Perpetual Inventory - Purchases: Videos & Practice Problems

In a perpetual inventory system, purchases increase the inventory account and create a corresponding accounts payable. For example, if a company buys 500 units at $5 each, inventory increases by $2,500, and accounts payable also increases by $2,500. If goods are returned, inventory decreases, and accounts payable is adjusted accordingly. A purchase allowance occurs when the company retains goods but negotiates a lower price, requiring a decrease in both inventory and accounts payable to reflect the new value. Understanding these transactions is crucial for accurate financial reporting and maintaining the accounting equation.

Perpetual Inventory:Purchases

Alright, so let's go a little more in detail about purchasing in a perpetual inventory system. One thing I want to note quickly, we're going to have a deep discussion about the perpetual inventory system, and then we're going to have a very similar discussion about periodic inventory, and books like to cover both of them. I have separate lessons that are very similar so you can compare and contrast between the two. And then, of course, some are only periodic, and then I'm not sure why you would be watching this video if you're only studying periodic. Anyway, let's go ahead and dive into the perpetual here. So, we're going to dive into purchases and we're going to think about a merchandising company that generally purchases goods in bulk, right? They're going to buy a bunch of goods in a big bulk to save money and then sell them to customers individually. They'll break up these bulk purchases and sell them to the customers in smaller amounts. That's a standard business model, but we have to remember that when we're talking about inventory, we're only considering that one product that we're in the business to sell. So for a T-shirt company, our inventory is going to have T-shirts, right? There's not going to be computers, equipment, or machines in our inventory. None of that's going to be inventory. The only thing that's inventory is the merchandise that we're selling. So notice that companies are going to purchase many different things. The goods they acquire for resale, like that T-shirt company, well, that's going to go into inventory. But what if they're buying things like pens, paper, staplers, office supplies? Those are going to go into our supplies category. Notice the difference there between the supplies and the inventory. Supplies are what gets used around the office, while inventory is what we're actually selling. And a copy machine, for instance, if we buy a copy machine, that would be considered machinery or equipment, something like that, some sort of long-term asset. We can make all sorts of purchases, but the purchases we're focused on now are these inventory purchases. So let's see how this works. When the company purchases goods, we debit the inventory account. We're going to increase our inventory for the goods that they purchase. Let's look at this example: TOS company purchased 500 units of things on account at a price of 5 dollars per thing. So we have a price that they paid, how many they bought, and how they bought it. Let's go into the details here.

They bought 500 units times $5 each, right? Each one cost $5, so they spent $2,500. $2,500 is the value of the goods that they bought. So, that's what's going to go into the inventory. We're going to increase our inventory with a debit for that $2,500 of stuff they bought. And notice this has nothing to do with selling it yet; this is just purchasing it. We haven't sold anything yet. So inventory is going up by $2,500, and they told us we bought it on account. So, when we buy something on account, we're not paying cash, right? We're giving them an IOU. So what's going to be our credit in this journal entry? Well, it's not going to be accounts receivable, right? Accounts receivable relates to things we're supposed to receive, but this is something we're going to pay, right? This is an accounts payable. It's an IOU we gave to the other company. So we're going to credit our accounts payable to increase that liability. I'm going to put AP; it's a very common acronym for accounts payable that we use and we're going to credit that the $2,500, right? Because that's the amount that we owe to our supplier. So in this example, we saw that the inventory went up by $2,500 and the liabilities, right? We owe money. This went up by $2,500 and there was no effect on our equity. So there you go, our balance our equation stays balanced. The assets went up and the liabilities went up by the same amount, so we're good here. Alright? Let's pause and in the next video, we'll discuss purchase returns. Let's do that now.

Perpetual Inventory:Purchase Returns

Alright, so let's continue here at the top of the screen. If the company returns the goods to the supplier for a refund, so now this is a situation where we bought goods and we're not so satisfied we want to return it to the supplier, right? This is called a purchase return, okay? And when we're in a perpetual inventory account, okay? So let's see what happens. TOS company returned 100 units of things to its supplier. So up above, we saw that they bought those things at $5 per thing and now they're returning 100 of them, right? So this is going to be 100 times the $5 price. There's a value of $500 that we're returning to the supplier, right? So we're returning these 100 units. So we don't have these units, right? We're going to have to get rid of them from our inventory because they were previously in our inventory and now we have to get rid of them. Okay? So we're going to have a credit to our inventory to lower the inventory and we're going to have a debit to our accounts payable, right? Because we debit the accounts payable because we don't owe this money anymore, right? In our first example, we said we were going to owe them 2,500 for the 500 units. Well, we don't have 500 units anymore, we only have 400 that we need to pay for, right? So we need to lower it by that 500. So this $500 right here is a debit to accounts payable, which is lowering the amount that we, in essence, owe to the supplier now and we're crediting inventory, right? Because we at first said we were going to have these 500 units in inventory, but we're selling back or we're giving back 100, so there's only going to be 400 units in our inventory. So we're crediting this $500 value, right? This is the value of those 100 units, it's not 500 units, it's $500 value of 100 units. Okay? So that would be the entry to record this purchase return. We're decreasing our inventory, decreasing the payable. Right, so in the first example we had our inventory go up 2,500, our accounts payable up 2,500, well now we return some of it, so our inventory is going down by the 500 of what we return and our liabilities, we no longer owe 2,500 to them, we only owe 2,000 so we're going to lower that by 500. Notice, so if we net these 2 entries, the one above and this one, we're going to see that there's $2,000 worth of value in our inventory and that's the 400 units that we still have. We still have 400, right? We gave back 100, we started with 500. So that's that $2,000 value, the 2,500 inventory from the first entry minus the 500 return. Same thing with the accounts payable, right? We were originally going to pay them for the 500 units, well now we only owe for 400. Cool? Alright, so let's pause here, and then in the next video, let's talk about purchase allowances, alright? Let's do that now.

Perpetual Inventory:Purchase Allowance

Alright now let's try this with the purchase allowance. A purchase allowance is where we're going to keep the goods; we're not going to return them to the supplier but we are going to get a better price, right? Maybe they were low quality goods and we want a better price. So let's check out the example:

TOS ordered 500 things on account at $5 per thing. When low quality things arrived, the supplier agreed to lower the price to $2 per thing. Okay? So instead of paying $5 per thing, we're now going to pay $2 per thing. So we would still be making that first entry just like we did above, when we bought the 500 things we would have made some sort of entry like inventory and accounts payable. We would debit inventory and credit accounts payable, and that was for the 500 things at $5 which would have made an entry to increase our inventory to $2,500 and we would owe our supplier $2,500, right? That's the credit to accounts payable. But now our supplier said, "Okay, they are low quality things so I am going to give you a discount down to $2." So we need to lower the value of our inventory. Our inventory should be valued at $1,000, which is 500 times $2. Right now, our inventory is valued at $2,500. So we need to decrease inventory by $1,500, right? Because it's at $2,500 and we want to get to $1,000. So we're going to make a second entry here for the purchase allowance where we are going to debit our accounts payable, right? Because we're no longer going to owe them so much money; we're only going to owe them $1,000 at this lower price. So we have to debit accounts payable by $1,500 and credit inventory by $1,500. By making this second entry, it's bringing our inventory down to the $1,000 value which is for the 500 things at $2 per, and our accounts payable down to the $1,000 value, the amount that we owe to our supplier, right?

So we saw that our inventory went up by $2,500, right? But then our inventory in the second entry went down by $1,500 and that gets us to the inventory balance of $1,000. The same thing is happening with the liabilities where accounts payable went up by $2,500 in the first entry and then down by $1,500 to our correct amount of $1,000 at the new price of $2. Cool? So that's a purchase allowance. Notice that in a purchase it's because of some situation where we're still going to keep the goods, but we want a better price for the goods.

Alright? So let's go ahead and pause here and then move on to the next video.

Here’s what students ask on this topic:

What is a perpetual inventory system and how does it work?

A perpetual inventory system continuously updates inventory records for every purchase and sale. When a company buys goods, it debits the inventory account and credits accounts payable. For example, if a company purchases 500 units at $5 each, the inventory account increases by $2,500, and accounts payable also increases by $2,500. This system provides real-time inventory levels, helping businesses manage stock more efficiently and maintain accurate financial records.

How are purchase returns recorded in a perpetual inventory system?

In a perpetual inventory system, purchase returns are recorded by decreasing the inventory account and adjusting accounts payable. For instance, if a company returns 100 units purchased at $5 each, the inventory account is credited by $500, and accounts payable is debited by $500. This reflects the reduction in inventory and the amount owed to the supplier, ensuring accurate financial records.

What is a purchase allowance and how is it recorded in a perpetual inventory system?

A purchase allowance occurs when a company keeps goods but negotiates a lower price due to issues like low quality. For example, if a company initially buys 500 units at $5 each but the price is reduced to $2 each, the inventory account is adjusted. The initial entry debits inventory and credits accounts payable by $2,500. The allowance entry debits accounts payable and credits inventory by $1,500, reflecting the new value of $1,000 for the inventory and the amount owed.

How do you record inventory purchases in a perpetual inventory system?

To record inventory purchases in a perpetual inventory system, you debit the inventory account and credit accounts payable. For example, if a company buys 500 units at $5 each, the journal entry would be a debit to inventory for $2,500 and a credit to accounts payable for $2,500. This entry increases the inventory and records the liability to the supplier, maintaining the accounting equation.

What are the advantages of using a perpetual inventory system?

The advantages of using a perpetual inventory system include real-time inventory tracking, improved accuracy in financial records, and better inventory management. This system helps businesses quickly identify stock levels, reduce stockouts or overstock situations, and make informed purchasing decisions. Additionally, it simplifies the process of preparing financial statements and ensures compliance with accounting standards.