Source: Chapter 8, Intermediate Financial Accounting II (Penn State)
Tags: inventory, merchandising, manufacturing, perpetual, periodic, COGS, FOB, consignment, purchase discounts, ACCTG 471
Difficulty: Intermediate | Prerequisites: Introductory financial accounting (debits/credits, journal entries, the accounting cycle)
Inventory is one of the largest current assets on most balance sheets, and the way a company tracks and values it flows directly into cost of goods sold and net income. This chapter covers the two main inventory tracking systems (perpetual and periodic), the rules for deciding which goods belong in your inventory count (transit, consignment, anticipated returns), and how purchase discounts are recorded. If you are comfortable with basic journal entries and the structure of the income statement, you are ready for this material. Everything here feeds into the cost flow assumptions (FIFO, LIFO, average cost) covered in Part 2.
Companies hold either merchandising or manufacturing inventory and track it using a perpetual system (updated in real time) or a periodic system (updated only at period end). Ownership of goods in transit depends on the FOB term, consigned goods stay on the consignor's books, and purchase discounts can be recorded gross or net. Getting these basics right is the foundation for every inventory valuation method that follows.
Merchandising inventory
Goods purchased in finished form for resale. Cost includes the purchase price plus all costs needed to get the goods into saleable condition and location. In simple terms, this is the stock a retailer buys from a supplier and sells on to customers without further processing.
Manufacturing inventory
Goods produced by a company for sale. Consists of three sub-categories: raw materials, work-in-process (WIP), and finished goods. Think of it as inventory that moves through a production pipeline before it is ready to sell.
Perpetual inventory system
A system that updates the inventory account continuously, in real time, every time goods are bought, sold, or returned. In simple terms, the books always reflect what is (or should be) on the shelf right now.
Periodic inventory system
A system that updates inventory and records COGS only at the end of each reporting period, using a physical count and temporary purchase accounts. Think of it as a "true-up at year end" approach: purchases go into holding accounts and the real inventory balance is worked out later.
Cost of goods sold (COGS)
The expense recognised when inventory is sold. Under the periodic system: COGS = beginning inventory + net purchases - ending inventory. Also written as COGDS or cost of goods sold. This is the figure that reduces gross profit on the income statement.
FOB shipping point
Title and risk pass to the buyer when the seller hands the goods to the carrier. The buyer records the purchase and includes the goods in inventory from the ship date, even if they have not arrived yet.
FOB destination
Title and risk remain with the seller until the goods reach the buyer's location. The seller keeps the goods in its own inventory until delivery is complete.
Goods on consignment
Inventory placed with a third party (the consignee) for sale, but legal ownership stays with the original owner (the consignor) until a buyer is found. In simple terms, the consignee is selling someone else's stock and does not bear the risk of unsold goods.
Purchase discount
A reduction in the amount owed if the buyer pays within a specified window. Notation example: 2/10, n/30 means a 2% discount if paid within 10 days, otherwise the full amount is due in 30 days.
Gross method (for purchase discounts)
Records the purchase at the full invoice price. The discount is recognised as a credit to a contra-purchases account only if the buyer pays early.
Net method (for purchase discounts)
Records the purchase at the invoice price minus the available discount from day one. If the buyer misses the discount window, the extra amount paid is recorded as interest expense.
Merchandising inventory is purchased in finished form (retailers, wholesalers). Cost = purchase price + freight + any costs to get goods ready for sale.
Manufacturing inventory passes through three stages:
Raw materials: inputs waiting to enter production
Work-in-process (WIP): partially completed goods (raw materials + direct labour + manufacturing overhead)
Finished goods: completed products ready for sale
When finished goods are sold, the cost moves to COGS on the income statement.
The inventory account is adjusted in real time with every purchase, sale, or return.
Inventory bought: Debit Inventory, Credit Accounts Payable
Inventory sold (two entries):
Debit Accounts Receivable, Credit Sales Revenue (for the selling price)
Debit COGS, Credit Inventory (for the cost of the goods)
Advantages: management can determine goods on hand at any date, units sold during a period, and make better purchasing decisions without waiting for a physical count.
Inventory and COGS are calculated only at the end of the reporting period.
Inventory bought: Debit Purchases, Credit Accounts Payable
Inventory sold: Debit Accounts Receivable, Credit Sales Revenue. No COGS entry is made at the time of sale.
End-of-period COGS entry (closes the temporary accounts):
Debit COGS
Debit Inventory (ending, per physical count)
Credit Inventory (beginning)
Credit Purchases
The beginning inventory debit is cancelled out, the ending inventory is recorded, and the Purchases temporary account is closed to zero.
Worked example (periodic system): Beginning inventory 120k, purchases on account 600k, sales 820k, ending inventory per physical count 180k.
COGAS = 120k + 600k = 720k
COGS = 720k - 180k = 540k
Closing entry: Debit COGS 540k, Debit Inventory (ending) 180k, Credit Inventory (beginning) 120k, Credit Purchases 600k
Ownership depends on the shipping term, which determines who includes the goods in inventory at the balance sheet date.
FOB shipping point: title passes when the goods leave the seller's dock. The buyer records the purchase and includes the goods in ending inventory even if they have not yet arrived.
FOB destination: title passes when the goods arrive at the buyer's location. The seller keeps the goods in its own ending inventory until delivery.
Example: Goods shipped 29 December, arrive 3 January, fiscal year ends 31 December.
FOB shipping point: the seller records the sale in December; the buyer includes the goods in December ending inventory.
FOB destination: the seller keeps the goods in December ending inventory and records the sale in January; the buyer records the purchase in January.
Consigned goods remain in the consignor's inventory until the consignee sells them to a third party.
The consignee bears no risk of unsold inventory; unsold goods are simply returned.
When a sale is made, the consignee remits the selling price minus commission and approved expenses to the consignor.
Estimated sales returns reduce both sales revenue and net accounts receivable.
COGS is reduced and inventory is increased for the cost of goods expected to be returned.
The company includes in inventory the cost of merchandise it anticipates will come back.
A return is treated as a reduction of net purchases.
Perpetual system: Debit Accounts Payable, Credit Inventory
Periodic system: Debit Accounts Payable, Credit Purchase Returns (a temporary contra-purchases account that is netted against Purchases at period end)
Example: Merchandise purchased for 20k, terms 2/10, n/30. Buyer pays 14k portion on day 10 (within the discount window) and the remaining 6k on day 30 (after the window). Periodic system.
At purchase:
Gross method: Debit Purchases 20k, Credit AP 20k
Net method: Debit Purchases 19,600, Credit AP 19,600 (20k less the 2% discount)
Payment within discount window (14k portion):
Gross method: Debit AP 14k, Credit Purchase Discounts 280 (14k x 2%), Credit Cash 13,720
Net method: Debit AP 13,720, Credit Cash 13,720
Payment after discount window (6k portion):
Gross method: Debit AP 6k, Credit Cash 6k
Net method: Debit AP 5,880, Credit Interest Expense 120 (6k x 2%), Credit Cash 6k
The net method treats a missed discount as a financing cost (interest expense), which arguably gives a more accurate picture of the true cost of inventory.
COGS (periodic): Beginning inventory + Net purchases - Ending inventory = COGS
Cost of goods available for sale (COGAS): Beginning inventory + Net purchases
Units on hand at end of period: Beginning inventory (units) + Purchases (units) - Units sold
Net purchases: Purchases - Purchase returns - Purchase allowances - Purchase discounts + Freight-in
Most large retailers (supermarkets, department stores) use perpetual systems tied to barcode scanners at the point of sale, so every scan updates inventory in real time. Smaller businesses or those with very low-value, high-volume goods sometimes still rely on periodic systems because the cost of tracking every unit in real time outweighs the benefit.
FOB terms matter whenever goods are in transit at a reporting date. If your company ships products on 30 December under FOB shipping point, those goods leave your inventory on that date, even though the customer has not received them. Getting this wrong misstates both inventory and COGS for the period.
Students often think the periodic system records COGS at the time of each sale. It does not. COGS is calculated and recorded only at period end.
Students confuse FOB shipping point with FOB destination. Remember: "shipping point" = the buyer takes ownership (and risk) the moment goods ship. "Destination" = the seller keeps ownership until the goods arrive.
Students assume consigned goods belong to the consignee because they are in the consignee's physical possession. They do not. The consignor retains ownership and carries the goods in its own inventory.
Students sometimes think the gross method and net method produce different total costs for inventory over the life of a transaction. They do not, so long as all payments are made. The difference is in how missed discounts are classified (as a reduction to purchase discounts taken vs. as interest expense).
Exam questions commonly test the journal entries for perpetual vs. periodic systems. Be able to write both sets from memory.
FOB terms and their effect on which company reports the goods in ending inventory is a frequent multiple-choice topic.
The COGS closing entry under the periodic system (debiting COGS and ending inventory, crediting beginning inventory and purchases) is a classic exam question.
Know the difference between gross method and net method journal entries for purchase discounts, including what happens when the discount window is missed.
Consignment inventory belongs to the consignor, not the consignee. This is tested often.
True or false: Under a perpetual system, COGS is recorded only at year end. (False)
Fill in the blank: COGS (periodic) = Beginning inventory + ______ - Ending inventory. (Net purchases)
True or false: Under FOB destination, the buyer includes goods in transit in its ending inventory. (False)
True or false: Consigned goods are included in the consignee's inventory. (False)
Fill in the blank: Under the net method, a missed purchase discount is recorded as ______. (Interest expense)
Q: A company uses a periodic inventory system. Beginning inventory is 50k, purchases are 200k, and a physical count shows ending inventory of 60k. What is COGS?
A: COGS = 50k + 200k - 60k = 190k.
Q: Goods are shipped FOB shipping point on 28 December and arrive on 4 January. The seller's fiscal year ends 31 December. Who includes the goods in 31 December ending inventory?
A: The buyer. Under FOB shipping point, ownership transfers when the goods are handed to the carrier.
Q: Under the gross method, a company purchases merchandise for 10,000 with terms 2/10, n/30 and pays within the discount window. What is the journal entry at payment?
A: Debit Accounts Payable 10,000, Credit Purchase Discounts 200 (10,000 x 2%), Credit Cash 9,800.
Q: A consignor ships 15,000 of goods to a consignee. The consignee sells 10,000 of those goods to a third party. How much inventory does the consignor report?
A: 5,000. The 10,000 sold to the third party is removed from the consignor's inventory when the consignee makes the sale. The remaining 5,000 unsold goods stay on the consignor's books.
Q: Under a perpetual system, what two journal entries are recorded when goods are sold?
A: (1) Debit Accounts Receivable, Credit Sales Revenue (for the selling price). (2) Debit COGS, Credit Inventory (for the cost of the goods sold).
This material connects directly to the cost flow assumptions covered in Part 2 of these notes (FIFO, LIFO, average cost, specific identification, dollar-value LIFO). The perpetual vs. periodic distinction matters because FIFO and average cost produce different COGS figures depending on which system is used, while LIFO results are the same either way.
Inventory valuation also ties into lower-of-cost-or-net-realisable-value (LCNRV) testing, typically covered in Chapter 9, and into the gross profit and retail inventory estimation methods.
Inventory, COGS, cost of goods sold, perpetual inventory, periodic inventory, merchandising inventory, manufacturing inventory, raw materials, work-in-process, WIP, finished goods, FOB shipping point, FOB destination, goods in transit, goods on consignment, consignor, consignee, sales returns, purchase returns, purchase discounts, gross method, net method, 2/10 n/30, COGAS, cost of goods available for sale, ACCTG 471, intermediate accounting, inventory systems