Periodic Inventory System Journal Entries

Periodic inventory system updates inventory balance once in a period. We discussed this concept in
theperpetual-periodic inventory comparison. Here, we will learn the typical journal entries under a
periodic inventory system.
Let us assume that all sales and purchases are on credit. Also assume that where discounts are
provided or availed on sales/purchases, they are recorded using the gross method (to learn more
about gross method, see discount on sales and discount on inventory purchases).

Following are the typical journal entries under a periodic inventory system:

Inventory Purchase:
The purchase of inventory is recorded by debiting purchases account and crediting accounts payable.
Purchases
Accounts Payable
Purchase Discount:
Under gross method, purchase discount is recorded using the following journal entry:
Accounts Payable
Purchase Discounts
Note: The above two journal entries are usually combined in a single entry which is shown below:
Purchases
Accounts Payable
Purchase Discounts
Purchase Return:
Purchase returns are recorded as shown below
Accounts Payable/Accounts Receivable
Purchase Returns
Inventory Sale:
Unlike perpetual inventory system, the periodic inventory system records the transaction of sale via a
single journal entry:
Accounts Receivable
Sales
Sales Discounts:
A sales discount is recorded as shown below:
Sales Discount
Accounts Receivable

Again, the above two entries are combined in a period inventory system as shown below:

Accounts Receivable
Sales Discounts
Sales
 Sales Return:
Similarly, sale returns are also recorded via a single journal entry:
Sales Returns
Accounts Receivable/Accounts Payable

At the end of each accounting period, the value of ending inventory is determined by physical count.
Cost of goods sold is determined either as a balancing figure in the closing entry shown at the end or
by using the following formula:

COGS = Beginning Inventory + Purchases Ending Inventory

The closing entry required in a periodic inventory system debits:
inventory account by the value of ending inventory
cost of goods sold account by the value as determined above or by the balancing figure

and credits:

inventory account by beginning inventory

purchases account

The entry is shown below:

Inventory (Ending Inventory)

Cost of Goods Sold (Balancing Figure)
Inventory (Beginning Inventory)
Purchases

A simplified form of the above journal entry uses a single debit or credit to inventory account by
calculating the difference of ending inventory and beginning inventory. If the difference is positive, the
inventory account will be debited for the difference and if it the difference is negative, the journal
entry will credit the inventory account by the difference.

Adjusting Entries for a Merchandising Company

Remember this?

Accounting Cycle

1. Analyze Transactions 5. Prepare Adjusting Journal Entries 9. Prepare Closing Entries

2. Prepare Journal Entries 6. Post Adjusting Journal Entries 10. Post Closing Entries

3. Post journal Entries 7. Prepare Adjusted Trial Balance 11. Prepare Post-Closing Tr

4. Prepare Unadjusted Trial Balance 8. Prepare Financial Statements

We learned how the accounting cycle applies to a service company but guess what? The same
accounting cycle applies to any business. We spent the last section discussing the journal entries
for sales and purchase transactions. Now we will look how the remaining steps are used in a
merchandising company. Those wonderful adjusting entries we learned in previous sections still
apply.

Adjusting entries reflect unrecorded economic activity that has taken place but has not yet been
recorded because it is either more convenient to wait until the end of the period to record the
activity, or because no source document concerning that activity has yet come to the
accountants attention. Additionally, periodic reporting and the matching principle necessitate
the preparation of adjusting entries. Remember, the matching principle indicates that expenses
have to be matched with revenues as long as it is reasonable to do so. To follow this principle,
adjusting entries are journal entries made at the end of an accounting period or at any time
financial statements are to be prepared to bring about a proper matching of revenues and
expenses.

Each adjusting entry has a dual purpose: (1) to make the income statement report the proper
revenue or expense and (2) to make the balance sheet report the proper asset or liability.
Thus, every adjusting entry affects at least one income statement account and one balance
sheet account. Adjusting entries fall into two broad classes: accrued (meaning to grow or
accumulate) items and deferred (meaning to postpone or delay) items. The entries can be further
divided into accrued revenue, accrued expenses, unearned revenue and prepaid expenses.

For a merchandising company, Merchandise Inventory falls under the prepaid expense category
since we purchase inventory in advance of using (selling) it. We record it as an asset
(merchandise inventory) and record an expense (cost of goods sold) as it is used. The adjusting
journal entry we do depends on the inventory method BUT each begins with a physical
inventory.

A physical inventory is typically taken once a year and means the actual amount of inventory
items is counted by hand. The physical inventory is used to calculate the amount of the
adjustment.

Perpetual Inventory Method

Under the perpetual inventory method, we compare the physical inventory count value to the
unadjusted trial balance amount for inventory. If there is a difference (there almost always is for
a variety of reasons including theft, damage, waste, or error), an adjusting entry must be
made. If the physical inventory is less than the unadjusted trial balance inventory amount, we
call this an inventory shortage. This is the most common reason for an adjusting journal entry.

The video showed an example of an inventory shortage. Lets look at another example. Our
company has an unadjusted trial balance in inventory of $45,000 and $150,000 in cost of goods
sold. The physical inventory count came to $43,000. We have a difference in inventory of
$2,000 ($45,000 unadjusted inventory $43,000 physical count) that needs to be recorded. We
want to reduce our inventory and increase our expense account Cost of Goods Sold. The journal
entry would be:

Account Debit Credit

Cost of goods sold 2,000

Merchandise Inventory 2,
To adjust inventory to match the physical count.

When we post this adjusting journal entry, you can see the ending inventory balance matches the
physical inventory count and cost of good sold has been increased.

Account: Merchandise Inventory Debit Credit Balan

Unadjusted Balance

Adjust for shortage 2,000

Account: Cost of goods sold Debit Credit Balanc

Unadjusted Balance 1

Adjust for shortage 2,000 1

On the rare occasion when the physical inventory count is more than the unadjusted inventory
balance, we increase (debit) inventory and decrease (credit) cost of goods sold for the difference.

Periodic Inventory Method

Under the periodic inventory method, we do not record any purchase or sales transactions
directly into the inventory account. The unadjusted trial balance for inventory represents last
periods ending balance and includes nothing from the current period. We have not record any
cost of goods sold during the period either. We will use the physical inventory count as our
ending inventory balance and use this to calculate the amount of the adjustment needed.

To determine the cost of goods sold, a company must know:

Beginning inventory (cost of goods on hand at the beginning of the period).

Net cost of purchases during the period (purchases + transportation in purchase
discounts purchase returns and allowances)
Ending inventory (cost of unsold goods at the end of the period).

To illustrate, Hanlon Food Store had the following unadjusted trial balance amounts:

Trial Balance Accounts Debit Credit

Merchandise Inventory 24,000

Purchases 167,000

Purchase discounts

Purchase returns and allowances

Transportation In 10,000

The unadjusted trial balance amount for inventory represents the ending inventory from last
period. In our first adjusting entry, we will close the purchase related accounts into inventory to
reflect the inventory transactions for this period. Remember, to close means to make the balance
zero and we do this by entering an entry opposite from the balance in the trial balance.

Account Debit Credit

Merchandise Inventory 166,000

Purchase discounts 3,000

Purchase returns and allowances 8,000

Purchases 16

Transportation In 10
To close net purchases into inventory.

Next we can look at recording cost of goods sold. The beginning inventory is the unadjusted
trial balance amount of $24,000. The net cost of purchases for the year is $ 166,000 (calculated
as Purchases $167,000 + Transportation In $10,000 Purchase discounts $3,000 Purchase
returns and allowances $8,000). On December 31, the physical count of merchandise inventory
was $ 31,000, meaning that this amount was left unsold. We calculate cost of goods sold as
follows:

Beg. Inventory $24,000 + Net Purchases $166,000 Ending inventory count $31,000 =
$159,000 cost of goods sold

The second adjusting journal would increase (debit) cost of goods sold and decrease
(credit) inventory for the calculated amount of cost of goods sold and would look like:

Account Debit Cre

Cost of goods sold 159,000

Merchandise Inventory 159,

To record cost of goods sold for the period.
Next we would post these adjusting journal entries. We will look at the how the merchandise
inventory account changes based on these transactions. The physical inventory count of $31,000
should match the reported ending inventory balance.

Account: Merchandise Inventory Debit Credit

Unadjusted Balance

(1) Close net purchases 166,000

(2) Record cost of goods sold 159,000

Notice how the ending inventory balance equals physical inventory of $31,000 (unadjusted
balance $24,000 + net purchases $166,000 cost of goods sold $159,000).

Summary

The perpetual inventory method has ONE additional adjusting entry at the end of the
period. This entry compares the physical count of inventory to the inventory balance on the
unadjusted trial balance and adjusts for any difference. The difference is recorded into cost of
goods sold and inventory.

The periodic inventory methods has TWO additional adjusting entries at the end of the
period. The first entry closes the purchase accounts (purchases, transportation in, purchase
discounts, and purchase returns and allowances) into inventory by increasing inventory. The
second entry records cost of goods sold for the period calculated as beginning inventory
(unadjusted trial balance amount) + net purchases ending inventory (physical inventory
account) from the inventory account.

Income Statements for Merchandising

Companies and Cost of Goods Sold
Merchandising companies sell products but do not make them. Therefore, these
companies will have cost of goods sold but the calculation is much easier than for a
manufacturing company. Expenses for a merchandising company must be broken down
into product costs (cost of goods sold) and period costs (selling and administrative).
Just like all income statements, the first line is revenue. In the case of a business that
sells a product, we refer to revenue as Sales or Sales Revenue. This lets the reader
know that the company generates its revenue from the sale of products rather than the
delivery of services.

Cost of Goods Sold

Next, we subtract cost of goods sold. Cost of goods sold is the cost of all the products
(goods) that were sold during the period. If the company uses a perpetual inventory
system, cost of goods sold is being calculated every time a sale takes place. In this
case, no calculation is needed. We can simply take the amount from the cost of goods
sold account on the trial balance. And you thought you could forget everything from
financial accounting!
If the company uses a periodic inventory system, we must do some calculations to
figure out cost o f goods sold. Under a periodic inventory system, all goods purchased
as placed in the Purchasesaccount, not the inventory account. When sales are
recorded, there is no adjustment to inventory and cost of goods sold like there is in a
perpetual system. Therefore, at the end of the year, we must look at how much was
purchased and physically count how much inventory is left in order to manually
calculate cost of goods sold.

Under a periodic system, we add beginning inventory to the cost of purchases. This
gives us goods available for sale. Goods available for sale is the maximum value of
goods that could be sold. If we sold every unit we had on hand and had no inventory left
at the end of the year, goods available for sale would equal cost of goods sold. If there
is inventory remaining, we must subtract the ending inventory from goods available for
sale to calculate cost of goods sold.
To calculate cost of goods sold under a period inventory system:
Beginning Inventory
Plus: Purchases
= Goods Available for Sale
Less: Ending Inventory
= Cost of Goods Sold
Lets look at an example to help illustrate the point.
Example #1
Kingram Pencil Pushers sells pencils to office supply stores and other retailers
around the world. On January 1, the companys inventory was $41,000. During the
year, the company purchased $895,000 worth of pencils. A physical count of the
inventory on December 31 revealed that there were $23,000 worth of pencils
remaining. Calculate cost of goods sold for the year.
Whenever you are working on a word problem, the first thing you want to do is remove
the numbers from the problem and label them. We are told that January 1 inventory is
$41,000. How would you label this number? If you said beginning inventory you are
correct. January 1 is the beginning of the year, hence our beginning inventory.
$41,000 beginning inventory
How would you label $895,000? Well we are told this is what the company purchased,
therefore this is the amount of our purchases.
$41,000 beginning inventory
$895,000 purchases
Can you guess what the last number is? Ending inventory! If January 1 is the beginning
of the year then December 31 is the end of the year.
$41,000 beginning inventory
$895,000 purchases
$23,000 ending inventory
What is the problem asking us to do with these numbers? Calculate cost of goods sold.
$41,000 beginning inventory
$895,000 purchases
$23,000 ending inventory
?????? cost of goods sold
Okay, lets think about this logically. We need to figure out what we sold. Now we can
jump to the formula or we can try to think this through without the formula. What is cost
of goods sold? Its the stuff we sold, therefore it is no longer in the building. So if we
take the stuff we could have sold (goods available for sale) and subtract the stuff we
have left, we can figure out what was sold.
What is the maximum amount of goods that were available for sale? Well we had some
pencils, $41,000 worth of pencils actually. Then we purchased more pencils, $895,000
worth. So if we add the pencils we had, plus the pencils we bought, that tells us how
many pencils we had available that could have been sold.

So we could have sold $936,000 worth of pencils but we know we had some pencils left
so our cost of goods sold must be less than $936,000. Cost of goods sold CANNOT
be more than goods available for sale. I cant stress this point enough because this is
where a lot of people mess up this calculation. If you keep in mind that cost of goods
sold cannot be more than goods available for sale, it might save you points on your next
exam.
I have $23,000 worth of pencils leftover. These pencils were not sold. So if I take the
number of pencils I could have sold and subtract what I did not sell, that will tell me what
I did sell.

Of the $936,000 in pencils we could have sold, $913,000 were sold. That is the answer
to the problem.

Putting together the income statement

Its been a long, strange journey to get here but we are finally ready to do our income
statement. Once you have cost of goods sold, the rest of the statement is fairly easy.
Here is the format:
Sales
Less: Cost of Goods Sold
=Gross Profit
Less: Selling and Administrative Expenses
=Operating Income
This is called the traditional format income statement. Later on in the course, we will
discuss another format for the income statement called the contribution margin
income statement. This statement breaks out costs into product and period costs.
Gross profit is the amount from sales that is left over after your product is paid for. This
is an important figure for many companies because it lets the company know the
average percentage of each sale left over to cover operating expenses and generate
profit.
Lets look at an example of a traditional format income statement for a manufacturing
company:
You will notice that there is less detail in this statement than there was in the service
company income statement. You can add all the detail if you wish but many times that
causes the statement to become a bit cluttered, especially if you are putting in a
subtotal for selling expenses and another for administrative expenses. Many times
selling and administrative expenses are called operating expenses. These terms are
used interchangeably. Sometimes, you will just see operating expenses or selling and
administrative expenses and the total without the breakdown shown above. This format
is also perfectly acceptable.

Final thoughts
When creating the income statement for a merchandising company, it is important to
break costs out into product costs and period costs. If you are working with a company
that uses a perpetual inventory system, cost of goods sold will already be computed for
you. In a period system, you will have to do some calculations to compute cost of goods
sold. Focus on what is actually happening, the business process, and the calculations
are much easier. Dont forget to calculate gross profit (sales cost of goods sold).
Operating expenses and selling and administrative expenses can be used
interchangeably to refer to period costs.

What is a Classified Balance Sheet?

A classified balance sheet is a financial statement that reports asset, liability,
and equity accounts in meaningful subcategories for readers ease of use. In
other words, it breaks down each of the balance sheet accounts into smaller
categories to create a more useful and meaningful report.

Theres no standardized set of subcategories or required amount that must be

used. Management can decide what types of classifications to use, but the
most common tend to be current and long-term.

This format is important because it gives end users more information about
the company and its operations. Creditors and investors can use these
categories in their financial analysis of the business. For instance, they can
use measurements like the current ratio to assess the companys leverage
and solvency by comparing the current assets and liabilities. This type of
analysis wouldnt be possible with a traditional balance sheet that isnt
classified into current and long-term categories.

Example
Lets take a look at a classified balance sheet example.
As you can see, each of the main accounting equation accounts is split into
more useful categories. This format is much easier to read and more
informational than a report that simply lists the assets, liabilities, and equity in
total. You can use this example as a template for your homework or business.

Remember, there are no set subcategory requirements across industries. For

instance, a manufacturer might list different categories than a retailer. You can
do the same thing.

Lets walk through each one of these sections and answer the question what
is a classified balance sheet.

Format
Assets Section
The assets section is typically broken down into three main subcategories:
current, fixed assets, and other.

Current assets include resources that are consumed or used in the current
period. Cash and accounts receivable the most common current assets. Also,
merchandise inventory is classified on the balance sheet as a current asset.

Fixed assets consist of property, plant, and equipment that are long-term in
nature and are used to produce goods or services for the company. These
long-term assets are typically depreciated over time and reported at their
historical cost along with the associated accumulated depreciation.
The other assets section includes resources that dont fit into the other two
categories like intangible assets. Heres a list of the most common assets
found in each section.

Current Assets
Cash
Accounts receivables
Prepaid expenses
Inventories
Investments held for sale

Fixed Assets
Furniture and fixtures
Leasehold improvements
Buildings
Vehicles
Less: Accumulated depreciation

Other Assets
Copyrights
Trademarks
Less: Accumulated Amortization
Goodwill

Liabilities Section
The liabilities section is typically broken into three main subcategories:
current, long-term, and owner/ officer debt.
Current liabilities include all debts that will become due in the current period.
In other words, this is the amount of principle that is required to be repaid in
the next 12 months. The most common current liabilities are accounts payable
and accrued expenses.

The long-term section lists the obligations that are not due in the next 12
months. These obligations could be 5, 10, or 30-year notes. Keep in mind a
portion of these long-term notes will be due in the next 12 months. Thus, this
portion is always reported in the current section.

The owner/officer debt section simply includes the loans from the
shareholders, partners, or officers of the company. This section gives
investors and creditors information about the source of debt and more
importantly an insight into the financing of the company. For instance, if there
is a large shareholder loan on the books, it could mean the company cant
fund its operations with profits and it cant qualify for a commercial loan. This
information is important to any potential investor or creditor.

Heres an example of what the liabilities section typically looks like:

Current Liabilities
Accounts payable
Accrued expenses
Line of credit
Current portion of long-term debt

Long-term Liabilities
Commercial loans payable
Mortgages payable
Deferred taxes payable
 Owners Liabilities
Due to shareholder/partner
Due to officer

Equity Section
The equity section of a classified balance sheet is very simple and similar to a
non-classified report. Common stock, additional paid-in capital, treasury stock,
and retained earnings are listed for corporations. Partnerships list member
capital accounts, contributions, distributions, and earnings for the period.