Inventory Systems

I. Periodic – used where the turnover of the items or the selling cycle is fast Ex. Grocery, office and home
supplies
Cost of goods sold is determined only at the end of an accounting period. This
system involves:
• Record purchase of Inventory.
• Record revenue only when the item is sold.
• At the end of the period, you must compute cost of goods sold (COGS):

1. Determine the cost of goods on hand at the beginning of the accounting period (Beginning Inventory =
BI),
2. Add it to the cost of goods purchased (COGP),
3. Subtract the cost of goods on hand at the end of the accounting period
4. (Ending Inventory = EI) illustrated as follows:

BI + COGP = Cost of goods available for sale - EI = COGS

Recording purchases and related transactions under the Periodic Inventory System

PURCHASES OF MERCHANDISE: PERIODIC SYSTEM

1. When merchandise is purchased for resale to customers, the account, Purchases, is debited for the cost of
goods purchased.
2. Like sales, purchases may be made for cash or on account (credit).
3. The purchase is normally recorded by the purchaser when the goods are received from the seller.
• Each credit purchase should be supported by a purchase invoice.
• A purchase invoice received by the buyer is actually a sales invoice or a charge invoice prepared by the
supplier or vendor.
• Note that only purchases of merchandise are debited to the ‘Purchase’ account. Acquisition (purchases) of
other assets: supplies, equipment, and similar items are debited to their respective accounts.
PURCHASE RETURNS AND ALLOWANCES
Unsatisfactory goods :
• damaged or defective
• of inferior quality
• not in accord with the purchaser’s
specifications
• The purchaser initiates the request for a reduction of the balance due through the issuance
of a debit memorandum. The debit memorandum is a document issued by a buyer to inform
a seller that the seller’s account has been debited because of unsatisfactory goods.

• A return of the merchandise (a deduction from the purchase price when unsatisfactory
goods are kept) is shown by the entry where Accounts Payable is debited and Purchase
Returns and Allowances is credited to show that the purchases was reduced with a return or
an allowance.

• The Purchase Returns and Allowances account is a “contra purchases” account when
merchandise is returned to a supplier.
Purchase xxx Cash/Accounts Payable xxx
Cash xxx Purchase Returns & allowances xxx
ACCOUNTING FOR FREIGHT COSTS
The sales agreement should indicate whether the
seller or the buyer is to pay the cost of transporting
the goods to the buyer’s place of business. The
two most common arrangements for freight costs
are FOB SHIPPING POINT AND FOB
DESTINATION.
FOB Shipping Point:
• Goods placed free on board (FOB) the carrier by seller.
• Buyer pays freight costs.
• Freight-In is debited if buyer pays freight.
• Cash is credited if the goods come on cash on delivery (COD), for
example, and was paid immediately. Accounts Payable would be
credited if on account.
• Legal ownership over the goods is transferred to the buyer once it
is out of the premises of the seller.
FOB Destination
• Goods placed free on board (FOB) at buyer’s
business.
• Seller pays freight costs.
• Delivery Expense is debited if seller pays freight
on outgoing merchandise to a buyer. This is an
operating expense to the seller.
• Ownership over the goods is transferred to the buyer
once the goods are delivered and received by the
buyer.
PURCHASE DISCOUNTS:
• Credit terms (specify the amount of cash discount and time period during which a
discount is offered) may permit the buyer to claim a cash discount for the prompt payment
of a balance due.
If the credit terms show 2/10, n/30 means a 2% discount is given if paid within 10 days
(called the discount period); otherwise, the invoice is due in 30 days.
• The buyer calls this discount a purchase discount.
• A purchase discount is normally based on the invoice cost less returns and allowances, if
any.
Purchases xxx Accounts Payable xxx
Cash xxx Cash xxx
Purchase Discount xxx
SALES TRANSACTIONS: REVENUE ENTRIES FOR A MERCHANDISER
• Revenues are reported when earned in accordance with the revenue recognition principle,
and in a merchandising company, revenues are earned when the goods are transferred from
seller to buyer.
• All sales should be supported by a document such as a cash register tape (to provide
evidence of cash sales) or cash receipt, or office receipt for cash sales, and charge invoice for
credit sales, or sales on account.
• One entry is made with each sale:
Debit — Accounts Receivable (if a credit sale) or Cash (if a cash sale) which increases
assets for the sales amount
Credit — Sales which increases revenues
• The sales account is credited only for sales of goods held for resale. Sales of assets not held
for resale (such as equipment, buildings, land, etc.) are credited directly to the asset account.
FREIGHT TERMS: FOB DESTINATION —
SELLER PAYS FREIGHT
• An entry is made when seller pays the freight to
deliver goods to a customer or buyer. If the buyer will
pay for the freight, no entry is made by the seller.
• Debit — Delivery Expense and credit — Cash or
Accounts Payable
SALES RETURNS AND ALLOWANCES:
• Sales Returns result when customers are dissatisfied with merchandise and are allowed to return
the goods to the seller for credit or a refund.
• Sales Allowances result when customers are dissatisfied, and the seller allows a deduction from
the selling price.
• To grant the return or allowance, the seller prepares a credit memorandum to inform the
customer that a credit has been made to the customer’s account receivable.
• Sales Returns and Allowances is a contra revenue account to the Sales account. A contra account is
a reduction to a particular account.
• A contra account is used, instead of debiting sales, to disclose the amount of sales returns and
allowances in the accounts.
• This information is important to management as excessive returns and allowances suggest inferior
merchandise, inefficiencies in filling orders, errors in billing customers, and mistakes in delivery or
shipment of goods.
• The normal balance of Sales Returns and Allowances is a debit.
• One entry is made with each sales return and allowance:
The entry to record the sales return or allowance:
Cash/Accounts Receivable xxx Sales Returns and Allowances xxx
Sales xxxx Cash/Accounts Receivables xxx
SALES DISCOUNTS
1. A sales discount is the offer of a cash discount to encourage customers
to pay the balance at an earlier date.
2. An example of a discount term is commonly expressed as: 2/10, n/30,
which means that the customer is given 2% discount if payment is made
within 10 days. After 10 days there is no discount, and the balance is due
in 30 days.
3. Sales Discounts is a contra revenue account with a normal debit
balance.
Sales Discount xxx
Cash xxx
Accounts Receivable xxx
Determining Cost of Goods Sold under Periodic Inventory System
The Cost of Goods Sold under the periodic inventory system is determined
at the end of the period (monthly or yearly) by a short computation.

In a periodic inventory system, separate ledger accounts are maintained for

various items composing the cost of goods sold (Purchases, Purchase
Returns & Allowances, Freight-In, Purchase Discounts). At the end of the
accounting period, a physical count of inventory is necessary to establish
the ending balance of the inventory.
II. Perpetual – used with high priced items Ex. Luxury items
A Stock ledger for each item is maintained to (frequently) monitor the balance.
- Detailed records of the cost of each item are maintained, and the cost of each item sold is
determined from records when the sale occurs. For example, a car dealership has separate inventory records for
each vehicle.
• Record purchase of Inventory.
• Record revenue and record cost of goods sold when the item is sold.
• At the end of the period, no entry is needed except to adjust inventory for losses, etc.

Physical count is done in both systems and done at the end of the accounting period.
 Additional Considerations (Perpetual
Inventory System):
• Perpetual systems have traditionally been used by companies that sell merchandise with high unit values such
as automobiles, furniture, and major home appliances. With the use of computers and scanners, many
companies now use the perpetual inventory system.
• The perpetual inventory system is named because the accounting records continuously —
perpetually —show the quantity and cost of the inventory that should be on hand at any time. The periodic
system only periodically updates the cost of inventory on hand.
• A perpetual inventory system provides better control over inventories than a periodic inventory, since the
records always show the quantity that should be on hand. Then, any shortages from the actual quantity and
what the records show can be investigated immediately.
 Types of Merchandising Discounts:
1. Trade Discount – reduction from a list or catalog price that can
vary for wholesalers, retailers and consumers.
 Not recorded in the book of the merchandiser

List Price 50,000

Less: 20% trade discount 10,000
Net 40,000
Less: 15% trade discount 6,000
Invoice Price 34,000
2. Cash Discount – reduction in the
price of merchandise granted by a
seller to a buyer when payment is
made within the discount period. The
cash discount is recorded in the
books.