Journal Entries

What is a warranty?

Most of the products we purchase come with some type of warranty. A warranty is guarantee that the manufacturer of the product will repair or replace the product for a certain period of time. In 2013, I bought my husband a Weber Smokey Mountain Cooker, because he likes to smoke meat and I like to eat smoked meat. It works out well for everyone! This product came with a 10-year limited warranty. That means that if something breaks because of a defect (not normal wear and tear or abuse), the company will replace the part that broke. This was not something that we purchased in addition to the product. It came with the product as part of the purchase.

Do not confuse standard warranties with extended warranties that consumers purchase for an additional fee.

Why must companies record a liability?

When a company provides a warranty with its product, the company has an obligation to repair or replace the product if it is defective. That obligation generates a liability at the time the product is sold because the company has a liability that starts when the product is sold.

When must the company record the warranty expense?

The matching principle states that a company must match revenue with expenses. If Weber sells a smoker in 2013 but expenses a warranty claim in 2020 (remember it is a 10-year warranty), the company is violating the matching principle. The warranty expense occurs because the sale took place. The expense is a cost of the sale and therefore should be matched with the revenue generated by that sale.

How does the company record an expense for a repair that has not happened yet?

It might seem a little strange to ask a company to record an expense when it hasn’t occurred yet but we have done this many times in accounting. Accounting requires the use of many estimates. Warranties are no exception. Remember when we recorded Bad Debt Expense under the allowance method and had to estimate the expense at the time of the sale? Warranty expense is very similar. We must estimate the expense based on previous company history and record the journal entry.

In order for a company to estimate the warranty expense and liability, we need to know three things:

  • How many units of the product were sold during the period of time we need to record?
  • What percentage of the products sold will need repairs or replacement based on previous experience?
  • What is the average cost of the repair or replacement under warranty?

All of this information is readily available to managers and accounts within the company. To calculate the warranty expense, first figure out how many products will need repair or replacement:

Total number of units sold X Percentage of units that are defective

Next, calculate the cost of repair or replacement for those units:

Units needing repair or replacement X cost per unit to repair or replace

Let’s look at an example to see how a company would estimate and record warranty expense.

Example #1

Hydration-on-the-Go makes stylish water bottles. Each water bottle includes a one-year warranty against manufacturing defects. Based on five years worth of data, the company estimates that 3% of the water bottles sold will be returned because of a defect. When this occurs the company replaces the water bottle. Each water bottle costs $4 to produce. 

In 2013, the company sold 250,000 water bottles. Record the amount of warranty expense that the company should record for 2013.

To record the warranty expense, we need to know three things: units sold, percentage that will be replaced within the warranty period, and the cost of replacement.

First calculate the number of units the company believes will need to be replaced under warranty.

250,000 water bottles sold x 3% defect rate = 750 water bottles potentially defective

Next, calculate the cost of replacing those potentially defective water bottles.

750 water bottles potentially defective x $4 replacement cost = $3000 estimated warranty liability

WL1

That is all there is to it. Recording the expense and the liability as an adjusting journal entry.

Recording customer warranty claims

When a customer requests a repair or replacement under warranty, the customer files a claim. The company must record this claim. Every time the company fulfills a claim, a portion of the warranty liability is also fulfilled. In other words, every time a claim is fulfilled, the company must decrease the amount of the liability by the cost of fulfilling the claim.

There are a number of ways that the company can fulfill a claim. It can replace the item with an item from inventory, therefore decreasing inventory. The company could repair the product using parts from inventory and outside labor (which would require cash) or inside labor (wages payable). Always record the replacement or repair at cost, not at the retail value of the item or parts.

Example #2

On February 1, Hydration-on-the-Go received 14 water bottles in the mail that had been returned by customers to be replaced under warranty. Each water bottle costs $4 to produce and sells for $9. Record the entry for fulfillment of the warranty claims.

The problem is asking us to record the warranty claim. When the company fulfills a warranty claim, we need to debit the estimated warranty liability. This is because part of the warranty obligation is being fulfilled. The amount of liability is decreasing.

Now to determine the account to credit. Ask yourself how how the liability is being fulfilled. How is the company fulfilling the liability in this case? The company is replacing the water bottle. Water bottles are the product that the company sells. They are inventory. Therefore, we will reduce inventory by the amount that the bottles cost. When we use inventory to fulfill the warranty liability, the value of inventory falls.

How much should we record as the cost of the water bottles? If we are removing them from inventory, we should remove them at cost. Therefore, use $4 per water bottle.

14 water bottles x $4 per water bottle = $56 cost of inventory

We have all the information we need to record the journal entry.

WL2

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What is a liability?

liability is an obligation that the company has to another party. Typically when we think of liabilities, we think of accounts payable or notes payable, but there are many other liabilities that a company can have to other people or entities.

Whenever a company owes money or services to another party, there is a liability. A liability must be recorded if the company can estimate the amount of the liability and is reasonably sure that the liability is owed.

Liabilities have a normal credit balance. When a liability increases, we credit the account. When a liability is paid or an obligation is fulfilled, either in whole or in part, the account is debited.

What is a current liability?

Current liabilities are liabilities that are due in less than one year or one operating cycle. The most notable liability that most people think of when they think of current liabilities is accounts payable. There are however many other accounts qualify as current liabilities.

Accounts payable is a current liability used for normal day-to-day bills. Some textbooks will argue that accounts payable should only be used for the purchase of inventory and supplies, but in my experience, accounts payable is used for all routine bills that must be paid. This would include supplies, inventory, utility bills, telephone bills, and other bills which the company plans to pay at a later date.

Any other current amount owed must be placed in its own payable account. This includes salaries payable, taxes payable, interest payable and any other obligations a company would have.

Recording and paying accounts payable

When a company purchases something and does not pay for it at the time of purchase, a payable is created.

Example #1

On January 15, KLI, LLC purchases $1,500 worth of supplies on account, terms n/30.

In this example, the company is purchasing supplies but has not paid for them yet. How do we know the company has not paid for them? There are a few key things to look for. First, the statement does not use the word “paid.” “Paid” always indicates that cash is involved. Since cash is not involved, We know we have not paid for the purchase.

Second, we see “on account” in the statement. On account indicates either Accounts Payable or Accounts Receivable. When we see on account, we should ask “Are we going to pay cash later or receive cash later?” If we are going to pay cash later because we purchased something, we have Accounts Payable.

If you do not have either “paid” or “on account”, there is one additional give away in the transaction. If you see terms, the purchase was made on account. Payment terms, such as n/30, are only included if the transaction has not been paid for. If the transaction had been paid for, we wouldn’t need to know that the bill must be paid within 30 days.

Here is the journal entry for the transaction:

CL1

 

Example #2

On February 10, KLI, LLC paid for the supplies purchased on January 15.

In this transaction, we are paying for the supplies previously purchased. Be careful when recording a transaction like this. Many people studying accounting get this one wrong the first few times they try it.

The transaction states that the company paid for something. That is one of the keywords we discussed above. When we see “paid” in the transaction, Cash is involved.

What did the company actually pay for? We are told to refer back to the transaction on January 15. In that transaction, we recorded Supplies and Accounts Payable. Are we purchasing more supplies or are we paying off the Accounts Payable? The transaction indicates that we are paying for supplies that were previously purchased, not purchasing more supplies.

Let’s see if that fits into our journal entry. We know that Cash will be a credit. Does it make sense to debit Accounts Payable? Since we are paying off what we owed, we are fulfilling the obligation. We want the balance in Accounts Payable to decrease so we would debit Accounts Payable.

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Lots of different liabilities

Over the next few posts, we will be covering a number of new current and long-term liabilities. All of these liabilities follow the same rules as described above. When classifying a liability ask yourself if the company has an obligation to anther party. If the answer is yes, then you have a liability.

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For many students, bank reconciliations are a difficult topic because most people don’t do them anymore. Twenty years ago, before debit cards and online banking, there was only one way to keep track of how much money you had in the bank: keep a checkbook and reconcile it.

Clearly, online banking has not made us better at managing our bank accounts. In 2012, U.S. consumers paid $32 billion in overdraft fees. That’s approximately $135 per adult in the United States! Maybe we should consider going back to writing down all our transactions and balancing our checkbooks!

What is a bank reconciliation?

A bank reconciliation is a monthly process by which we match up the activity on the bank statement to ensure that everything has been recorded in the company’s or individual’s books. As we all engage in more automatic and electronic transactions, this is a critically important step to ensure that the cash balance is correct.

There are two parts to a bank reconciliation, the book (company) side and the bank side. When the reconciliation is completed, both balances should match.

What are we looking for?

There are a number of items that can cause differences between your book and bank balances. Here is a list of the most common items you’ll encounter when doing a bank reconciliation:

  1. Deposits in Transit – A deposit in transit is a deposit that has been submitted to the bank but has not get been recorded by the bank. The account holder has recorded the deposit in his records but the bank has not. This occurs because a deposit was submitted after the bank closed for the day or because of lag in electronic deposits. We see this a lot with credit card deposits because there is typically a 1-3 day lag in the time the card is processed and when the funds are deposited to the merchant’s account. Deposits in Transit must be added to the bank side of the reconciliation because they have been added to the book side when the deposits were recorded by the company.
  2. Outstanding Checks – These are checks that have been written by the company but have not yet cleared the bank. When a check is written it takes a few days to clear. Most businesses have a number of outstanding checks at the end of the month. Outstanding Checks should be subtracted from the bank side of the reconciliation because they were subtracted from the book balance when the checks were written.
  3. Bank Service Charges – These are amounts that the bank withdraws from the account as a charge for having the account. Bank service charges include regular monthly fees, overdraft fees, returned check fees and credit card processing fees. Typically, the company does not record these fees until the bank statement is received. Bank service charges are subtracted from the book balance since they are a decrease in the account balance and have not yet been recorded.
  4. Interest Earned – Some banks pay interest on account. The account holder does not know how much the interest will be until the bank statement is received. Interest earned is deposited into the account by the bank causing the balance to increase. Interest earned is added to the book balance to reflect the increase in the balance from the deposit of interest.
  5. Returned Checks – A returned check is an item that was originally deposited into the company’s account (usually a customer check) and later bounced. When this happens the bank withdraws the funds from the company’s account and sends a notice to the company. Returned checks should be subtracted from the book balance since the bank removed the amount from the balance when the check bounced.
  6. Recording Errors – A recording error occurs when the company incorrectly records a transaction or when the bank clears an item for the incorrect amount. This sometimes occurs when checks are written and an incorrect amount is entered into the system. Sometimes the bank clears the transaction for the wrong amount. Say the company wrote a check for $452.00 but the bank cleared the check for $450.00. There is now a $2 error in the books. Since the bank has cleaned the transaction, you must adjust the books to match. Recording errors should be added or subtracted from the book balance. If the item cleared the bank for less than the amount in the books, add the amount of the error. If the item cleared the bank for more than the amount in the books, subtract the amount of the error.
  7. Other Unrecorded Items – With the number of transactions that occur digitally or automatically, it’s easy to forget to record transactions, especially if they occur infrequently. Look for remaining items that cleared the bank that have not been recorded on the books. Other unrecorded items can be either deposits or withdrawals. All other unrecorded items should be recorded on the book side of the reconciliation. To determine if you should add or subtract the item, mimic what the bank did. If the bank added it to the account balance, do the same to the book balance. 

How to start

To do a bank reconciliation, you’ll need a copy of the bank statement and a copy of all of the outstanding items in the checking account through the ending date of the bank statement. For some businesses, including my own, the bank statement does not close at the end of the month. Sometimes the statement end date is based on the date the account was opened.

Once you have those two items, use a pencil or highlighter to mark off all the items that appear on both the bank statement and the check register. If an item appears on both, that means that the item was properly recorded and has cleared. After going through all the items, anything that remains unmarked is a an item that will need to be dealt with in the reconciliation.

Create two columns on a piece of paper or use a spreadsheet to do the calculations for you. My bank reconciliations look like a large T-account.

Start by writing the ending balance for the book and the bank under the appropriate column.

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I like to do the bank side first because it is generally easier than the book side. You are only dealing with outstanding checks and deposits in transit on the bank side. List the deposits in transit and the outstanding checks. Add the deposits in transit to the beginning balance and subtract the outstanding checks.

BR2

The bank side is relatively easy to do. That is why I like to do that side first. It is more likely to be correct if you have an error in your reconciliation. Most students who have errors have them on the book side. Being confident in the bank side helps resolve errors on the book side.

On the book side, most items are fairly simple. Subtract bank service charges and add interest income. Subtract returned checks. Add unrecorded deposits and subtract unrecorded withdrawals. The last item, recording errors, requires a bit more thinking.

Let’s imagine that you recorded a check for $715, but the bank cleared that check for $751. The check was used to pay for utilities and was recorded to utilities expense for $715. If the check cleared for $751, what happened to your utilities expense? Did it increase or decrease? It increased because more was paid for utilities. If the expense increased, cash must have decreased. Therefore, cash must be adjusted down or decreased by $36. This would be subtracted from book side of the reconciliation.

Thinking about what is happening to your expenses can help you work your way through the problem.

Once you have worked through all the remaining items on the book side, compute the reconciled balance for the books.

BR3

When you are finished, the reconciled balances should agree.

If they do not, take the difference between the two balances. Does that amount stick out in your mind. Check to see if there is a missing item for that amount that you might have forgotten to record. You may have forgotten multiple items. Place them in the reconciliation and see if you now balance.

If you do not have an item for that amount, take the difference and divide it by 2. Look for that amount. If that amount appears in your reconciliation, you added (or subtracted) the amount when you should have subtracted (or added) the amount. Reverse the sign and check your balance again.

Once you finish the bank reconciliation, there is one more step in the process. All the items that you recorded on the book side of the reconciliation must be recorded in the company’s accounting system. Prepare a journal entry (or several) to record those items. I usually record one large journal entry but you can also record a separate entry for each item in the reconciliation. Only record items on the book side!

Bank reconciliations become easier as you do more of them. Get all the practice you can. Here is the bank reconciliation problem I created for the video on this subject. You are provided with the check register and the bank statement. See if you can complete the reconciliation before watching the video.

BR4

Related Videos:

How to do a bank reconciliation

Journal entries for the bank reconciliation

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What Is a Discount?

We all love discounts, but why would a business offer offer a discount on their products? Typically, a business might offer a discount to increase sales, make an unhappy customer happy or incentivize a customer to pay quickly.

Understanding Payment Terms

Typically when customers purchase inventory, they are not expected to pay cash. The seller extends credit to the buyer, but extending credit comes at a cost for the seller. The seller does not have the cash and therefore must pay its bills from other sources, either cash reserves or borrowing. The seller may lose out on interest earned on cash reserves or possibly even pay interest on loans or lines of credit. In order to decrease the time a receivable is outstanding, a company may offer a discount for fast payment. When a company offers this type of discount, it is listed in the payment terms on the bill:

Payment terms: 2/10, n/30

What does this mean? Well, first notice the comma. That means there are two parts to the payment terms. So let’s look at each part, starting with 2/10. This does not mean that the bill is due on February 10. It means “2% discount if paid in 10 days”. Therefore, if the date of the bill is February 15 and you pay the bill on or before February 25, you get a 2% discount off the balance due. What happens if you don’t pay in the first 10 days? For that, we have to look at the statement after the comma: n/30. The “n” in the statement stands for net. So the statement tells us that the net, or entire, amount is due in 30 days. Taking it all together, the statement is as follows:

Payment terms: If paid within 10 days, we will give you a 2% discount, or you can pay the full balance within 30 days.

Can you see why businesses prefer 2/10, n/30? Takes up a lot less space on a bill. What happens if you don’t pay with bill within 30 days? After 30 days, your payment is now late and the seller can add on late charges or interest, depending on state law.

Let’s look at some examples using payment discounts.

Example #1:

Medici Music purchased instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 with terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Medici Music.

The first step is to break down the information. Medici purchased inventory for $5,000 on August 13 and paid the bill on August 20. Looks like we have two transactions. Wait! We are dealing with inventory. Have you realized we are missing something? If not, take a second to see if you can figure it out. <Insert Jeopardy theme here> Is Medici using periodic or perpetual inventory? Remember, we are about to record an entry dealing with the movement or change in value of inventory! I know we are talking about payments here but we are still talking about inventory. That trumps the payment discussion!

We will look at this transaction under both methods so you can see the difference. Before we start looking at each method, let’s start by discussing what is the same under each of the methods. We have two transactions. The first transaction deals with the purchase of the inventory. The second transaction deals with the payment for the instruments already received.

When working with discounts, we generally calculate the discount and record it at the time of payment. Some textbooks may show you two different methods for recording the discount, one in which the discount is recorded at the time of the purchase and one where the discount is recorded at the time of the payment. I prefer the second method. When you record the discount at the time of the purchase and the discount is not taken because the buyer does not pay within the discount window, we must alter the payment entry to undo the discount taken in the first entry. By recording the discount at the time of the payment, we are only recording a discount that has actually been taken and we never need to undo something from the first entry.

Perpetual Inventory

First, we need to record the entry to show the purchase of the inventory.

DISC1

Notice that we used Inventory, because under the perpetual method, whenever the value of inventory is changing, we must show that change in the account.

Now let’s look at the second transaction. We are paying off what is owed but we are receiving a discount. We must show the accounts payable fully paid off, so we must debit Accounts Payable for $5,000. How are we paying the balance? With cash, so we must credit Cash for the amount of cash being paid. Because of the discount, the amount will be less than $5,000. If we take 3% of $5,000, we calculate the discount as $150. Therefore, the amount of cash needed to fulfill the obligation is $4,850.

What do we do with the $150? Remember the rules for perpetual inventory. If the value of the inventory is changing, we need to target the inventory account. Is the value of the inventory changing? Currently, we have $5,000 in the Inventory account for this purchase. Did we actually pay $5,000 for the inventory? Well, no, we didn’t. We actually paid $4,850 for the inventory. Therefore, the value of the inventory is not $5,000 but $4,850. We need to reduce the value of the inventory by $150 to reflect the discount received. Now, we have all the information we need to complete the second entry.

DISC2

Now the process is complete. The Accounts Payable balance is now zero and the Inventory balance is $4,850 which matches what we actually paid for the inventory.

Periodic Inventory

Under the periodic method, we do not update the value in the inventory account until we do the adjusting entries at the end of the period. Therefore, we should never use the inventory account in purchase transactions for companies that use the periodic method. Instead, we use the purchases account.

Let’s look at the first entry.

DISC3

Pretty similar to the perpetual method, except for the use of the purchases account. The second entry will also be similar to the perpetual method, except for one difference. Can you figure out what that difference would be?

We will not be using the Inventory account. Instead we will use an account related to the Purchases account. We do not use the Purchases account because we want to preserve the balance in that account, in case we need to match it up with purchase documents. In order to preserve the original balance in the Purchases account, we will use a contra account. A contra account is an account that is linked to an account but acts in the opposite way. It acts contrary to the account it is linked to. Since Purchases has a normal debit balance, the contra account will have a normal credit balance because it will be used to decrease the value in the Purchases account. The account we will use is called Purchase Discounts (very tricky, huh?). Here is the entry:

DISC4

The Sales Side

So far, we have looked at the purchase side of the transaction. What about the sales side? Let’s look at our original example again. This time, we will look at it from the seller’s perspective.

Example #2:

Medici Music purchases instruments to sell in its stores from Whistling Flutes, LLC on August 13. The total purchase was $5,000 (with a cost of $3,000), terms 3/10, n/30. Medici paid for the purchase on August 20. Record the necessary journal entries for Whistling Flutes, LLC.

When recording sales transactions, we still must be concerned with whether the company uses perpetual or periodic inventory. We will review perpetual inventory first.

Perpetual Inventory

Under the perpetual method, when inventory changes or the value changes, we must record that change. When a business sells merchandise, inventory is leaving the building, therefore the amount and value of the inventory left is changing. There will be two parts to the August 13 entry. The first part will record the sale and increase in an asset (Accounts Receivable). The second part will record the change in Inventory and the cost of the sale. Let’s look at the entry:

DISC5

The value of Inventory dropped $3,000, which moves to the income statement as an expense.

Now let’s look at the entry on August 20. This is the date that Whistling Flutes, LLC gets paid in full. However, because of the discount, the Company will not receive the full $5,000. Therefore, we must show the obligation fully paid even though the amount received is less than the amount in Accounts Receivable. The amount of the discount is 3% of $5,000 or $150. The amount of cash received is $4,850. Is Inventory changing? No, the payment on August 20 has no effect on Inventory. We will use a contra account, Sales Discounts, to record the discount amount.

DISC6

By using a contra account, the company knows how much its sales were over the course of the year and how much was lost because of discounts and other items. This is good information for managers to have in order to make decisions about the effectiveness of company policy.

Periodic Inventory

How would the entry be different under a periodic system? On the sales side, the only difference is the fact that we would not track the change in inventory at the time of the sale. The rest of the entry is exactly the same. Let’s look at both entries together, since we already discussed the methodology. Again, the only difference is that we do not track the changes in inventory under the periodic system.

DISC7

Read Transactions Slowly!

The biggest problem students have with this topic is confusing purchase and sale transactions. I have had students do the problem perfectly, except they give me the journal entries for the purchase when I ask for the sale or vice versa. Spend extra time if needed to make sure that you understand what the transaction actually means. Do not jump right into the entries until you know what is happening in the transaction. Typically, a problem will state which company you should do the entries for. Go back through the transactions to see if the company is the buyer or seller. Sometimes, I will even note that when I am reading the problem. Read the transactions carefully or you may lose a lot of points on a problem you know how to do.

Related Videos

Sales Entries: Periodic and Perpetual Methods

Purchasing Inventory: Periodic and Perpetual Journal Entries

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What Is a Return?

A return occurs when inventory is purchased and later returned to the seller. When this happens, the purchaser no longer has the merchandise. This transaction has an effect on inventory for both the seller and the buyer, because inventory is physically moving. Remember, the rules for perpetual and periodic inventory still apply so we will look at both cases here. We will also look at the transactions from the seller and buyer’s perspectives.

Returns Under Perpetual Inventory

Let’s look at an example.

Example #1:

On August 14, Medici Music returns $700 worth of merchandise to Whistling Flutes, LLC because the wrong merchandise was received. The merchandise cost Whistling Flutes $400.

First, let’s look at this from the perspective of Medici Music, the buyer. Medici is returning inventory, which means the balance in the inventory account is decreasing. Medici also owes less money to Whistling Flutes because the merchandise is returned.

RA1

Essentially, we are reversing a portion of the original purchase journal entry.

Now, let’s look at the entry from Whistling Flute’s perspective. As the seller, Whistling Flute needs to show not only the return of the inventory but also the reduction in sales. Because we want to preserve the original sales data and track returns, we are going to use a contra account called Sales Returns and Allowances to record the revenue portion of the transaction. The value being returned to inventory is the cost that Whistling Flute paid for the inventory, which is $400.

RA2

Notice there is no contra account for Cost of Goods Sold. We just reduce the amount in Cost of Goods Sold. Since we are tracking the returns through Sales Returns and Allowances, there is no need to create a contra account for Cost of Goods Sold.

Returns Using Periodic Inventory

Under periodic inventory, we do not use the Inventory account to record day-to-day transactions. Instead, we use Purchases and the contra accounts related to Purchases. When we discussed discounts, we used Purchase Discounts. Since we are now discussing returns and allowances, can you figure out what account we will use? It’s really tricky. Can you guess? Purchase Returns and Allowances! Really tricky, huh? Most of the time in accounting, the account names describe what is going on. The names are pretty basic. So let’s look at the entry for the same transaction under periodic inventory.

First, the entry for Medici Music:

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This entry is very similar to the entry used under perpetual inventory, but instead of Inventory we use Purchase Returns and Allowances.

Now, the entry for Whistling Flutes:

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Under period inventory, we do not record changes in inventory until the end of the period, so this entry is fairly simple.

What Is an Allowance?

An allowance is similar to a return in the fact that the seller is giving the buyer a credit on the account because something is wrong with the order. In the case of an allowance, the physical inventory is not returned to the seller. The buyer gets to keep the merchandise but receives a discount on the merchandise. Sometimes this happens because the inventory is incorrect but the buyer thinks it can still be sold. Maybe it was the wrong color or maybe there is slight damage to the product but it can still be sold at a discount. When dealing with allowances, it is important to note if the value of the inventory is changing on each side of the transaction and record that change correctly depending on the inventory method being used.

Example #2:

On August 16, Medici Music discovers that two of the flutes it ordered from Whistling Flutes, LLC were slightly scratched. Whistling Flutes agreed to discount the flutes by $200 and Medici agreed to keep the flutes.

Allowances Under Perpetual Inventory

Under the perpetual method, we must always track changes to the cost of inventory. Did the cost of the inventory purchased by Medici change? Yes, the cost is now $200 lower than it was previously recorded because of the allowance provided by Whistling Flutes. Therefore, we must record the decrease in the cost of the inventory. Even though the quantity of inventory is the same, the cost has changed.

RA5

Notice the entries for returns and allowances are the same for the buyer. We are not tracking physical quantities of inventory here. We are tracking dollar value. In both cases the dollar value of the inventory has changed, so the entry is the same.

What about the seller’s entry? We know the amount of the sale has changed along with the amount owed on the receivable. Did the seller’s cost of inventory change? Does the seller have more or less value in the Inventory account because of the allowance? There is no change to the Inventory account. Whistling Flutes has the same amount of value in inventory that it had before the transaction.

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Allowances Under Periodic Inventory

When using the periodic method, the entries for allowances are the same as entries for returns because we do not track inventory under the periodic method.

The entry for Medici Music:

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The entry for Whistling Flutes:

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NOTE: When working with discounts, returns and allowances, it is very important to track the balances in Accounts Payable and Accounts Receivable. Every time there is a return or an allowance, the balances in Accounts Payable and Accounts Receivable decrease. I find it very helpful to do a T-account for these accounts so you can keep track of the balances, especially when you must calculate the amount that should be paid. Remember that each transaction affects the account balance. Make sure you have factored all transactions into your balance.

Related Videos:

Sales Entries: Periodic and Perpetual Methods

Purchasing Inventory: Periodic and Perpetual Journal Entries

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