Periodic Inventory System

A periodic inventory system is a method of accounting for inventory in which the business does not track the quantity and cost of goods continuously. Instead, purchases during the period are recorded in a separate purchases account, and inventory on hand is determined by counting it at the end of the period. Cost of goods sold is then calculated as the difference between goods available for sale and the counted ending inventory.

The periodic system was the standard method before computers made real-time tracking cheap, and it is still used by small retailers, restaurants and businesses that sell many low-value items. Its alternative is the perpetual inventory system, which updates inventory records with every purchase and sale.

• During the period, purchases are debited to a purchases account, not to inventory. Freight-in, purchase returns and purchase discounts have their own accounts.
• When goods are sold, the business records the sale but makes no entry for the cost of the goods sold.
• At period end, staff count the goods on hand and value them using a cost flow method, such as first-in, first-out (FIFO), last-in, first-out or weighted average.
• Closing or adjusting entries remove the beginning inventory, record the ending inventory, close the purchases-related accounts and record cost of goods sold.

A gift shop starts the year with inventory costing $25,000. During the year it records purchases of $140,000, freight-in of $4,000 and purchase returns of $3,000. A count on 31 December values the remaining stock at $30,000. Cost of goods sold is:

Here $\text{Beginning inventory}$ is the prior period's counted stock, $\text{Net cost of purchases}$ is purchases plus freight-in minus returns and discounts, and $\text{Ending inventory}$ is the value of the year-end count. Net cost of purchases is $141,000, so cost of goods available for sale is $166,000 and cost of goods sold is $136,000. If sales were $230,000, gross profit is $94,000.

A typical sale during the year is recorded by debiting cash or accounts receivable and crediting sales. A purchase of $2,000 on credit is recorded by debiting purchases and crediting accounts payable. At year end, the inventory account is adjusted from $25,000 to $30,000 and the purchases, freight-in and returns accounts are closed into cost of goods sold or the income summary account.

The periodic system is simple and inexpensive, needing no item-by-item tracking at the point of sale. However, it has important weaknesses:

• Inventory and gross profit are unknown between counts, so monthly or quarterly results require estimates such as the gross profit method or the retail method.
• Theft, damage and recording errors are hidden inside cost of goods sold, because anything not counted is assumed to have been sold. Inventory shrinkage cannot be measured separately.
• There is no real-time information for reordering, so stockouts and overstocking are more likely.
• Errors in the year-end count flow straight into profit: overstating ending inventory by $5,000 understates cost of goods sold and overstates profit by $5,000.

Under a perpetual system, every purchase is debited to inventory and every sale triggers an entry moving cost from inventory to cost of goods sold, so balances are always up to date and shrinkage can be found by comparing records with counts. Modern point of sale systems and barcode scanning have made perpetual tracking affordable for most businesses. Even so, the results under the two systems can differ for LIFO and weighted average methods, because the periodic method applies the cost flow assumption once for the whole period, while the perpetual method applies it at each sale. Businesses using either system still perform physical counts or cycle counting to confirm the figures and support inventory valuation.