What is a Periodic Inventory System?
Periodic inventory system does not keep continuous track of ending inventories and cost of goods sold. Instead, these items are determined only periodically, at the end of each quarter, each year, or other accounting period. Although this method may be easier to use for record-keeping purposes, it results in a significant loss of information for managerial decision-making purposes. However, the sheer volume of transactions in some merchandising businesses makes it impossible to use anything but a periodic method.
Accounting under the Periodic Inventory System (Journal Entries)
The journal entries necessary to record inventories under the periodic method are shown below. The data are from the example data used to illustrate the perpetual inventory system. When the periodic method is used, no entry is made to record the cost of the inventory sold for a particular sale. Furthermore, as the journal entries show, inventory purchases are not debited to the Merchandise Inventory account. Rather, they are accumulated in a separate account called Purchases.
As a result, there are no entries during the period to the asset account, Merchandise Inventory, Therefore, before any adjusting entries, the balance in the Merchandise Inventory account will reflect the amount of inventory at the beginning of the year, as indicated in the following T accounts.
Determining Cost of Goods Sold and Ending Inventory
Before financial statements can be prepared under the periodic inventory system, the cost of goods sold during the period as well as the ending inventory must be calculated. This is done by taking a physical inventory or counting the end-of-period inventory, to determine the quantity and the cost of the ending inventory and then applying this formula (the data is from the current example):
In effect, the total of the beginning inventory and purchases during the period represents the total of all goods that the firm had available for sale. If the ending inventory is subtracted from this total, the remaining balance represents the cost of the items sold.
Determining the cost of the ending inventory and the resulting cost of goods sold is extremely important to determine the periodic income and financial position. At this point, assuming that we have determined these amounts, we are illustrating the journal entries to record these figures.
Adjusting and Closing Entries under the Periodic Inventory Method
Once the ending inventory and cost of goods sold have been determined, the accounts must be adjusted to reflect the ending inventory balance and the cost of goods sold. There are several ways to do this, but we recommend that the following adjusting and closing entries be made:
The adjusting entry is based on the formula to calculate cost of goods sold, that is, the two credits, Purchases and Merchandise Inventory (beginning), are added together and represent goods available for sale. The debit, Merchandise Inventory (ending), is subtracted from that total to determine the balancing debit to Cost of Goods Sold. For convenience, merchandise inventory is labeled beginning and ending; however, there is only one ledger account, Merchandise Inventory.
Note that the result of this adjusting entry is to adjust the Merchandise Inventory account to its proper ending balance, to zero out the Purchases account, and to create a Cost of Goods Sold account. The entry to close Cost of Goods Sold to Income Summary or Retained Earnings is like all entries to close expense accounts. After the adjusting and closing entries have been posted, the T accounts appear as follows:
An alternative method to record the ending inventory and to determine cost of goods sold is by means of the following closing entry:
Although this method requires one less entry, cost of goods sold is not specifically determined. However, this account is necessary in order to prepare the income statement.