10 Inventory

In the periodic inventory system, the inventory account changes periodically, usually at the end of every month or year. That means we do not use the inventory account except at the end of each period. You may wonder: if we can’t use the inventory account, how will sales and purchases be recorded? That’s a great question because, in the perpetual inventory system, both sale and purchase journal entries affect inventory. The periodic inventory system gets around this by using an account called purchases. If you’re ever scanning a trial balance and you see a purchases account, that’s a hot tip that the company uses a periodic inventory system. Please remember this for your exams: purchases account means periodic inventory system.

The purchases account holds the cost of all inventory purchased during the period. That means all the inventory we purchase between inventory adjustment dates, which are usually monthly or yearly. Let’s think about the journal entry for purchases. When a company receives inventory, they need to record that they owe the supplier money. In double entry accounting, where assets = liabilities + equity, we need a debit.

In the perpetual system, this would be a debit to inventory, but we are not using the perpetual system. We are using the periodic system, so we use the purchases account:

And you might be wondering: what type of account is Purchases? or where will the Purchases account show up on the financial statements? Those are fabulous questions, and I would like to respond with a short equation:

Cost of Goods Sold = Beginning Inventory + Purchases – Ending Inventory

Okay I get it if you don’t love this equation. But notice that purchases are part of Cost of Goods Sold. We will see the Purchases account on the Income Statement as an increase to Cost of Goods Sold (COGS). On the Income Statement, this equation will look a bit different because it will be presented vertically:

Let’s pretend that we own a bookstore, in this example of calculating Cost of Goods Available for Sale, Ending Inventory, and Cost of Goods Sold.

At the beginning of the month we have 2 copies of Catcher in the Rye on the shelf. Then we purchase 3 more copies. How many copies of Catcher in the Rye do we have available for sale? That’s right: 5 copies are available for sale! Now let’s say that each copy costs $7. What is the cost of the five copies available for sale? Yes, you got it – $35. This is calculated as 5 copies x $7 per copy). You’ve calculated Cost of Goods Available for Sale!

Now let’s pretend that our bookstore subsequently sells 4 copies. How many copies will we have in Ending Inventory? Yep, you guessed it – 1 copy (5 copies less 4 copies sold). And that ending inventory will have a value of $7 (1 copy x $7 per copy).

So you see that we can calculate Ending Inventory as:

Ending Inventory = Beginning Inventory + Purchases – Cost of Goods Sold

And this is a logical way to look at the equation because it follows the flow of goods over time. But notice that the equation above, where COGS = beginning inventory + purchases – ending inventory, is equivalent. We’ve just moved around COGS and ending inventory. This equation is telling us that of all the goods we had available for sale, some of them are still in inventory at the end of the period. And what happened to the ones that aren’t in ending inventory? Well, we must have sold them!

Going back to the book example, if we had 5 copies of Catcher in the Rye available for sale in the month and we only had one in stock at the end of the month, so we must have sold 4 copies of the book (5 copies available less 1 copy still in inventory = 4 copies sold). If each copy costed us $7 then the value of Cost of Goods Sold will be $28 (4 copies sold x $7 per copy). Here it is in tabular form:

You’ll often see this calculation right on the Statement of Financial Position. I hope this makes sense, but let’s do a couple examples just to make sure you are getting the concept.

My turn

JJ Ltd. Is a retailer of children’s puzzles and toys. JJ uses their point-of-sale system to keep track of inventory and uses a periodic inventory system for accounting. As accountants, we are concerned with the accounting system. A periodic system means that purchases are recorded when inventory is received, and inventory is updated at the end of every month. At the end of September, the trial balance shows inventory of $82,000 and September purchases of $105,000. The point-of-sale system shows that the cost of inventory at September 30 is $60,000.

We’re going to calculate cost of goods sold to be shown on the Statement of Financial Position. But first, let’s get our information straight. We need three pieces of information: beginning inventory, ending inventory, and purchases. Given this information we can calculate cost of goods sold as beginning inventory plus purchases less ending inventory. Let’s start with beginning inventory. Remember that the inventory account in the trial balance is only updated once per month, therefore the trial balance is showing inventory at its opening balance (September 1) of $82,000. The point of sales system, however, is keeping track of inventory, so we can take ending inventory from there: $60,000. Now to the calculation:

Great; we’ve calculated cost of goods sold! Let’s take just a minute to go over this calculation. JJ started with inventory costing $82,000 and spent $105,000 on inventory purchased during the month. That means that JJ had $187,000 of inventory to sell during the month (at cost). We’re interested in where that inventory went: it’s either still in inventory or we sold it. Because we’re trying to determine cost of goods sold, let’s take the total cost of goods available for sale and subtract what’s still in JJ’s inventory at the end of the month. Voilà; cost of goods sold!!

You may be wondering how JJ will update the inventory account at the end of the month. Remember that inventory is adjusted monthly, so we need to update the inventory account so the trial balance reflects the beginning balance of inventory for October’s calculation of cost of goods sold.

So how does the inventory account get adjusted? That’s a wonderful and fascinating question. Let’s demonstrate with our example. In this case, inventory decreases from $82,000 to $60,000; a $22,000 reduction. Because inventory is a debit balance, we’ll reduce it with a credit.

What will we debit? We know that cost of goods sold is a debit, but cost of goods sold for the period is $127,000. Ahhhh… we also need to transfer purchases to cost of goods sold!! Purchases has a debit balance because it is set up with a debit to purchases and credit to Cash or A/P. Let’s see the journal entry in its entirety.

That looks great!

OK; now you try it!

Excellent work!! Now that we’ve looked at the perpetual inventory system and the periodic system, let’s compare them using an example. I want you to see how the journal entries differ between the two systems.

My turn

KK Inc. is a coffee bean wholesaler. During the month of December, KK Inc. engaged in the following transactions:

December 2: KK purchased 40 cases of beans for $50 per case (on account)

December 10: KK sold 10 cases of beans for $80 per case (cost of each case is $45)

December 16: KK sold 18 cases of beans for $75 per case (cost of each case is $50)

December 20: KK sold 17 cases of beans for $78 per case (cost of each case is $50)

December 21: KK purchased 30 cases of beans for $52 per case (on account)

December 23: KK sold 5 cases of beans for $83 per case (cost of each case is $50)

December 26: KK had a boxing day sale and sold 25 cases for $72 per case ($52 cost per case)

December 29: KK purchased 30 cases of beans for $53 per case (on account)

December 31: KK paid cash for the purchases on December 2 and 21.

KK’s trial balance at December 31 showed inventory of 10 cases at a total cost of $450, and an inventory count at December 31 shows 32 cases in inventory at a total cost of $1,694.

Let’s prepare KK’s journal entries using the perpetual and periodic systems!

*Note that there should be 35 cases in inventory with a calculated value of $1,850 [(5 cases x $52) + (30 cases x $53)]. But KK only counted 32 cases in inventory. The 3 missing cases may have been stolen, but most likely they were given to potential customers as promos or used to incentivize sales. They need to be written off.

** COGS: beginning inventory + purchases – ending inventory = 450 + (2,000 + 1,560 + 1,590) – 1,694 = $3,906

Fun, right? I’m glad you think so, because now it’s your turn. Take a breath – you’ve got this!

That was a long problem, but you made it. Thanks for flexing your accounting muscles and giving it your best try!