Companies using periodic inventory don’t update the Merchandise Inventory account when purchases or sales are made. Instead, the company posts purchases of inventory to an expense account called Purchases. The Purchases account is usually grouped with the income statement expense accounts in the chart of accounts.

See the invoice long description here.

Let’s record this invoice using a periodic system:

Before we record the invoice though, let’s take a closer look at this formula:

[latex]\text{Beginning inventory}+\text{Purchases}-\text{Ending inventory}=\text{Cost of goods sold}[/latex]

We can expand it to look like this:

[latex]\text{Beginning inventory}+\text{Purchases}+\text{freight in}-\text{Ending inventory}=\text{Cost of goods sold}[/latex]

Shipping on Inventory Purchases (Freight In)

We learned that shipping terms tell you who is responsible for paying for shipping. Free on board (FOB) destination means the seller is responsible for paying shipping and the buyer would not need to pay or record anything for shipping. Free on board (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.

The general rule is that all the costs we incur to get the product on the shelf and ready to sell are product costs. The freight we pay to get the sound systems into our shop is part of the cost of the inventory. In other words, instead of the unit cost being $100, it is actually $103.50 (total cost, including freight, of $20,700 divided by 200 units).

The entry is as you might expect it to be:

Notice that we did not post the purchases to the inventory account, which is a major difference between this periodic system and the perpetual system. The perpetual system is what we will be doing in the next unit as we study the perpetual system.

Also, we are going to make some adjustments in the next section for returns, allowances, and discounts; but first, let’s check in on recording purchases.

Purchase Adjustments under a Periodic System

Let’s make one more adjustment to our formula to account for three common events:

1. Inventory we return in exchange for a credit to our account with the vendor (or a refund).
2. Inventory that is damaged or otherwise unusable and not worth returning for which we get an allowance (reduction in the amount we owe).
3. Discounts we take for prompt payment (e.g., 2% if we pay within 10 days).

Beginning inventory + (Purchases, net of returns and allowances, and purchase discounts) + freight in − Ending inventory = Cost of goods sold

The account called Purchases is only used with the periodic inventory system. It is a temporary account used in the periodic inventory system to record the purchases of merchandise for resale. This account reports the gross amount of purchases of merchandise.

Net purchases are the amount of gross purchases minus purchase returns, purchase allowances, and purchase discounts. While the Purchases Accounts are normally classified as temporary expense accounts, they are actually hybrid accounts. The purchase accounts are used along with freight in, and the beginning and ending inventory to determine the cost of goods sold (COGS).

Before we dive into the COGS details for the periodic system, begin to familiarize yourself with this chart. This is a quick way to compare the differences between how the two methods record the details involved with inventory.

Now, let’s go back to our invoice:

See the invoice long description here.

In the accounting department, you have matched up the receiving documents sent with this invoice and it is now ready to be paid.

Gross Method of Recording Accounts Payable

For review, here is the journal entry the accounts payable department made based on the invoice and the shipping documents:

First, let’s assume one whole case was returned for some reason on December 26. So 40 units went back to Bryan and the accounting department received a credit memo for $4,000. They also paid shipping of some amount that will be posted to a shipping expense account that is not part of COGS.

Bryan issues us a “Credit Memo” because they debited accounts receivable when they shipped the product to us, so when they get it back, they reduce their receivable by crediting our account. We are going to debit accounts payable and reduce inventory:

We are also going to update two subsidiary ledgers: the Accounts Payable subsidiary ledger that showed we owed Bryan $20,700 will now show we owe $16,700 and the inventory subsidiary ledger that lists all our items and the corresponding costs will now show 160 units of XPS-101 at $104.375 each ($16,700 divided by 160).

An allowance would be the same entry. The basic difference between a return and an allowance is that we usually don’t return the goods if they are damaged or unsatisfactory in some way. The vendor issues a Credit Memo anyway and we remove the items from inventory and dispose of them.

Let’s assume then that you, in the accounting department, pay the invoice on January 10:

Because the terms were 2/10, n 30, and the invoice was dated December 19, the discount for prompt payment (a.k.a. cash discount) expired at the close of business on the 29th. How much was the discount not taken?

[latex]\$16,000 \times 0.02 = \$320.00[/latex]

Remember, the discount does not apply to shipping costs that are passed through to the buyer.

If total purchases for the year were $1,532,444 and the company missed the discount window every time, what would be the effect on the bottom line of the company (how much would the company end up paying out in missed discounts)?

[latex]\$1,532,444 \times 0.02 = \$30,648.88[/latex]

Let’s back up for a minute then and assume you paid the invoice on the 29th. What would the journal entry look like?

The entry extinguishes the account payable for that invoice and the check includes $700 for shipping plus the invoice minus the credit memo minus the 2% discount on the adjusted balance of $16,000. Check the calculations above and make sure the journal entry is correct.

This is called the gross method of recording accounts payable.

There is another way to do it: the net method.

Net Method of Recording Accounts Payable

Under the net method, the payable net of the discount ($20,000 − $320 = $19,600) would have been recorded like this:

The unit cost would then be net of the discount but would include freight, so $101.50 [latex]\left(\dfrac{\$20,300}{200\text{ units}}=\$101.50\right)[/latex].

The return of 40 units on Dec. 30th would be recorded like this, even though the credit memo was for $4,000 [latex]\left(\$4,000 \times 0.02\text{ discount}= \$80.00 : \$4,000 - \$80 = \$3,920\right)[/latex]:

And the prompt payment on Dec. 29th would look like this [latex]\left(\$19,600 - \$3,920 + \$700 = \$16,380\right)[/latex]:

Because we recorded the original invoice net of the discount under the assumption that we always take the discount, we don’t need the Purchase Discount account. Here is what the subsidiary ledger (and the GL) would show us under this net method:

This example may look unreasonably complicated, but there is a hidden benefit. Let’s follow this through with one more scenario though—paying after the cash discount has expired:

The net method allows you to track discounts lost, which then gives you a direct read on how much profit you are losing to what is essentially a finance charge.

Next, let’s tackle something a bit easier—recording sales.