Perpetual Inventory System LO8-1 Continually adjusted for each change in inventory Caused by: A purchase A sale, or A return of merchandise by the company to its supplier Cost of goods sold account is adjusted each time goods are sold or are returned by a customer Designed to track inventory quantities from their acquisition to their sale Allows management to: Determine goods on hand on any date Determine the number of items sold during a period An important objective in inventory accounting is to match the appropriate cost of goods sold with sales revenue. The inventory amount in the balance sheet at the end of an accounting period represents the cost of the inventory still on hand, and cost of goods sold in the income statement represents the cost of the inventory sold during the period. The historical cost principle and the desire to match expenses with revenues offers guidance for measuring inventory and cost of goods sold, but it’s usually difficult to measure inventory (cost of goods sold) at the exact cost of the actual physical quantities on hand (sold). Two accounting systems are used to record transactions involving inventory: the perpetual inventory system and the periodic inventory system. A perpetual inventory system continuously records both changes in inventory quantity and inventory cost. The system is aptly termed perpetual because the account inventory is continually adjusted for each change in inventory, whether it’s caused by a purchase, a sale, or a return of merchandise by the company to its supplier. The cost of goods sold account, along with the inventory account, is adjusted each time goods are sold or are returned by a customer. If the system is accurate, it allows management to determine how many goods are on hand on any date without having to take a physical count. However, physical counts of inventory usually are made anyway, either at the end of the fiscal year or on a sample basis throughout the year, to verify that the perpetual system is correctly tracking quantities. Differences between the quantity of inventory determined by the physical count and the quantity of inventory according to the perpetual system could be caused by system errors, theft, breakage, or spoilage. In addition to keeping up with inventory, a perpetual system also directly determines how many items are sold during a period. When a company uses a perpetual inventory system to record inventory and cost of goods sold transactions, merchandise cost data also is included in the system. That way, when merchandise is purchased/sold, the system records not only the addition/reduction in inventory quantity but also the addition/reduction in the cost of the inventory.

Illustration: Perpetual Inventory System LO8-1 The Lothridge Wholesale Beverage Company purchases soft drinks from producers and then sells them to retailers. The company begins 2016 with merchandise inventory of $120,000 on hand. During 2016 additional merchandise is purchased on account at a cost of $600,000. Sales for the year, all on account, totaled $820,000. The cost of the soft drinks sold is $540,000. Lothridge uses the perpetual inventory system to keep track of both inventory quantities and inventory costs. The system indicates that the cost of inventory on hand at the end of the year is $180,000. Journal Entry-2016 Debit Credit First, we record the purchase of merchandise inventory for 2016 with a debit to the inventory account for $600,000 and credit to accounts payable for the same amount because the purchase is made on account. Illustration 8-3 Inventory 600,000 Accounts payable 600,000

Illustration: Perpetual Inventory System (continued) LO8-1 The Lothridge Wholesale Beverage Company purchases soft drinks from producers and then sells them to retailers. The company begins 2016 with merchandise inventory of $120,000 on hand. During 2016 additional merchandise is purchased on account at a cost of $600,000. Sales for the year, all on account, totaled $820,000. The cost of the soft drinks sold is $540,000. Lothridge uses the perpetual inventory system to keep track of both inventory quantities and inventory costs. The system indicates that the cost of inventory on hand at the end of the year is $180,000. Journal Entry-2016 Debit Credit Next, we record sales for 2016. The sales were made on account, so we debit accounts receivable for $820,000 and credit sales revenue for the same amount. Finally, we record the cost of sales sold with a debit to cost of goods sold for $540,000 and a credit to inventory for the same amount. Illustration 8-3 Accounts receivable 820,000 Sales revenue 820,000 Cost of goods sold 540,000 Inventory 540,000

Periodic Inventory System LO8-1 Adjusts inventory and records cost of goods sold only at the end of each reporting period Records merchandise purchases, purchase returns, purchase discounts, and freight-in in temporary accounts Determines period’s cost of goods sold by combining temporary accounts with the inventory account: A periodic inventory system is not designed to track either the quantity or cost of merchandise. The merchandise inventory account balance is not adjusted as purchases and sales are made but only periodically at the end of a reporting period. A physical count of the period’s ending inventory is made and costs are assigned to the quantities determined. Merchandise purchases, purchase returns, purchase discounts, and freight-in (purchases plus freight-in less returns and discounts equals net purchases) are recorded in temporary accounts and the period’s cost of goods sold is determined at the end of the period by combining the temporary accounts with the inventory account: Beginning inventory + Net purchases - Ending inventory = Cost of goods sold Cost of goods sold Beginning inventory Net purchases Ending inventory = + –

Illustration: Periodic Inventory System LO8-1 The Lothridge Wholesale Beverage Company purchases soft drinks from producers and then sells them to retailers. The company begins 2016 with merchandise inventory of $120,000 on hand. During 2016, additional merchandise was purchased on account at a cost of $600,000. Sales for the year, all on account, totaled $820,000. Lothridge uses a periodic inventory system. A physical count determined the cost of inventory at the end of the year to be $180,000. First, we record purchases made during the year by debiting purchases for $600,000 and crediting accounts payable for the same amount, as the purchases were made on account. Illustration 8-4 Journal Entry-2016 Debit Credit Inventory 600,000 Accounts payable 600,000

Illustration: Periodic Inventory System (continued) LO8-1 The Lothridge Wholesale Beverage Company purchases soft drinks from producers and then sells them to retailers. The company begins 2016 with merchandise inventory of $120,000 on hand. During 2016, additional merchandise was purchased on account at a cost of $600,000. Sales for the year, all on account, totaled $820,000. Lothridge uses a periodic inventory system. A physical count determined the cost of inventory at the end of the year to be $180,000. Journal Entry-2016 Debit Credit Next, an entry is made to record sales on account. No entry is recorded for the cost of inventory sold. Illustration 8-4 Accounts receivable 820,000 Sales revenue 820,000 No entry is recorded for the cost of inventory sold.

Illustration: Cost of Goods Sold LO8-1 The Lothridge Wholesale Beverage Company purchases soft drinks from producers and then sells them to retailers. The company begins 2016 with merchandise inventory of $120,000 on hand. During 2016, additional merchandise was purchased on account at a cost of $600,000. Sales for the year, all on account, totaled $820,000. Lothridge uses a periodic inventory system. A physical count determined the cost of inventory at the end of the year to be $180,000. Beginning inventory Net purchases Ending inventory Cost of goods sold + – = Because cost of goods sold isn’t determined automatically and continually by the periodic system, it must be determined indirectly after a physical inventory count. Illustration 8-4 Beginning inventory $120,000 Plus: Purchases 600,000 Cost of goods available for sale 720,000 Less: Ending inventory (180,000) Cost of goods sold $540,000

Illustration: Cost of Goods Sold (continued) LO8-1 Beginning inventory $120,000 Plus: Purchases 600,000 Cost of goods available for sale 720,000 Less: Ending inventory (180,000) Cost of goods sold $540,000 Journal Entry-December 31, 2016 Debit Credit This journal entry combines the components of cost of goods sold into a single expense account and updates the balance in the inventory account. It adjusts the inventory account to the correct period-end amount, closes the temporary purchases account, and records the residual as cost of goods sold. Illustration 8-4 Cost of goods sold 540,000 Inventory (ending) 180,000 Inventory (beginning) 120,000 Purchases 600,000

Concept Check √ The Golson Company uses the periodic inventory system. Information for 2016 is as follows: Sales $1,325,000 Beginning inventory 340,000 Purchases 600,000 Purchase returns 6,000 Ending inventory 370,000 Golson's cost of goods sold for 2016 is: a. $761,000. b. $594,000. c. $570,000. d. $564,000. $340,000 (beginning inventory) + $600,000 (purchases) - $6,000 (purchase returns) - $370,000 (ending inventory) = $564,000

Illustration: Inventory Transactions—Perpetual and Periodic Systems (continued) LO8-3 $ in 000s Perpetual System Periodic System Purchases Inventory 588 Accounts payable Freight 16 Freight-in Cash Returns 20 Purchase returns Sales Accounts receivable 830 Sales revenue Cost of goods sold 550 No entry Purchases are recorded by debiting inventory and credit accounts payable under the perpetual system for the net price of $588,000 ($600, 000 x 98%)and by debiting purchases instead of inventory under the periodic system. Next, we record freight charges. For this, we debit inventory under the perpetual system and freight-in under the periodic system and credit cash in both the cases for $16,000. Then, we record purchase returns by debiting accounts payable under both systems and crediting inventory under perpetual system and purchase returns under the periodic system, for $20,000. Then, we record sales for the year by debiting accounts receivable and crediting sales revenue under both systems for $830,000. We also record cost of goods sold under the perpetual inventory system by debiting cost of goods sold and crediting inventory for $550,000. There is no entry under the periodic inventory system to record cost of goods sold. Under the periodic system, we record cost of goods sold at the end of the period. Illustration 8-6

Supporting Schedule: Cost of goods sold Illustration: Inventory Transactions—Perpetual and Periodic Systems (continued) LO8-3 $ in 000s Perpetual System Periodic System End of the period No entry Cost of goods sold 550 Inventory (ending) 154 Purchase returns 20 Inventory (beginning) 120 Purchases 588 Freight-in 16 Before recording cost of goods sold under the periodic inventory system we determine cost of goods sold using the cost of goods sold equation. We add the beginning inventory ($120,000) and net purchases ($584,000) to get the cost of goods available for sale. Net purchases are determined by deducting purchase returns ($20,000) and adding freight-in ($16,000). Then, we deduct the ending inventory($154,000) from the cost of goods available to get the cost of goods sold of $550,000. Then, we close all the temporary accounts cost of goods sold by debiting cost of goods sold for $550,000, ending inventory for $154,000 and purchase returns for $20,000. Then we credit beginning inventory for $120,000, purchases for $588,000 and freight-in for $16,000. Illustration 8-6 Supporting Schedule: Cost of goods sold Beginning inventory $120,000 Plus: Net Purchases ($588–20+16) 584,000 Cost of goods available 704,000 Less: Ending inventory (154,000) Cost of goods sold $550,000