Source: Lothridge Wholesale Beverage Company example | Gross method
Difficulty: Intermediate | Prerequisites: introductory financial accounting, basic journal entries (debits and credits), familiarity with the accounting equation.
Every merchandising company needs a system for tracking what it buys, what it sells, and what is left on the shelves. The two main approaches, perpetual and periodic inventory systems, differ in when and how they record inventory changes and cost of goods sold. This topic sits at the heart of intermediate financial accounting and directly affects how income statements and balance sheets look at year end. If you are comfortable with basic journal entries but have not yet seen how purchase discounts, returns, and freight fold into inventory accounting, start here.
A perpetual system updates the Inventory account in real time for every purchase, return, freight charge, discount, and sale. A periodic system uses temporary accounts (Purchases, Freight-in, Purchase Returns, Purchase Discounts) during the year and calculates cost of goods sold only at period end. Both systems reach the same COGS and ending inventory figures; the difference is timing and which accounts carry the detail.
Perpetual inventory system
A system that updates the Inventory account continuously as transactions occur (purchases, sales, returns). The balance in Inventory at any point should reflect what is physically on hand.
Think of it as a running tally that changes every time stock moves in or out.
Periodic inventory system
A system that does not update the Inventory account during the period. Instead, it uses temporary accounts and computes cost of goods sold at the end of the period via the COGS equation.
In simple terms, this means you only figure out what you sold (in cost terms) when you do the books at period end.
Gross method
A method of recording purchases at the full invoice price (before any discount), and recognising the discount separately only when payment is made within the discount window.
Think of it as recording the sticker price first, then logging the savings when you pay early.
Purchase discount (terms 2/10, n/30)
A reduction in the amount owed to a supplier, offered for paying within a specified period. "2/10, n/30" means a 2% discount if paid within 10 days; otherwise the full (net) amount is due in 30 days.
In simple terms, this means the supplier knocks 2% off the bill if you pay quickly.
Freight-in
Transportation costs paid by the buyer to get purchased goods to their location. Under the perpetual system, this is debited directly to Inventory. Under the periodic system, it goes to a separate Freight-in account.
Think of it as shipping costs that become part of the inventory's total cost.
Purchase returns and allowances
Reductions to the total purchases figure when goods are sent back to the supplier or a price reduction is granted. Under the perpetual system, Inventory is credited. Under the periodic system, a separate Purchase Returns account is credited.
Cost of goods sold (COGS)
The total cost of merchandise that was actually sold to customers during the period. Under a perpetual system it is recorded at the time of each sale. Under a periodic system it is calculated at the end of the period using the COGS equation.
Cost of goods available for sale
Beginning inventory plus all net purchases (gross purchases, minus returns, minus discounts, plus freight-in). This is the pool from which ending inventory and COGS are drawn.
Think of it as everything you could have sold during the period.
All entries below use the gross method (purchases recorded at full invoice price before discounts). Dollar amounts are in thousands.
Perpetual: Debit Inventory, credit Accounts Payable for the full purchase price.
Example: $620,000 purchased on account. Inventory increases by 620, A/P increases by 620.
Periodic: Debit the temporary account Purchases (not Inventory), credit Accounts Payable.
The Inventory account is not touched until period end.
Perpetual: Debit Inventory, credit Cash. Freight becomes part of inventory cost immediately.
Periodic: Debit the temporary account Freight-in, credit Cash.
Example: $16,000 in freight. Either way, cash goes down by 16. The difference is whether the cost lands in Inventory or in a holding account.
Both systems: Debit Accounts Payable (reduces the amount owed to the supplier).
Perpetual: Credit Inventory (stock went back, so inventory cost drops).
Periodic: Credit the temporary account Purchase Returns.
Example: $20,000 of goods returned. A/P decreases by 20. Inventory or Purchase Returns is credited for 20.
When payment is made within the discount window (here, 2/10 means 2% off if paid within 10 days):
Both systems: Debit Accounts Payable for the original amount owed (net of any returns already recorded).
Perpetual: Credit Inventory for the discount amount, credit Cash for the net payment.
Periodic: Credit Purchase Discounts for the discount amount, credit Cash for the net payment.
Example: A/P balance after returns = $620,000 - $20,000 = $600,000. Discount = 2% of $600,000 = $12,000. Cash paid = $588,000.
The key pattern: in a perpetual system, everything flows through the Inventory account. In a periodic system, each category of adjustment gets its own temporary account that is closed out at year end.
Both systems: Debit Accounts Receivable, credit Sales Revenue for the selling price.
Example: $830,000 in sales on account. A/R up 830, Sales Revenue up 830. Identical under both systems.
Perpetual: At the time of each sale, debit Cost of Goods Sold, credit Inventory.
Example: COGS of $550,000. Inventory decreases by 550, COGS expense increases by 550.
Periodic: No entry is made at the time of sale for COGS. Cost of goods sold is determined and recorded only at the end of the period.
This is the most important operational difference between the two systems. In a perpetual system, you always know your COGS and current inventory balance. In a periodic system, you only know them after the closing process.
At the end of the period, the periodic system requires a compound closing entry that accomplishes three things at once: recognises COGS, updates the Inventory account from the beginning to ending balance, and closes all the temporary purchase-related accounts.
The entry debits:
Cost of Goods Sold: 550
Inventory (ending): 174
Purchase Returns: 20
Purchase Discounts: 12
The entry credits:
Inventory (beginning): 120
Purchases: 620
Freight-in: 16
Total debits = 756. Total credits = 756.
After this entry, the Inventory account reflects the ending physical count ($174,000), all temporary accounts are zeroed out, and COGS appears on the income statement.
The perpetual system requires no period-end closing entry for inventory because inventory and COGS were already updated throughout the year. (A physical count may still be done to check for shrinkage, but that is a separate adjustment.)
\text{COGS} = \text{Beginning Inventory} + \text{Net Purchases} - \text{Ending Inventory}Where net purchases are calculated as:
\text{Net Purchases} = \text{Gross Purchases} - \text{Purchase Returns} - \text{Purchase Discounts} + \text{Freight-in}Worked example from the Lothridge scenario (in thousands):
Beginning Inventory: 120
Gross Purchases: 620
Purchase Returns: (20)
Purchase Discounts: (12)
Freight-in: 16
Net Purchases: 620 - 20 - 12 + 16 = 604
Cost of Goods Available for Sale: 120 + 604 = 724
Ending Inventory: (174)
COGS: 724 - 174 = 550
\text{Discount} = (\text{Gross Purchases} - \text{Returns}) \times \text{Discount Rate}Worked example: (620 - 20) x 0.02 = 12
Cash paid = 600 - 12 = 588
Most modern retailers and wholesalers use perpetual systems because point-of-sale technology and barcode scanning make real-time tracking practical. A supermarket scanning items at checkout is running a perpetual system: every sale instantly reduces the inventory record for that product.
Periodic systems are still used by smaller businesses where tracking every unit in real time is not cost-effective, such as a hardware shop that sells thousands of low-value items like bolts and washers. The trade-off is simplicity during the period versus a lack of visibility into inventory levels until the count is done.
Students often think the perpetual and periodic systems produce different COGS figures. They do not. Both arrive at the same cost of goods sold and the same ending inventory. The difference is in timing and the accounts used along the way.
Students sometimes forget that under the gross method, the discount is only recorded when payment is actually made within the discount period. If payment is late, no discount entry is made and the full amount is paid.
A common error is debiting Purchases under a perpetual system. Under perpetual, there is no Purchases account. Everything runs through Inventory.
Students frequently confuse freight-in (a cost to the buyer, added to inventory cost) with freight-out or delivery expense (a selling expense, never added to inventory cost). Only freight-in affects the cost of goods available for sale.
Exams commonly ask you to journalise the same set of transactions under both systems side by side. Be ready to write both columns without mixing up which accounts belong to which system.
The COGS equation and the period-end closing entry for the periodic system are heavily tested. You need to be able to reconstruct the closing entry from the individual figures.
Watch for questions that change one variable (e.g., "what if not all purchases were paid within the discount period?") and ask you to adjust the entries accordingly.
The discount calculation is a frequent source of exam errors. Remember: the discount is applied to the net amount after returns, not to gross purchases. In the Lothridge example, the 2% discount applies to $600,000 (620 - 20), not to $620,000.
True or false: Under a perpetual system, COGS is recorded at the end of the period. (False. It is recorded at the time of each sale.)
Fill in the blank: Under the periodic system, freight charges paid by the buyer are debited to the ______ account. (Freight-in)
True or false: The Purchases account exists in a perpetual inventory system. (False. Perpetual systems debit Inventory directly.)
Fill in the blank: The discount under terms 2/10, n/30 on net purchases of $600,000 equals $______. (12,000)
True or false: Both perpetual and periodic systems arrive at the same COGS figure. (True.)
Q: Under the perpetual system, what journal entry records the purchase of $620,000 of merchandise on account?
A: Debit Inventory 620,000; credit Accounts Payable 620,000.
Q: Under the periodic system, how is the same purchase recorded?
A: Debit Purchases 620,000; credit Accounts Payable 620,000.
Q: A company using the periodic system has beginning inventory of $120,000, gross purchases of $620,000, purchase returns of $20,000, purchase discounts of $12,000, freight-in of $16,000, and ending inventory of $174,000. Calculate COGS.
A: Net purchases = 620 - 20 - 12 + 16 = 604. Cost of goods available for sale = 120 + 604 = 724. COGS = 724 - 174 = 550 (thousands).
Q: Why is there no COGS journal entry at the time of sale under the periodic system?
A: The periodic system does not track inventory movements during the period. COGS is determined only at period end using the COGS equation and a physical inventory count.
Q: In the period-end closing entry for the periodic system, which accounts are debited and which are credited?
A: Debits: Cost of Goods Sold, Ending Inventory, Purchase Returns, Purchase Discounts. Credits: Beginning Inventory, Purchases, Freight-in. This entry simultaneously recognises COGS, updates the inventory balance, and closes the temporary accounts.
Q: Under the gross method with terms 2/10, n/30, how much cash is paid if all $600,000 of net purchases are paid within the discount period?
A: Cash paid = 600,000 - (600,000 x 0.02) = 600,000 - 12,000 = 588,000.
This material connects directly to inventory valuation methods (FIFO, LIFO, weighted average), which determine how costs are assigned to individual units sold and units remaining. Once you understand how transactions enter the system, the next question is which specific costs attach to which units.
The period-end closing entry ties into the broader closing process for temporary accounts (revenue, expenses, dividends), covered in the accounting cycle. The same logic of zeroing temporary accounts and updating permanent ones applies across the board.
The gross method covered here contrasts with the net method, where purchases are recorded at the discounted price and any failure to pay within the discount period is recorded as a separate interest or penalty expense. Both methods are testable.
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