Under periodic inventory procedure, the Merchandise Inventory account is updated periodically after a physical count has been made. Usually, the physical count takes place immediately before the preparation of financial statements. This method is most effective for a company with a small amount of inventory due to the labor required to do a physical count of inventory.  Companies using periodic inventory procedure make no entries to the Merchandise Inventory account nor do they maintain unit records during the accounting period. Thus, these companies have no up-to-date balance against which to compare the physical inventory count at the end of the period.

Since a company does not use the Merchandise inventory account during the accounting period, what accounts do they use for merchandise purchases?  Here is a list of the accounts needed under a periodic inventory system:

Inventory Purchases under Periodic

Companies using periodic inventory procedure make no entries to the Merchandise Inventory account nor do they maintain unit records during the accounting period. Under periodic inventory procedure, a merchandising company uses the Purchases account to record the cost of merchandise bought for resale during the current accounting period. The Purchases account, which is increased by debits, appears with the income statement accounts in the chart of accounts.

To illustrate the periodic inventory method journal entries, assume that Hanlon Food Store made two purchases of merchandise from Smith Company.

• On May 4, Hanlon purchased $30,000 of merchandise with credit terms of 2/10, n30 and shipping terms FOB Destination.
• on May 21, Hanlon purchased $20,000 of merchandise for cash with shipping terms FOB Shipping Point.

The required journal entries for Hanlon are: 

On May 4, we know credit terms means we have not paid for it yet but will pay for it later (accounts payable)  We are offered a 2% discount if we pay within 10 days but do not record it yet as we do not know if we will make the discount due date.  On May 21, we paid with cash so we do not have credit terms since it has been paid.

Shipping on Inventory Purchases

We learned shipping terms tells you who is responsible for paying for shipping.  FOB Destination means the seller is responsible for paying shipping and the buyer would not need to pay or record anything for shipping.  FOB Shipping Point means the buyer is responsible for shipping and must pay and record for shipping.

Buyers must record shipping charges as transportation in (or Freight In)  when the goods were shipped FOB shipping point and they have received title to the merchandise.

In our example for Hanlon, May 4 was FOB Destination and we will not have to do anything for shipping.  On May 21, shipping terms were FOB Shipping Point meaning we, as the buyer, must pay for shipping.  Under the periodic inventory system, we will debit Transportation (or freight) In for the shipping cost and credit cash or accounts payable depending on if we paid it now or later.  Let’s continue with another example from Hanlon.

On May 22 Hanlon paid We Ship It $200 for shipping on the items purchased May 21. The journal entry would be:

Purchase returns and allowances

A purchase return occurs when a buyer returns merchandise to a seller. When a buyer receives a reduction in the price of goods shipped but does not return the merchandise, a purchase allowance results.

Regardless of whether we have return or allowance, the process is exactly the same under the periodic inventory system.  Both returns and allowances reduce the buyer’s debt to the seller (accounts payable) and decrease the cost of the goods purchased (purchases). The buyer may want to know the amount of returns and allowances as the first step in controlling the costs incurred in returning unsatisfactory merchandise or negotiating purchase allowances. For this reason, buyers record purchase returns and allowances in a separate Purchase Returns and Allowances account.

If Hanlon returned $350 of merchandise to Smith Wholesale on May 6 before paying for the goods, Hanlon would make this journal entry:

The entry would have been the same to record a $ 350 allowance. Only the explanation would change.

If Hanlon had already paid the account, the debit would be to Cash instead of Accounts Payable, since Hanlon would receive a refund of cash. If the company took a discount at the time it paid the account, only the net amount would be refunded. For instance, if a 2% discount had been taken, the return amount would be $350 – (350 x 2%) or $343.  Discounts are recorded in a separate purchase discounts account.  Hanlon’s journal entry for the return would be:

Notice a 2% discount is taken on the return since we already paid and received the 2% discount.  We reduce the amount of the discount (originally recorded as a credit) since we can no longer claim that as a discount since the merchandise was returned.

Paying for Inventory Purchased on Credit

When paying for inventory purchased on credit, we will decrease what we owe to the seller (accounts payable) and cash.  If we take a discount for paying early, we record this discount in the purchase discount account under the periodic inventory method.

Using the purchase transaction from May 4 and no returns, Hanlon pays the amount owed on May 10.  May 10 is within the discount period and Hanlon will take the 2% discount provided in the terms 2/10, n30 (remember, this means 2% discount if paid in 10 days of the invoice date otherwise, full amount is due in 30 days).

We reduce the full amount owed on May 4 and calculate the 2% discount based on this amount.  The cash amount is the amount we owe – discount.

Assume we also had the return on May 6 of $350.  Hanlon pays the amount owed less the return and takes the 2% discount on May 12.  Notice how accounts payable has been reduced to reflect the return.  The journal entry for this payment would be:

We reduce the full amount owed on May 4 less the return of $350.  The discount is calculated based on the amount owed less the return x 2%.  The cash amount is the amount we owe – the return – the discount.

Finally, if instead Hanlon did not have any returns and did not pay the invoice within the discount period but paid the invoice from May 4 on May 30.  The entry would be:

Summary

Under periodic inventory procedure, the Merchandise Inventory account is updated periodically after a physical count has been made.  Companies using periodic inventory procedure make no entries to the Merchandise Inventory account nor do they maintain unit records during the accounting period. Thus, these companies have no up-to-date balance against which to compare the physical inventory count at the end of the period.