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What is the periodic inventory system?

The periodic inventory system does not update the general ledger account Inventory when a company purchases goods to be resold. Instead, the company debits the temporary account Purchases. Any adjustments related to these purchases of goods will be credited to a general ledger contra account such as Purchases Discounts or Purchases Returns and Allowances. When the balances of these three purchases accounts are combined, the resulting amount is known as net purchases.

Another characteristic of the periodic inventory system is that when goods are sold there is no entry to credit the Inventory account or to debit the account Cost of Goods Sold. Hence, the Inventory account merely contains only the ending balance from the previous year. This requires the company to compute an inventory amount at the end of each accounting period in order to report the amount of its ending inventory for its balance sheet and the cost of goods sold for its income statement.

At the end of an accounting year, the company's ending inventory is normally computed based on a physical inventory of its goods, but the inventory amounts for the monthly and quarterly financial statements are usually estimates. Under the periodic inventory system the cost of goods sold is computed as follows: beginning inventory (previous year's ending inventory cost) + net purchases = cost of goods available - costs computed for the ending inventory = cost of goods sold.

It should be noted that companies using the periodic inventory system for their general ledger often have sophisticated inventory systems outside of the general ledger for tracking the goods it purchases, produces, sells and has on hand.