Companies using the periodic inventory method make no attempt to determine the cost of goods sold at the time of each sale. Instead, they calculate the cost of all the goods sold during the accounting period at the end of the period. We will look at calculating cost of goods sold a little later.  Key point to remember:  Under the periodic inventory method, a cost of good sold account is not used to record sales transactions.

This section explains how to record sales revenues, including the effect of trade discounts. Then, we explain how to record two deductions from sales revenues—sales discounts and sales returns and allowances.

Usually sales are for cash or on account. When a sale is for cash, the company credits the Sales account and debits Cash. For example, it records a $20,000 sale for cash as follows:

When a sale is on account, it credits the Sales account and debits Accounts Receivable. The following entry records a  $20,000 sale on account:

When a company sells merchandise to a customer, the seller provides credit terms.  Remember, terms tell a buyer when the invoice is due and if there is a discount allowed for paying early.  Discounts are not recorded until payment is received since the seller does not know if the buyer will take the discount at the time of the sale.

Sales returns and allowances

Merchandising companies usually allow customers to return goods that are defective or unsatisfactory for a variety of reasons, such as wrong color, wrong size, wrong style, wrong amounts, or inferior quality.  A sales return is merchandise returned by a buyer.  A sales allowance is a reduction of the price when the customer keeps the merchandise but is dissatisfied for any of a number of reasons, including inferior quality, damage, or deterioration in transit.  The account entry is the same whether it is a sales return or allowance.

Sellers record sales returns and sales allowances in a separate Sales Returns and Allowances account. The Sales Returns and Allowances account is a contra revenue account (to Sales) that records the selling price of merchandise returned by buyers or reductions in selling prices granted.

Following are two examples illustrating the recording of sales returns in the Sales Returns and Allowances account:

• Assume that a customer returns $300 of goods sold on account. If payment has not yet been received, the required entry is:

• Assume that the customer has already paid the account and the seller gives the customer a cash refund. Now, the credit is to Cash rather than to Accounts Receivable. If the customer has taken a 2% discount when paying the account, the company would return to the customer the sales price less the sales discount amount. For example, if a customer returns goods that sold for $300, on which a 2% discount was taken, the following entry would be made:

The debit to the Sales Returns and Allowances account is for the full selling price of the purchase. The $6 credit reduces the balance of the Sales Discounts account and the balance is the cash refund.

Next, we illustrate the recording of a sales allowance in the Sales Returns and Allowances account. Assume that a company grants a $400 allowance to a customer for damage resulting from improperly packed merchandise. If the customer has not yet paid the account, the required entry would be:

If the customer has already paid the account, the credit is to Cash instead of Accounts Receivable. If the customer took a 2% discount when paying the account, the company would refund only the net amount $ 392. Sales Discounts would be credited for $8. The entry would be:

 Receiving Payment from Customers

Remember, the credit terms (or terms) provides information to the buyer about when the invoice is due and if there is a discount allowed for paying the invoice early.  The discount is not recorded until payment is received because the seller does not know if a buyer will take the discount or not.  Discounts are recorded in a contra-revenue account called Sales Discounts.  We will be reducing the amount owed by the customer (accounts receivable) and increasing sales discounts (if any) and cash.

For example, we receives payment of the $20,000 and the customer took a 2% discount.  The entry to record this transaction would be:

If the customer had returned merchandise for $300 before paying the invoice, the entry to record this transaction with a 2% discount would be:

If the customer had a $400 allowance but paid the invoice after the discount period, the entry to record the transaction (less the allowance) would be:

Cost of Goods Sold

Remember, companies using the periodic inventory method make no attempt to determine the cost of goods sold at the time of each sale. Instead, they calculate the cost of all the goods sold during the accounting period at the end of the period. 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.
• Ending inventory (cost of unsold goods at the end of the period).

Inventory is a permanent account meaning the balance rolls over from period to period.  The ending inventory balance of on period is the beginning inventory of the next period.

The net cost of purchases is calculated as Purchases + Transportation In – Purchase Discounts – Purchases Returns and Allowances.

Ending inventory is based on a physical count of inventory on hand before issuing financial statements.  Taking a physical inventory consists of counting physical units of each type of merchandise on hand. To calculate inventory cost, they multiply the number of each kind of merchandise by its unit cost. Then, they combine the total costs of the various kinds of merchandise to provide the total ending inventory cost. When taking a physical inventory, company personnel must be careful to count all goods owned, regardless of where they are located, and include them in the inventory.

The company would show this information as follows:

An adjusting entry would be made at year end to record the cost of goods sold expense and reduce inventory so the balance in inventory matches the physical count.  The entry for the example above would be:

Summary

Under the periodic inventory method, the seller will use the following accounts:

Sales Discounts and Sales Returns and Allowances are contra-revenue accounts.  Remember, we do not record sales transactions using either merchandise inventory or cost of goods sold expense account under the periodic inventory method.  Instead, cost of goods sold is calculated at the end of the period and recorded in an adjusting journal entry.