Perpetual Inventory System

A perpetual inventory system is a method of accounting for inventory in which the inventory records are updated continuously, every time goods are bought, sold, returned or moved. Each purchase is debited directly to the inventory account, and each sale triggers two entries: one recording the revenue and one transferring the cost of the goods from inventory to cost of goods sold. At any moment, the books show how many units should be on hand and what they cost.

Perpetual systems are now the norm for most retailers, wholesalers and manufacturers, made practical by barcode scanners, point of sale terminals and inventory management software. The alternative is the periodic inventory system, which determines inventory and cost of goods sold only by counting stock at the end of each period.

• Purchases: inventory is debited and accounts payable or cash is credited for the cost of the goods, including freight-in.
• Purchase returns and discounts: inventory is credited directly, reducing its recorded cost.
• Sales: accounts receivable or cash is debited and sales revenue credited; at the same time, cost of goods sold is debited and inventory credited for the cost of the units sold.
• Sales returns: the revenue entry is reversed and, if the goods can be resold, their cost is moved back from cost of goods sold to inventory.

The cost assigned to each sale depends on the cost flow method, such as first-in, first-out (FIFO), moving weighted average or last-in, first-out (LIFO), applied at the time of each sale.

An electronics store holds 20 headphones at $50 each. On 3 March it buys 30 more at $56. On 10 March it sells 35 units at $90. Using FIFO, the cost of the 35 units sold is 20 times $50 plus 15 times $56, or $1,840. The store records:

• 3 March: debit inventory $1,680; credit accounts payable $1,680.
• 10 March: debit cash $3,150; credit sales $3,150. Debit cost of goods sold $1,840; credit inventory $1,840.

The inventory record now shows 15 units at $56, a balance of $840. Gross profit on the sale is $3,150 minus $1,840, or $1,310. If a count at month end finds only 14 units, the missing unit is inventory shrinkage of $56, recorded by debiting an inventory shrinkage or cost of goods sold account and crediting inventory. The shrinkage percentage, a key retail measure, is:

Here $\text{Book inventory}$ is the value per the perpetual records and $\text{Counted inventory}$ is the value found on the shelves. In the example, the rate is $56 divided by $840, or about 6.7 percent, high enough to prompt an investigation.

The perpetual system gives managers current information for reordering, pricing and preparing monthly financial statements without a full count. It allows shrinkage to be measured separately, improving control over theft and errors, and supports automatic replenishment and analysis of fast- and slow-moving lines. Its drawbacks are the cost of systems and the need for accurate recording: a scanning mistake or an unrecorded transfer creates differences between the books and the shelves.

For that reason, a perpetual system does not eliminate counting. Businesses still carry out annual physical counts or rolling cycle counting, and auditors observe counts to confirm that recorded quantities exist. Under the LIFO and weighted average methods, a perpetual system can produce different cost of goods sold from a periodic system, because the cost flow assumption is applied at each sale rather than once at period end. Companies using LIFO for tax often compute it on a periodic basis even while tracking quantities perpetually, and must also observe the inventory conformity rule.