How to Use the
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The periodic inventory system maintains the beginning inventory balance throughout the year. New inventory purchases are recorded in the "purchases" account, and at year end a physical count is taken of the inventory to determine the Ending inventory balance and the cost of goods sold.
The following formula is used to determine COGS:
| Beginning Inventory + Purchases – Ending Inventory = COGS |
*A Note on Beginning Balances* In accounting, the beginning balance always refers to the balance as of the beginning of the year before any new transactions for the year are recorded. Consequently, the beginning balance for inventory, or accounts receivable, or equity, or any other real (balance sheet) account is always the same as the balance as of the end of the prior year, carried forward as the beginning balance in the new year.
For the Periodic Inventory System, this is important because the ending inventory balance was adjusted to a physical count last year, and carried forward to the beginning inventory balance. This inventory balance will remain the same throughout the year, as new products purchased are recorded in the purchases account, and later adjusted to inventory based on a new physical count at year end.
In January, for example, even though Sunny had purchased $4,500 on the first day of business, January 1, 2007, as listed on the January sample balance sheet, this amount does not represent the beginning inventory balance since the ending inventory as of December 31, 2006 was zero. Rather, this amount is included as part of total purchases made throughout the year when using the Periodic Inventory System.
Let's see how Sunny Sunglasses would calculate COGS for 2007 under the Periodic Inventory System.
Throughout the year, Sunny had net purchases of $48,825 in total inventory. Ending Inventory as listed on the examples of balance sheets page equaled $5,625. Therefore, we can calculate COGS as:
Total Cost of goods available for sale during 2007 was the Beginning Inventory plus all Purchases made throughout the year less Purchase Returns and Discounts. Because the Ending Inventory had a balance as of December 31, this amount is subtracted to arrive at the total COGS.
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The following Journal Entries illustrate how the Periodic Inventory System uses the Purchases account for Inventory, and is later closed to Cost of Goods Sold at year end. Cost of Goods Sold is then adjusted based on the Inventory balance at year end based on a physical count of inventory:
In the Journal Entry above, Purchases are made and the items are then sold. At no time during the year does the Periodic Inventory System adjust the Inventory account until year end adjusting entries. Purchases are debited to the Purchases account, and Sales are made with no adjustment to the Inventory account. The Perpetual Inventory System, by contrast, adjusts the Inventory balance when items are both purchased and sold.
When Purchases are made and then returned, the amount returned is recorded in a contra account to adjust total purchases. A contra account is an account that offsets the main account. Since the Purchases account is a debit account, the contra account is a credit account that offsets the balance to determine Net Purchases. The Purchases account has two contra accounts: Purchase Returns and Purchase Discounts.
In this example, Purchase Returns are credited to reduce the Purchases balance. Accounts Payable is also reduced with a debit.
The Purchases account and its contra accounts are simply a replacement for the Inventory account in the Periodic Inventory System. Under the Perpetual Inventory System, any Purchase Returns or Discounts reduce the Inventory Account directly.
Similarly, Purchase Discounts are credited to reduce the Purchases balance. In this example, Sunny Sunglasses Purchased product with a 2% discount when paid within 10 days (2/10), with full payment due within 30 days (n/30). Discounts encourage quicker payment of items purchased on credit. Purchase Discounts are recorded in the contra account Purchase Discounts.
Even though Sunny Sunglasses Shop had no Beginning Inventory, in this example it is important to note that any Beginning Inventory is closed (credited) to COGS under the Periodic Inventory System. If a business did not actually sell anything during the year, or sold an amount less than the balance in the Beginning Inventory, the journal entry to record Ending Inventory in the last journal entry below makes the appropriate adjustment to COGS.
Purchases and its contra accounts, purchase returns and purchase discounts, are temporary accounts closed to cost of goods sold at year end. Since the purchases account is a debit account, it is closed with a credit to the balance. Likewise, the contra accounts are credit accounts that are closed with debit entries. The balance reflects net purchases closed to cost of goods sold ($48,825).
At year, Sunny takes a physical count of the remaining inventory to determine and ending balance of $5,625. Since this amount reflects goods available for sale that were not sold, this amount is debited to inventory to record the amount as an asset, and credited to cost of goods sold to reduce the amount recorded as cost of goods sold.
At the beginning of next year, the beginning inventory balance is $5,625. Cost of goods sold is recorded on the 2007 sample income statement as $43,200.
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