How the Periodic Inventory Method Tracks Inventory and COGS
Learn how businesses account for inventory and cost of goods sold using a traditional, non-continuous method that relies on periodic updates.
The periodic inventory method helps businesses manage stock and calculate the cost of goods sold. This accounting system does not continuously update inventory balances after each sale or purchase. Instead, it relies on periodic physical counts to determine the quantity of goods on hand at specific intervals. This method is suited for smaller businesses or those with a low volume of transactions.
Core Principles of Periodic Inventory
Throughout an accounting period, the periodic inventory system operates by recording inventory-related transactions in temporary accounts. When a business acquires inventory, the cost is debited to a “Purchases” account rather than directly increasing the “Inventory” asset account on the balance sheet. This approach keeps the Inventory asset account at its beginning-of-period balance for most of the accounting cycle.
Costs associated with bringing inventory to the business’s location, such as freight-in charges, are also recorded separately. These expenses are debited to a “Freight-in” account. This segregation helps track all costs related to acquiring merchandise. When customers purchase goods, only the sales revenue is recorded, with no corresponding entry at the time of sale to recognize the cost of goods sold.
The Inventory asset account’s balance remains consistent through the period, reflecting the inventory value from the previous period’s closing. A physical inventory count is necessary at the end of the accounting period to determine the actual quantity of goods remaining. This count provides the data needed to adjust the inventory account and calculate the cost of goods sold for the period.
Determining Ending Inventory and Cost of Goods Sold
Calculating ending inventory and the cost of goods sold (COGS) is central at the close of an accounting period under the periodic method. The physical inventory count, conducted at the period’s end, establishes the value of goods still on hand. This count provides the ending inventory, which is an important input for financial reporting.
The Cost of Goods Sold is then determined using the formula: Beginning Inventory + Net Purchases – Ending Inventory = Cost of Goods Sold. Beginning Inventory represents the value of merchandise available at the start of the current period, carried over from the prior period’s ending balance.
Net Purchases are calculated by taking the total debits in the “Purchases” account, adjusting for any returns or allowances granted by suppliers, and adding freight-in costs. For instance, if purchases were $50,000, returns $2,000, and freight-in $1,000, Net Purchases would be $49,000. If beginning inventory was $10,000 and ending inventory $15,000, the Cost of Goods Sold would be $44,000 ($10,000 + $49,000 – $15,000).
Accounting Entries in the Periodic System
Transactions are recorded using journal entries reflecting the periodic inventory method. When a business purchases inventory on credit, the “Purchases” account is debited, and “Accounts Payable” is credited. If the purchase is made with cash, the “Cash” account is credited instead.
Should a business return goods to a supplier or receive an allowance for damaged items, the entry involves a debit to “Accounts Payable” or “Cash” and a credit to “Purchase Returns and Allowances.” Freight costs incurred to bring inventory into the business are recorded by debiting the “Freight-in” account and crediting “Accounts Payable” or “Cash.” When sales occur, “Accounts Receivable” or “Cash” is debited, and “Sales Revenue” is credited, with no corresponding cost entry.
At the fiscal year-end, an adjusting and closing entry updates the inventory account and calculates the Cost of Goods Sold. This involves removing the beginning inventory balance from the “Inventory” account by crediting it. Simultaneously, temporary accounts like “Purchases,” “Purchase Returns and Allowances,” and “Freight-in” are closed out. Finally, the ending inventory balance from the physical count is debited to the “Inventory” account, and the “Cost of Goods Sold” account is established.