Periodic Inventory System Overview
The periodic inventory system only updates the ending inventory balance in the general ledger when you conduct a physical inventory count. Since physical inventory counts are time-consuming, few companies do them more than once a quarter or year. In the meantime, the inventory account in the accounting system continues to show the cost of the inventory that was recorded as of the last physical inventory count.
Under the periodic inventory system, all purchases made between physical inventory counts are recorded in a purchases account. When a physical inventory count is done, you then shift the balance in the purchases account into the inventory account, which in turn is adjusted to match the cost of the ending inventory.
The calculation of the cost of goods sold under the periodic inventory system is:
Beginning inventory + Purchases = Cost of goods available for sale
Cost of goods available for sale – Ending inventory = Cost of goods sold
For example, Milagro Corporation has beginning inventory of $100,000, has paid $170,000 for purchases, and its physical inventory count reveals an ending inventory cost of $80,000. The calculation of its cost of goods sold is:
$100,000 Beginning inventory + $170,000 Purchases - $80,000 Ending inventory
= $190,000 Cost of goods sold
Periodic Inventory Accounting
Under a periodic inventory system, inventory purchases made by a company are initially stored in a purchases (asset) account with the following journal entry:
There may be a number of these entries during an accounting period, which gradually increases the amount in the purchases account. At the end of the accounting period, the entire balance in the purchases account is shifted in the inventory (asset) account. This means that the purchases account is really an accumulation account for a single accounting period, rather than an account that holds a balance over multiple periods. The entry at the end of the period is:
Notice that there is no particular need to divide the inventory account into a variety of subsets, such as raw materials, work-in-process, or finished goods. The reason is that the level of inventory tracking is so infrequent that there is no point in using additional inventory accounts, since the balance in any one account will likely be inaccurate in comparison to the actual inventory count at any given time.
The final periodic inventory entry in an accounting period arises immediately after the physical count of the inventory, when the accounting staff establishes the actual cost of the inventory on hand at the end of the month. It then subtracts this actual ending inventory cost from the cost that has accumulated in the inventory account, and charges the difference to the cost of goods sold account with this entry:
|Cost of goods sold||xxx|
A variation on the last two entries is to not shift the balance in the purchases account into the inventory account until after the physical count has been completed. By waiting, you can then merge the final two entries together and apportion the balance in the purchases account between the inventory account and the cost of goods sold, using the following entry. The end result is the same, but with fewer entries.
|Cost of goods sold||xxx|
An additional entry that is related to the periodic inventory system, but which does not directly impact inventory, is the sale transaction. The following entry shows the transaction that you record under a periodic inventory system when you sell goods. There is not a corresponding and immediate decline in the inventory balance at the same time, because the periodic inventory system only adjusts the inventory balance at the end of the accounting period. Thus, there is not a direct linkage between sales and inventory in a periodic inventory system.
Periodic Inventory System Advantages and Disadvantages
The periodic inventory system is most useful for smaller businesses that maintain minimal amounts of inventory. For them, a physical inventory count is easy to complete, and they can estimate cost of goods sold figures for interim periods. However, there are several problems with the system:
- Minimal information. It does not yield any information about the cost of goods sold or ending inventory balances during interim periods when there has been no physical inventory count.
- Estimation errors. You must estimate the cost of goods sold during interim periods, which will likely result in a significant adjustment to the actual cost of goods whenever you eventually complete a physical inventory count.
- Large adjustments. There is no way to adjust for obsolete inventory or scrap losses during interim periods, so there tends to be a significant (and expensive) adjustment for these issues when a physical inventory count is eventually completed.
- Not scalable. It is not an adequate system for larger companies with large inventory investments, given its high level of inaccuracy at any given point in time (other than the day when the system is updated with the latest physical inventory count).