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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.

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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.

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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.

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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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What is Inventory?

Inventory is an asset account composed of items a company is planning to sell to customers. In financial accounting, we deal primarily with merchandising companies. A merchandiser is a company that purchases products from other companies to sell to customers. There are two major types of merchandisers: wholesalers and retailers. Wholesalers are middlemen. They purchase products from manufacturers and then sell them to retailers. Retailers sell products to the end users, either individual consumers or businesses who will use the product.

Perpetual and Periodic Inventory Systems

Every business that deals with inventory must decide how it will track its inventory. Large retailers and even some small retailers have computer systems which track inventory coming into the business and each item as it is sold. This is called a perpetual inventory system. According to Merriam-Webster, perpetual means “happening all the time or very often.” When a company using perpetual inventory, like Target, gets products shipped to them, all products are scanned into the computer system to let the system know how many units of each product the store has. When items are purchased, the computer system not only records the sale of the product (the revenue), it also records the decrease in inventory. When you purchase a roll of paper towels, the checkout system tells the store there is one less roll of paper towels in inventory.

What if the business doesn’t have a computerized inventory system? It would be very difficult to manually record how many of each item the company has at all times. These businesses use a periodic inventory system. The company tracks the dollar value of purchases and then counts what is left over at the end of the year. If the business knows what it had at the beginning of the year and how much it purchased, this tells the business how much product it could have sold. We call this goods available for sale. When we subtract how much we have left, called ending inventory, from goods available for sale, we can calculate how much we sold. We call this cost of goods sold.

Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold

We call this a periodic system because we only know the exact balances in inventory at the end of each period, usually the end of the year. The business must do an inventory count and do an entry to adjust the inventory account to the proper dollar value. The offset account for this adjusting entry is cost of goods sold.

Does a perpetual inventory system negate the need for a physical count? Absolutely not! All businesses must count inventory at least once a year. There are many reasons why physical inventory would not match the computer records. Theft, damaged goods and cashier error can all cause inventory errors. I worked for a number of retailers in high school and college and each of them did inventory counts multiple times a year to look for inventory errors.

Journal Entries: Purchasing Inventory

We stated earlier that under the perpetual system, changes in inventory are always recorded. Therefore, if inventory levels are changing, either because inventory is increasing or decreasing, we must include the Inventory account in the journal entry. Let’s look at some examples.

Example #1 – Perpetual Inventory

On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a perpetual inventory system.

Break down this statement. What is happening here? ABC is purchasing inventory, which means it is acquiring or getting inventory. Therefore, the balance in inventory is going up. What is the company exchanging for this inventory? Because the transaction is on account, ABC is not paying for the inventory today. Instead, the company is promising to pay for the inventory in the future. The account we use for that promise is accounts payable. Here is the journal entry:

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Notice we used the inventory account in the journal entry because the company uses the perpetual inventory system. How would this entry be different if we used the periodic system?

Example #2 – Periodic Inventory

On July 17, ABC company purchases $1200 worth of inventory on account. Record the journal entry for this company, which uses a periodic inventory system.

Remember the formula we used to calculate cost of goods sold under the periodic inventory system:

Beginning Inventory + Purchases = Goods Available for Sale – Ending Inventory = Cost of Goods Sold

In order to do this calculation, we must keep purchases separate from inventory. Therefore, we need an account to place those purchases in. We will use an account called Purchases (not very creative, is it?). That is the only difference in the journal entry.

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At the end of the year, we will close out the purchases account to update the balance in inventory after a physical count has been completed. We will discuss that process at the end of this discussion.

Journal Entries: Selling Inventory

In a perpetual inventory system, we must always include inventory in our journal entries when the balance in the account is changing. When we sell inventory to generate revenue, the balance in the inventory account is decreasing. Therefore, we need to add that information to the entry. Let’s look at an example.

Example #3 – Perpetual Inventory

On August 2, ABC company, which uses a perpetual inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.

Break down the transaction. What is happening here? ABC sold stuff to another company on account. The stuff ABC sold was purchased for $600. Therefore, ABC has a $1,000 sale and the cost of that sale is $600. First record the sale, then record the inventory adjustment. Here is the journal entry:

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Because the company uses a perpetual inventory system, we not only have to record the sale, we also have to record the change in inventory. Now let’s look at the transaction under a periodic inventory system.

Example #4 – Periodic Inventory

On August 2, ABC company, which uses a periodic inventory system, sells $1,000 worth of inventory to KLI, LLC on account. The inventory cost ABC $600.

When using a periodic inventory system, the company only updates the inventory balances periodically or occasionally. That means that we are not tracking inventory with every journal entry. Inventory is only updated at the end of the period (quarterly or annually). Since we are not constantly tracking the inventory balances, we do not include the change in inventory in our journal entry.

Under periodic inventory, the sales transaction looks just like those we have done previously for service based companies. All we need to do is record the revenue.

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That’s it. Record the revenue and you are done.

Final Thoughts

When working with inventory, it is important to keep the difference between perpetual and periodic straight in your mind.

Under perpetual inventory, we are constantly updating the balance in inventory. Anytime the quantity or value of inventory changes, it must be recorded to the Inventory account. This includes purchasing inventory, selling inventory and transactions related to returns and purchase discounts.

Under periodic inventory, we are only updating the balance in inventory periodically. Therefore, the only time you should use the Inventory account is when doing the adjusting entry to close out the Purchases account. When purchasing or selling inventory, do not use the inventory account. For purchases, use the Purchases account. When selling inventory, only record the sale. Inventory is not part of the transaction.

Related Videos

Introduction to Periodic and Perpetual Inventory

Sales Entries: Periodic and Perpetual Methods

Purchasing Inventory: Periodic and Perpetual Journal Entries

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