A service business sells time. A merchandiser buys goods and resells them, and that one difference adds a whole layer of journal entries: purchases, returns, discounts, freight and the cost of what was sold. Most US intro textbooks teach two ways to record all of this, the perpetual and the periodic inventory systems. This post records the same month of transactions both ways so you can see exactly where they differ.
This post covers the journal entries. How to value the units left on the shelf (FIFO, LIFO, average) is a separate skill, covered on our inventory valuation challenges.
The One Difference That Drives Everything
Under the perpetual system, the Inventory account is updated with every purchase and every sale. The Cost of Goods Sold account is debited at the moment of each sale, so the ledger always shows what should be on hand.
Under the periodic system, the Inventory account sits untouched all period. Purchases go to a separate Purchases account, and Cost of Goods Sold is worked out only at period-end, after a physical count.
Everything else follows from that difference.
The Transactions: Copperline Outfitters, March
- Mar 1: buys inventory for $6,000 on account, terms 2/10, n/30, FOB shipping point. Pays $150 freight in cash.
- Mar 4: returns $500 of defective goods to the supplier.
- Mar 10: pays the supplier in full, within the discount period.
- Mar 15: sells goods for $9,000 on account, terms 2/10, n/30, FOB destination. The goods cost $5,400. Pays $120 delivery freight in cash.
- Mar 18: the customer returns goods sold for $1,000 (cost $600). They go back into stock.
- Mar 24: collects the balance from the customer within the discount period.
Two pieces of shorthand to decode first. 2/10, n/30 means a 2% discount if paid within 10 days, otherwise the full amount is due in 30. FOB shipping point means the buyer owns the goods once they leave the seller and pays the freight. FOB destination means the seller owns them until delivery and pays the freight.
Side by Side
| Date | Perpetual | Periodic |
|---|---|---|
| Mar 1 purchase | Dr Inventory 6,000 Cr Accounts Payable 6,000 | Dr Purchases 6,000 Cr Accounts Payable 6,000 |
| Mar 1 freight-in | Dr Inventory 150 Cr Cash 150 | Dr Freight-In 150 Cr Cash 150 |
| Mar 4 return | Dr Accounts Payable 500 Cr Inventory 500 | Dr Accounts Payable 500 Cr Purchase Returns and Allowances 500 |
| Mar 10 payment | Dr Accounts Payable 5,500 Cr Inventory 110 Cr Cash 5,390 | Dr Accounts Payable 5,500 Cr Purchase Discounts 110 Cr Cash 5,390 |
| Mar 15 sale | Dr Accounts Receivable 9,000 Cr Sales Revenue 9,000 Dr Cost of Goods Sold 5,400 Cr Inventory 5,400 | Dr Accounts Receivable 9,000 Cr Sales Revenue 9,000 (no cost entry) |
| Mar 15 freight-out | Dr Delivery Expense 120 Cr Cash 120 | Dr Delivery Expense 120 Cr Cash 120 |
| Mar 18 sales return | Dr Sales Returns and Allowances 1,000 Cr Accounts Receivable 1,000 Dr Inventory 600 Cr Cost of Goods Sold 600 | Dr Sales Returns and Allowances 1,000 Cr Accounts Receivable 1,000 (no cost entry) |
| Mar 24 collection | Dr Cash 7,840 Dr Sales Discounts 160 Cr Accounts Receivable 8,000 | Dr Cash 7,840 Dr Sales Discounts 160 Cr Accounts Receivable 8,000 |
Walking Through the Tricky Lines
The purchase discount (Mar 10). The discount applies to what is still owed after the return: $6,000 − $500 = $5,500, × 2% = $110. Under perpetual, the discount reduces the cost of the inventory itself. Under periodic, it goes to a contra account, Purchase Discounts.
Freight-in vs freight-out. Freight to bring goods in is part of what the inventory cost, so it is added to inventory (perpetual) or to Freight-In (periodic), which feeds cost of goods sold. Freight to send goods out to a customer is a selling expense. It never touches inventory under either system.
The sale (Mar 15). Under perpetual, every sale needs two entries: one at selling price for the revenue, one at cost to move goods from Inventory to Cost of Goods Sold. Under periodic there is only the revenue entry.
The sales discount (Mar 24). The customer owes $9,000 − $1,000 = $8,000 after the return. 2% of that is $160, so $7,840 is collected. Sales Discounts and Sales Returns and Allowances are contra-revenue accounts. They are subtracted from Sales Revenue to give net sales.
How Periodic Finds Cost of Goods Sold
Because nothing was posted to COGS during the month, the periodic system computes it at the end:
Beginning inventory
+ Purchases − Purchase Returns and Allowances − Purchase Discounts + Freight-In (= cost of goods purchased)
= Cost of goods available for sale
− Ending inventory (from the physical count)
= Cost of Goods Sold
For Copperline, cost of goods purchased is 6,000 − 500 − 110 + 150 = $5,540, the same net figure that went into the perpetual Inventory account. Both systems reach the same place; the periodic one simply gets there at period-end.
Common merchandising entry mistakes
- Missing the cost entry under perpetual. A perpetual sale without a COGS entry leaves inventory overstated and gross profit wrong.
- Calculating the discount on the original invoice. Take the discount on the balance after returns.
- Capitalizing freight-out. Delivery to customers is an operating expense, never part of inventory.
- Reading FOB terms backwards. FOB shipping point puts freight on the buyer; FOB destination puts it on the seller.
- Recording a sales return at cost only, or at price only. Under perpetual, a return that goes back into stock needs both entries: one reversing the revenue, one reversing the cost.
- Debiting Sales Revenue directly for a return. Most questions expect the contra account, so the return stays visible on the income statement.
These entries are the input to a merchandiser's income statement, where net sales and cost of goods sold produce gross profit. Practice them on Accountely's merchandising transaction challenges, or by system on the perpetual and periodic inventory topics. For more single-entry drills, see our journal entry practice problems.
Frequently Asked Questions
What is the difference between the perpetual and periodic inventory systems?
A perpetual system updates Inventory and Cost of Goods Sold with every purchase and sale, so it records a second, cost entry for each sale. A periodic system records purchases in a Purchases account and works out cost of goods sold only at the end of the period, from a physical count.
How is a purchase discount recorded under 2/10, n/30 terms?
If the buyer pays within ten days, it takes a 2% discount on the amount owed after any returns. Under a perpetual system the discount reduces Inventory; under a periodic system it is credited to Purchase Discounts.
Who pays freight under FOB shipping point?
The buyer. Ownership passes when the goods leave the seller, so the buyer records the freight as part of the cost of inventory. Under FOB destination, the seller pays and records it as a delivery expense.
Why does a perpetual sale need two journal entries?
One records the sale at selling price (debit Cash or Accounts Receivable, credit Sales Revenue). The other records its cost (debit Cost of Goods Sold, credit Inventory), so inventory stays up to date.