Definition of Purchases and Inventory
When a company uses the periodic inventory system the amount of the company's inventory is determined by a physical count at the end of the accounting year. Throughout the year the general ledger account Inventory is dormant and contains only the cost of the prior year's ending inventory. With the periodic inventory system, the costs of additional purchases of goods are debited to the temporary account Purchases. (There will also be temporary accounts that will be credited for Purchase Returns and Allowances and for Purchase Discounts.)
When a company uses the perpetual inventory system, the general ledger account Inventory is continually being updated for all the purchases and sales of goods:
- The costs of the goods purchased are debited to Inventory
- The costs of the goods that were sold are credited to Inventory and are debited to the income statement account Cost of Goods Sold
- The costs of purchase returns, purchase allowances, and purchase discounts are credited to Inventory
Companies often have sophisticated inventory systems outside of its general ledger. As a result, a company may find it advantageous to use the periodic inventory system in its general ledger (instead of the perpetual inventory system) especially when it uses the LIFO cost flow assumption for valuing its inventory and cost of goods sold.