10.3 The Periodic Inventory Method, Inventory Equation & Closing Entries
Key Takeaways
- Periodic books debit Purchases, Freight-in, Purchase Returns and Allowances, and Purchase Discounts during the period; Inventory sits untouched at the beginning balance until closing.
- Net purchases equal Purchases plus freight-in minus purchase returns, allowances, and discounts. Saltbox’s net purchases are $17,520.
- The inventory equation is beginning inventory plus net purchases minus ending inventory equals cost of goods sold. Saltbox’s COGS is $6,400 + $17,520 − $5,860 = $18,060.
- A periodic sale records only Accounts Receivable and Sales. There is no Cost of Goods Sold or Inventory entry until the count and the closing entries.
- Closing debits Inventory for the $5,860 ending count, removes beginning inventory, closes the purchase accounts, and leaves Cost of Goods Sold at $18,060, which already includes shrinkage because ending inventory is the physical count.
When the Inventory account sleeps all year
Under the periodic inventory method, Inventory on the general ledger stays at last period’s ending balance until you close the books. Purchases of merchandise do not debit Inventory. They debit Purchases, a temporary account. Inbound freight debits Freight-in. Returns and allowances credit Purchase Returns and Allowances (a contra to Purchases). Cash discounts taken credit Purchase Discounts (also a contra to Purchases). Sales debit Accounts Receivable or Cash and credit Sales — and that is the whole sale-date entry.
AIPB’s Mastering Inventory periodic section covers purchases at net versus gross, sales, discounts, returns and allowances, sales returns, shrinkage, and closing out the inventory-related accounts at year end. This independent OpenExamPrep section works those mechanics with Saltbox Office Goods figures. Weighted-average costing, which also uses a periodic calculation, is Chapter 11.
Periodic is not “wrong” or obsolete. Small firms, firms without scan-based stock cards, and exam problems that give you a count and a pile of purchase totals still use it. Software can look perpetual while the accountant still computes COGS from the equation at month-end. You must recognize the account names the problem is using.
The inventory equation
Beginning inventory + net purchases = goods available for sale
Goods available for sale − ending inventory = cost of goods sold
Compressed: COGS = BI + net purchases − EI
Net purchases = Purchases + Freight-in − Purchase Returns − Purchase Allowances − Purchase Discounts
Saltbox Office Goods, May:
| Account / amount | Dollars |
|---|---|
| Beginning inventory (May 1) | $6,400 |
| Purchases (gross invoices) | $18,500 |
| Freight-in | $740 |
| Purchase returns | $1,150 |
| Purchase allowances | $250 |
| Purchase discounts taken | $320 |
| Ending inventory (May 31 physical count) | $5,860 |
Net purchases = $18,500 + $740 − $1,150 − $250 − $320 = $17,520.
Goods available = $6,400 + $17,520 = $23,920.
COGS = $23,920 − $5,860 = $18,060.
Check the other direction: $6,400 + $17,520 − $5,860 = $18,060. If your four-function calculator disagrees, you either omitted freight-in (too small a COGS) or treated freight-in as an operating expense (same understatement of COGS, overstatement of other expenses, gross profit too high).
Freight-in is not freight-out. Freight-in sits inside net purchases. Freight-out sits with selling expenses and never enters this equation.
Journals during the period (periodic)
May 6 — buy $2,200 of binders on account, FOB shipping point, freight $90 cash:
Dr Purchases 2,200
Cr Accounts Payable 2,200
Dr Freight-in 90
Cr Cash 90
May 9 — return $175 of warped binders:
Dr Accounts Payable 175
Cr Purchase Returns and Allowances 175
May 15 — pay a $3,000 invoice within 2/10, gross method:
Dr Accounts Payable 3,000
Cr Purchase Discounts 60
Cr Cash 2,940
Notice the credit is Purchase Discounts, not Inventory. Inventory did not move on May 6 and does not move on May 15.
Net method would have recorded Purchases at $2,940 and the payable at $2,940. Missing the discount then debits Purchase Discounts Lost $60, the same idea as section 10.2, still without touching Inventory.
May 20 — sell goods for $3,400 on account:
Dr Accounts Receivable 3,400
Cr Sales 3,400
There is no COGS entry and no credit to Inventory. That is the defining periodic sale.
May 22 — customer returns $220 of goods that can be resold:
Dr Sales Returns and Allowances 220
Cr Accounts Receivable 220
No Inventory debit. The units are physically back; the count at month-end will include them in ending inventory, which automatically reduces COGS through the equation. That is why periodic sales returns look “one-sided” compared with perpetual.
If the returned goods are trash, ending inventory should not include them. The count team has to set damaged returns aside or the equation will treat garbage as EI and understate COGS.
Closing and adjusting Inventory and COGS
At May 31 Saltbox still shows Inventory $6,400 (the beginning balance). Purchases, Freight-in, Purchase Returns and Allowances, and Purchase Discounts have balances. Ending inventory from the count is $5,860. You must (1) take beginning inventory off the balance sheet, (2) put ending inventory on the balance sheet, (3) close the temporary purchase accounts, and (4) leave COGS $18,060 as the income-statement residual.
One combined closing/adjusting entry that does all four jobs:
Dr Inventory 5,860
Dr Purchase Returns and Allowances 1,150
Dr Purchase Allowances 250
Dr Purchase Discounts 320
Dr Cost of Goods Sold 18,060
Cr Inventory 6,400
Cr Purchases 18,500
Cr Freight-in 740
Debits: $5,860 + $1,150 + $250 + $320 + $18,060 = $25,640.
Credits: $6,400 + $18,500 + $740 = $25,640.
After posting, Inventory = $5,860 (the count). Purchases and the related temporary accounts are zero. COGS = $18,060. If your firm uses a single Purchase Returns and Allowances account of $1,400 instead of splitting returns $1,150 and allowances $250, the debits still total $25,640.
A textbook sometimes uses Income Summary as a waypoint: close beginning inventory and net purchases into Income Summary, then set up ending inventory with a debit to Inventory and a credit to Income Summary. The net effect on income is still COGS $18,060. Exam items that say “close the inventory-related accounts” want you to know which balances die and which Inventory figure survives.
Stepwise instead of combined:
- Remove beginning inventory: debit COGS $6,400, credit Inventory $6,400.
- Close Purchases and Freight-in into COGS: debit COGS $18,500 and $740; credit those accounts.
- Close the contras into COGS: debit Purchase Returns $1,150, Allowances $250, Discounts $320; credit COGS $1,720.
- Establish ending inventory: debit Inventory $5,860, credit COGS $5,860.
Net COGS = 6,400 + 18,500 + 740 − 1,720 − 5,860 = 18,060. Same answer. Use whichever sequence the problem’s account titles support, but do not credit ending inventory off the books — that is the number that must remain as the current asset.
Shrinkage is buried in periodic COGS
Suppose Saltbox’s stock cards (if anyone kept informal counts) suggested about $6,100 should still be on the shelf, but the physical count is $5,860. The $240 difference is shrinkage — theft, breakage, or unrecorded issues. Periodic COGS of $18,060 already includes that $240 because EI is the count, not a book perpetual balance. There is no separate required shrinkage journal unless management wants a memo or a reconciling worksheet.
That is a major difference from perpetual (section 10.2), where recorded COGS tracks units sold and shrinkage is a second entry. Comparing a perpetual COGS to a periodic COGS for the same company without adjusting for shrinkage is comparing two different expense mixes.
Exam traps for section 10.3
- Debiting Inventory when merchandise arrives on a periodic problem.
- Recording COGS on the sale date.
- Omitting freight-in from net purchases, or parking it in Delivery Expense.
- Subtracting freight-in (as if it were a contra).
- Leaving Purchases open as if it were a balance-sheet asset.
- Crediting the $5,860 ending inventory to zero it “because we close everything.” Ending inventory is the asset you just measured.
- Forgetting that periodic COGS includes shrinkage, then adding a second shrinkage expense and double-counting the missing goods.
Saltbox Office Goods reports beginning inventory $6,400, purchases $18,500, freight-in $740, purchase returns $1,150, allowances $250, purchase discounts $320, and ending inventory $5,860. Periodic cost of goods sold is:
Saltbox uses the periodic method. On May 12 it buys $2,200 of goods on account; on May 20 it sells those goods for $3,400 on account. What is recorded at those dates?
After Saltbox counts $5,860 of ending inventory, which closing/adjusting approach correctly updates the accounts?