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.
Let’s look at an example.
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.
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.
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.
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:
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:
Under period inventory, we do not record changes in inventory until the end of the period, so this entry is fairly simple.
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.
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.
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.
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.
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:
The entry for Whistling Flutes:
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.
Sales Entries: Periodic and Perpetual Methods
Purchasing Inventory: Periodic and Perpetual Journal Entries
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