Definition of Periodic Inventory System
The periodic inventory system does not update the general ledger account Inventory when a company purchases goods to be resold. Rather than debiting Inventory, 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.
When goods are sold under the periodic inventory system there is no entry to credit the Inventory account or to debit the account Cost of Goods Sold. Hence, the Inventory account contains only the ending balance from the previous year. As a result, the company must 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.
Computing the Inventory Amount Under the Periodic Inventory Method
At the end of an accounting year, the company's ending inventory is normally computed based on a physical count of its inventory items. However, 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. An alternative format is: net purchases plus the decrease in inventory or minus the increase in inventory = cost of goods sold.
Inventory Records Outside of the General Ledger
It should be noted that companies using the periodic inventory system in their general ledger accounts often have sophisticated inventory systems outside of the general ledger for tracking the items it purchases, produces, sells and has on hand.