As I mentioned last time, perpetual inventory systems are the most common systems in use today, due to both technology and the advantages that perpetual systems create for inventory control. Other advantages to perpetual systems include the ability to measure profitability during an interim period, without having to take a physical count of the inventory

In a periodic inventory system, purchases are recorded in a separate, purchases account. Returns are recorded in the purchase returns and allowances account. Freight in is added to determine goods available for sale. When inventory is sold, however, no transaction is recorded to reflect the "use", that is the sale of that inventory. The cost of the inventory sold is calculated when ending inventory is counted and a dollar value for the inventory is established. That amount is then subtracted from goods available for sale to determine cost of goods sold, and ultimately gross margin and net income. And, the net income won't be known until that ending inventory is counted! So, if results need to be determined before the end of the fiscal period, then that ending inventory would have to be estimated!

Under a perpetual system, purchases are recorded directly in the merchandise inventory account as debits to that asset account. Returns are recorded as credits to merchandise inventory. When inventory is sold, the sale transaction is recorded, but another transaction is recorded simultaneously to transfer the cost of that inventory to an expense account called cost of goods sold. The result is that the merchandise inventory account is maintained all the time, that is, perpetually. At the end of the accounting period, a physical count of inventory is still taken and is compared to the merchandise inventory general ledger account. The difference between the two is recorded as a debit to inventory shrinkage expense and a credit to merchandise inventory. The perpetual system, therefore, allows the company to monitor how much of the inventory is lost due to theft, breakage, or such.

To illustrate the differences, look at exercise #10A, the TCS Company, page #239. This exercise calls for t account preparation, but instead, I will record them in journal entry form:

First, the journal entries under a periodic inventory system:

November 15	Accounts Receivable	2,600
	Sales		2,600
	(Sold merchandise to Quaker Company, term n/30)

November 20	Sales Returns and Allowances	600
	Accounts Receivable		600
	(Accepted return of merchandise from Quaker Company)

November 25	Cash	2,000
	Accounts Receivable		2,000
	(Received payment on account from Quaker Company)

Now, let's record the same transactions using a perpetual system: (I've italicized the transactions that result from the perpetual system.)

November 15	Accounts Receivable	2,600
	Sales		2,600
	(Sold merchandise to Quaker Company, term n/30)
	*Cost of Goods Sold*	*1,500*
	Merchandise Inventory		*1,500*
	(Transferred cost of merchandise sold to COGS account)

November 20	Sales Returns and Allowances	600
	Accounts Receivable		600
	(Accepted return of merchandise from Quaker Company)
	*Merchandise Inventory*	*350*
	*Cost of Goods Sold*		*350*
	(Transferred cost of merchandise returned to Merchandise Inventory account)

November 25	Cash	2,000
	Accounts Receivable		2,000
	(Received payment on account from Quaker Company)

Under a perpetual system, the merchandiser can compare the balance in cost of goods sold to sales at any time to estimate gross margin. In the example above, the merchandiser can determine that the gross margin on the 15th was $1,100, and that on the 20th, due to the return of merchandise; the gross margin is now $850. Furthermore, the balance in the merchandise inventory account is updated continually. And, that balance in the merchandise inventory account can be compared to an actual count and valuation of that inventory to determine shrinkage expense.

Under a periodic system, the balance in the general ledger account merchandise inventory is always the beginning balance for that fiscal period, and is changed during the closing process at the end of a fiscal period. Cost of goods sold is determined by only by an actual count of inventory, determining a value to apply to the count of goods, and then subtracting that from the sum of beginning inventory and the net cost of purchases. The periodic system is adequate for a merchandiser with high margins and relatively low volume, for instance, a "mom and pop" operation. The perpetual system relies on a more sophisticated information-gathering system, is more expensive to establish, but provides more precise information. The use of bar-code scanners, computers, and similar technology has reduced the costs of establishing and maintaining perpetual inventory systems.

Needles makes a point of distinguishing between the two systems when it comes to income statement presentation, but I don't think there is much of a difference, except perhaps in the presentation of items like freight in and net purchases. The basis statement is still the same, that is:

Sales - Cost of Goods Sold = Gross Margin

The differences between the perpetual and periodic inventory systems lie in the in the journal entries, as well as the way that cost of goods sold is determined, not the end product of the system, the presentation of the income statement.

Clifford