image source: Author

Cash and revenue both increase to recognize the sale. Cost of goods sold is calculated using the FIFO method, and inventory is decreased by that amount. The 10 units from June 1 and four of the June 5 units are included ((10 x $10) + (4 x $10.12)).

Periodic inventory vs. perpetual inventory: What's the difference?

The key difference between periodic and perpetual accounting is timing. Periodic inventory is done at the end of a period to create financial statements. Perpetual inventory is done as sales and inventory purchases happen.

Look back at the examples above. In the periodic section, we used a separate purchases account to track new inventory coming during the period, and then we used that account in a formula to calculate cost of goods sold.

The purchases account is closed at the end of the period with a closing journal entry that moves the balance into inventory.

With perpetual assets, there is no purchases account. When new inventory is purchased, it goes directly into the inventory account, and there is no closing entry. Cost of goods sold is increased, and inventory is decreased the instant that inventory is sold.

Using perpetual inventory, you’re able to track and manage inventory as transactions happen, buying more inventory when necessary and zeroing in on the best prices.

Perpetual vs. periodic: How to select the right method for your business

It’s easy to see why periodic inventory would be cumbersome for big businesses. It would not be cost effective for Amazon.com to count every Kindle, James Patterson book, or even jumbo pack of toilet paper in its warehouses once a month to calculate inventory.

It also wouldn’t make sense for small businesses that sell their inventory as a side project to use perpetual inventory. An appliance repair company selling two or three used refrigerators per month has no need to invest in an expensive point-of-sale system.

Most businesses are somewhere between these two extremes. If inventory is a key component of your business, and you need to manage it daily or weekly to make new orders and keep up with demand, use perpetual inventory accounting.

If you don’t need that sort of timeliness and can take the time each month to count inventory, go with periodic.

The decision is not black and white. Businesses that account for inventory periodically likely use the FIFO method to sell older units first. Retailers that use the perpetual system often make it a practice to count inventory (or at least a sample of inventory) to make adjustments for shrinkage.

At my father's box plant, inventory was counted twice a year. When I worked at a restaurant in high school, key items were counted every single night.

Measure what matters

Management pioneer Andy Grove made Intel into one of the leading tech companies for decades with a philosophy based on objectives and key results, or OKRs. You must have clear goals with results that are measurable.

Objectives are big-picture goals, such as "create a diverse and sustainable product line."

Key results are the tangible indicators that the objective has been achieved, such as: three or more product lines with over $10,000 in sales, average growth of more than 5% per product line, and at least two new product lines introduced.

If inventory is central to your business, it must be managed, and to do that it, must be measured. This can only be done with the perpetual inventory method.

If you have a service business that sells a few items on the side, use the periodic method so you can focus on measuring what matters.

Cash back, travel rewards, 0% intro APR financing: all of these can be great credit card perks for business owners. But how do you find the right business credit card for you? There are tons of offers on the market today, and sifting through them to find the right one can be a big hassle. So we've done the hard work for you.

Get started with one of our top business credit card picks of 2022 today.

[latex][/latex]

There are two ways in which a company may account for their inventory. They can use a perpetual or periodic inventory system. Let’s look at the characteristics of these two systems.

A perpetual inventory system automatically updates and records the inventory account every time a sale, or purchase of inventory, occurs. You can consider this “recording as you go.” The recognition of each sale or purchase happens immediately upon sale or purchase.

A periodic inventory system updates and records the inventory account at certain, scheduled times at the end of an operating cycle. The update and recognition could occur at the end of the month, quarter, and year. There is a gap between the sale or purchase of inventory and when the inventory activity is recognized.

Generally Accepted Accounting Principles (GAAP) do not state a required inventory system, but the periodic inventory system uses a Purchases account to meet the requirements for recognition under GAAP. IFRS requirements are very similar. The main difference is that assets are valued at net realizable value and can be increased or decreased as values change. Under GAAP, once values are reduced they cannot be increased again.

Figure 2.22 Inventory Systems By: Marcin Wichary Source: Flickr CC BY 2.0

There are some key differences between perpetual and periodic inventory systems. When a company uses the perpetual inventory system and makes a purchase, they will automatically update the Merchandise Inventory account. Under a periodic inventory system, Purchases will be updated, while Merchandise Inventory will remain unchanged until the company counts and verifies its inventory balance. This count and verification typically occur at the end of the annual accounting period, which is often on December 31 of the year. The Merchandise Inventory account balance is reported on the balance sheet while the Purchases account is reported on the Income Statement when using the periodic inventory method. The Cost of Goods Sold is reported on the Income Statement under the perpetual inventory method.

Figure 2.23 By: Rice University Source: Openstax CC BY SA 2.0

A purchase return or allowance under perpetual inventory systems updates Merchandise Inventory for any decreased cost. Under periodic inventory systems, a temporary account, Purchase Returns and Allowances, is updated. Purchase Returns and Allowances is a contra account and is used to reduce Purchases.

Figure 2.24 By: Rice University Source: Openstax CC BY SA 2.0

When a purchase discount is applied under a perpetual inventory system, Merchandise Inventory decreases for the discount amount. Under a periodic inventory system, Purchase Discounts (a temporary, contra account), increases for the discount amount and Merchandise Inventory remains unchanged.

Figure 2.25 By: Rice University Source: Openstax CC BY SA 2.0

When a sale occurs under perpetual inventory systems, two entries are required: one to recognize the sale, and the other to recognize the cost of sale. For the cost of sale, Merchandise Inventory and Cost of Goods Sold are updated. Under periodic inventory systems, this cost of sale entry does not exist. The recognition of merchandise cost only occurs at the end of the period when adjustments are made and temporary accounts are closed.

Figure 2.26 By: Rice University Source: Openstax CC BY SA 2.0

When a sales return occurs, perpetual inventory systems require recognition of the inventory’s condition. This means a decrease to COGS and an increase to Merchandise Inventory. Under periodic inventory systems, only the sales return is recognized, but not the inventory condition entry.

Figure 2.27 By: Rice University Source: Openstax CC BY SA 2.0

A sales allowance and sales discount follow the same recording formats for either perpetual or periodic inventory systems.

Figure 2.28 By: Rice University Source: Openstax CC BY SA 2.0

You have already explored adjusting entries and the closing process in prior discussions, but merchandising activities require additional adjusting and closing entries to inventory, sales discounts, returns, and allowances. Here, we’ll briefly discuss these additional closing entries and adjustments as they relate to the perpetual inventory system.

At the end of the period, a perpetual inventory system will have the Merchandise Inventory account up-to-date; the only thing left to do is to compare a physical count of inventory to what is on the books. A physical inventory count requires companies to do a manual “stock-check” of inventory to make sure what they have recorded on the books matches what they physically have in stock. Differences could occur due to mismanagement, shrinkage, damage, or outdated merchandise. Shrinkage is a term used when inventory or other assets disappear without an identifiable reason, such as theft. For a perpetual inventory system, the adjusting entry to show this difference follows. This example assumes that the merchandise inventory is overstated in the accounting records and needs to be adjusted downward to reflect the actual value on hand.

Figure 2.29 By: Rice University Source: Openstax CC BY SA 2.0

If a physical count determines that merchandise inventory is understated in the accounting records, Merchandise Inventory would need to be increased with a debit entry and the COGS would be reduced with a credit entry. The adjusting entry is:

Figure 2.30 By: Rice University Source: Openstax CC BY SA 2.0

To sum up the potential adjustment process, after the merchandise inventory has been verified with a physical count, its book value is adjusted upward or downward to reflect the actual inventory on hand, with an accompanying adjustment to the COGS.

Not only must an adjustment to Merchandise Inventory occur at the end of a period, but closure of temporary merchandising accounts to prepare them for the next period is required. Temporary accounts requiring closure are Sales, Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold. Sales will close with the temporary credit balance accounts to Income Summary.

Figure 2.31 By: Rice University Source: Openstax CC BY SA 2.0

Sales Discounts, Sales Returns and Allowances, and Cost of Goods Sold will close with the temporary debit balance accounts to Income Summary.

Figure 2.32 By: Rice University Source: Openstax CC BY SA 2.0

Note that for a periodic inventory system, the end of the period adjustments require an update to COGS. To determine the value of Cost of Goods Sold, the business will have to look at the beginning inventory balance, purchases, purchase returns and allowances, discounts, and the ending inventory balance.

The formula to compute COGS is:

\[\text{Cost of Goods Sold}=\text {Beginning Inventory}+\text {Net Purchases}-\text {Ending Inventory}\]

where:

\[\text{Net Purchases}=\text{(Gross) Purchases}-\text{Purchase Discounts}-\text{Purchase Returns and Allowances}\]

Once the COGS balance has been established, an adjustment is made to Merchandise Inventory and COGS, and COGS is closed to prepare for the next period.

Table 2.1 summarizes the differences between the perpetual and periodic inventory systems.

Table 2.1 Perpetual and Periodic Transaction Comparison: There are several differences in account recognition between the perpetual and periodic inventory systems. By: Rice University Openstax CC BY NC SA 4.0

Transaction	Perpetual Inventory System	Periodic Inventory System
Purchase of Inventory	Record cost to Inventory account	Record cost to Purchases account
Purchase Return or Allowance	Record to update Inventory	Record to Purchase Returns and Allowances
Purchase Discount	Record to update Inventory	Record to Purchase Discounts
Sale of Merchandise	Record two entries: one for sale and one for cost of sale	Record one entry for the sale
Sales Return	Record two entries: one for sales return, one for cost of inventory returned	Record one entry: sales return, cost not recognized
Sales Allowance	Same under both systems	Same under both systems
Sales Discount	Same under both systems	Same under both systems

There are advantages and disadvantages to both the perpetual and periodic inventory systems.

Advancements in point-of-sale (POS) systems have simplified the once tedious task of inventory management. POS systems connect with inventory management programs to make real-time data available to help streamline business operations. The cost of inventory management decreases with this connection tool, allowing all businesses to stay current with technology without “breaking the bank.”

One such POS system is Square. Square accepts many payment types and updates accounting records every time a sale occurs through a cloud-based application. Square, Inc. has expanded their product offerings to include Square for Retail POS. This enhanced product allows businesses to connect sales and inventory costs immediately. A business can easily create purchase orders, develop reports for cost of goods sold, manage inventory stock, and update discounts, returns, and allowances. With this application, customers have payment flexibility, and businesses can make present decisions to positively affect growth.

The perpetual inventory system gives real-time updates and keeps a constant flow of inventory information available for decision-makers. With advancements in point-of-sale technologies, inventory is updated automatically and transferred into the company’s accounting system. This allows managers to make decisions as it relates to inventory purchases, stocking, and sales. The information can be more robust, with exact purchase costs, sales prices, and dates known. Although a periodic physical count of inventory is still required, a perpetual inventory system may reduce the number of times physical counts are needed.

The biggest disadvantages of using the perpetual inventory systems arise from the resource constraints for cost and time. It is costly to keep an automatic inventory system up-to-date. This may prohibit smaller or less established companies from investing in the required technologies. The time commitment to train and retrain staff to update inventory is considerable. In addition, since there are fewer physical counts of inventory, the figures recorded in the system may be drastically different from inventory levels in the actual warehouse. A company may not have correct inventory stock and could make financial decisions based on incorrect data.

The periodic inventory system is often less expensive and time consuming than perpetual inventory systems. This is because there is no constant maintenance of inventory records or training and retraining of employees to upkeep the system. The complexity of the system makes it difficult to identify the cost justification associated with the inventory function.

While both the periodic and perpetual inventory systems require a physical count of inventory, periodic inventorying requires more physical counts to be conducted. This updates the inventory account more frequently to record exact costs. Knowing the exact costs earlier in an accounting cycle can help a company stay on budget and control costs.

However, the need for frequent physical counts of inventory can suspend business operations each time this is done. There are more chances for shrinkage, damaged, or obsolete merchandise because inventory is not constantly monitored. Since there is no constant monitoring, it may be more difficult to make in-the-moment business decisions about inventory needs.

While each inventory system has its own advantages and disadvantages, the more popular system is the perpetual inventory system. The ability to have real-time data to make decisions, the constant update to inventory, and the integration to point-of-sale systems, outweigh the cost and time investments needed to maintain the system.