FinancialAccountingPro.com - making financial accounting simple

Periodic Inventory System

By Yuriy Smirnov Ph.D.

Definition

Under the periodic inventory system, the Inventory account is updated only once at the end of the accounting period rather than after each sale and purchase of merchandise. The value of ending inventory is calculated by physically counting at the end of the accounting period.

The periodic inventory system involves the Purchases account to keep records of purchased merchandise during the accounting period. Under that system, the Cost of Goods Sold account is not updated after each sale of merchandise. Instead, the formula used to calculate the cost of goods sold (COGS) can be expressed as follows:

COGS = Beginning Inventory + Purchases - Ending Inventory

Please note that the cost of goods sold is a balancing figure!

Under the periodic inventory system, each sale of merchandise is recorded in the general journal through one entry by debiting Accounts Receivable and crediting the Sales account, assuming that a sale is made on credit. Purchase of merchandise is also recorded through one journal entry by debiting the Purchase account and crediting Accounts Payable if a purchase is made on credit.

The value of cost of goods sold and ending inventory depend on the inventory costing method being used, e.g., FIFO, LIFO, average cost, or specific identification.

Calculation example

RetailX LTD has made following transactions during March:

Let’s calculate ending inventory and cost of goods sold, assuming that the company is using the FIFO inventory method.

Units in beginning inventory = 2,500

Units purchased = 4,000 + 3,000 = 7,000

Units sold = 1,800 + 2,300 + 1,500 = 5,600

Units in ending inventory = 2,500 + 7,000 - 5,600 = 3,900

Beginning inventory = 2,500 × $80 = $200,000

Purchases = 4,000 × $85 + 3,000 × $90 = $610,000

Since RetailX LTD applies the FIFO inventory method, each batch should be assigned to the cost of goods sold in the order they were purchased. Thus, 3,900 units in ending inventory consist of 3,000 units purchased on Mar 27 and 900 units purchased on Mar 9.

Ending inventory = 900 × $85 + 3,000 × $90 = $346,500

COGS = $200,000 + $610,000 - $346,500 = $463,500

Journal entries

Under the periodic inventory system, each purchase requires one entry to be made in the general journal. It is recorded by debiting the inventory account and crediting Accounts Payable as follows:

Since the Cost of Goods Sold account is updated only once at the end of the accounting period, each sale of merchandise is recorded through one entry in the general journal by debiting Accounts Receivable and crediting the Sales account.

If a purchase or sale is made for cash, the Cash account should be used instead of Accounts Payable and Accounts Receivable respectively.

The periodic inventory system requires a closing entry to be made at the end of the accounting period. It debits the Inventory account by the value of ending inventory and Cost of Goods Sold account by the value of COGS. It also credits the Inventory account by the value of beginning inventory and Purchases account by the total value of purchases.

Periodic inventory system – closing entry

Example

Assuming that RetailX LTD has made all sales and purchases on credit, the journal entries to be made should look as follows:

The closing entry should look as follows:

Purchase return

If some merchandise was returned to the suppliers, it should be recorded under the periodic inventory system by debiting Accounts Payable and crediting the Purchase Returns account by the amount of returns outward.

Periodic inventory system – purchase return journal entry

Purchase discount

The purchase discount is recorded in the general journal by debiting Accounts Payable and crediting the Purchase Discount account by the amount of discount obtained.

Periodic inventory system – purchase discount journal entry

Sales return

The sales return is recorded by one entry in the general journal under the periodic inventory system by debiting the Sales Return account and crediting Accounts Receivable by the value of goods sold.

Periodic inventory system – sales return journal entry

T-accounts

T-accounts are used to show the balance of each account at the end of the accounting period. Debits are always recorded on the left side, and credits are always recorded on the right side.

Let’s transform the general journal entries from the example above to the T-accounts format.

Inventory is an asset account; thus, debit increases its balance, and credit decreases it.

The Cost of Goods Sold is a temporary account, so it is closed at the end of each accounting period. Thus, its beginning balance always equals zero.

Accounts Receivable is a real asset account. Let’s assume that its balance equals zero at the beginning of the accounting period.

Accounts Payable is a real liability account; thus, debits increase it, and credits decrease it. Let’s assume that its balance equals zero on Mar 1.

The Purchases account is temporary and should be transferred from the general journal as follows:

The Sales account is temporary, so it should be displayed as follows:

Advantages and disadvantages

Advantages

  1. The periodic system involves simpler calculation and fewer accounting records than the perpetual system.
  2. It is less expensive to maintain, so the periodic inventory system is still a good decision for a small business.

Disadvantages

  1. Under the periodic inventory system, the Inventory account is updated only once at the end of the accounting period by physically counting the merchandise, which means weak control over theft, waste, and leakage.
  2. The exact balance of the Inventory account and cost of goods sold is not available at any given time until the end of the accounting period. It can lead to a poor purchasing pattern and wrong selling prices and eventually to the loss of revenue and profit.
  3. Physically counting stock could take a lot of time and suspend normal activities of a business.