How do you account for customer returns?

Sales return is the transaction or event when customers return purchased goods back to the company due to various reasons, such as the wrong product, late delivery, or the goods are damaged or defective. Hence, accounting for sales return is important in this case.

The company may grant a reduction of the purchase price to customers so that customers can keep the goods. In this case, the customers do not need to return goods back to the company. However, the company still need to make allowance for such transactions in their accounting system.

In this case, the “sales returns and allowances” account is required for recording such transactions. Sales returns and allowances account is the contra account to sale revenues. It offsets the revenue account in the income statement. 

It is very important for the management to review the information regarding the sales return. This is due to a big volume or amount of sales return transactions can suggest various problems that may prevent the company from achieving its goal. Those problems may include inferior goods, problems in filling orders, errors in billing customers, late delivery, wrong product shipment, etc.

Hence, the company usually use sales returns and allowances account to record the total amount of sales return transactions for review and monitoring purposes.

Sales Return Journal Entry

The sales return journal entry is required to debit sales returns and allowances account and credit cash or accounts receivable as below:

Explanation of accounting for customer returns, sales and return allowances, purchase allowances, cash refunds and store credits.

1. Accounting for sale or purchase of damaged goods

Many businesses, whether a large chain store or a small “mom-and-pop” shop, have to deal with returns of merchandise because sold items may be broken or damaged. It is important to understand accounting for purchases and sales of damaged goods not only to make appropriate journal entries but also to design a good internal control system over returned merchandise and related accounts (e.g., Cash, Accounts Payable).

Please note that we are not going to cover the question of establishing reserves for customer returns in this article. Such reserves may need to be established to adhere to the generally accepted accounting principles and in particular, the matching principle.

2. Journal entries for damaged goods returned by customers

There are two common approaches to refunding customers for returned goods:

• a cash refund
• a store credit

Let us look at each one using the following example:

On May 1, 20X1, Jane Smith purchased, with a debit card, some pottery on sale at a local store called Pottery Wiz. She bought 10 cups ($5 each) and 10 plates ($8 each) for a total of $130, less 25% sales discount, and paid 8% sales tax. She received the following receipt from the store:

To record the sale, Pottery Wiz made the following journal entry:

Account Titles

Debit

Credit

Cash

105.30

Sales Discount

32.50

      Sales Taxes Collected

7.80

      Sales

130.00

Assuming the store bought the cups and plates for $1.50 and $3.00 each, respectively, at the time of sale to Jane Smith Pottery Wiz recorded the cost of goods sold in the amount of $45.00 (i.e., 10 x $1.50 + 10 x $3.00 = $15.00 + 30.00 = $45.00):

Account Titles

Debit

Credit

Cost of Goods Sold

45.00

      Merchandise Inventory

45.00

To continue the example, let us assume that on May 2, 20X1 Jane Smith came back to the store to return two (2) cups as they were damaged (e.g., paint defects). Pottery Wiz can either refund cash or issue a store credit, depending on its return policy.

2.1. Merchandise returned for cash refund

In the case of a cash refund, the store will make the following journal entry:

Account Titles

Debit

Credit

Sales Returns and Allowances

10.00

Sales Taxes Collected

0.60

      Cash

8.10

      Sales Discount

2.50

Note: The selling price of the returned cups before the discount is $10 = $5 x 2 cups. The discount amount related to the two cups is $2.50 = $10 x 25%. The sales tax for the returned cups is $0.60 = ($10 – $2.50) x 8%.

The store’s accountant debits (i.e., increases) the Sales Returns and Allowances account when recording the return of the cups. The increase in this account will result in a decrease in Net Sales because Sales Returns and Allowances are subtracted from Gross Sales to arrive at Net Sales. In other words, the increase in the sales returns results in the decrease in the net sales. As the Sales account has a credit balance, the Sales Returns and Allowances account, a contra-revenue account, has a debit balance.

Furthermore, Pottery Wiz’s accountant has to debit (i.e., decrease) the Sales Taxes Collected account in order to decrease this liability account. (The Sales Taxes Collected account represents a liability to the government, and as the taxes for the cups returned are no longer due, the store has to debit the Sales Taxes Collected account.)

To reverse the sales discount, the store’s accountant has to credit (i.e., decrease) the Sales Discount account. Note that the Sales Discount account normally has a debit balance because it’s a contra-revenue account.

Finally, to show the return of money to Jane Smith, Pottery Wiz’s accountant credits the Cash account.

At the time of the cash refund, the store gives Jane Smith the following credit slip:

Pottery Wiz’s accountant also has to record the returned inventory cost and decrease the cost of goods sold:

Account Titles

Debit

Credit

Merchandise Inventory

3.00

      Cost of Goods Sold 

3.00

The $3.00 is based on the cost of one cup and two cups returned: $3.00 = $1.50 x 2 cups.

2.2. Merchandise returned for store credit

Accounting for a return of merchandise for a store credit is almost the same as in the case of a cash refund. The only difference is that instead of crediting Cash the store’s accountant should credit Accounts Payable to recognize the liability to the customer. When the customer buys some merchandise in the future using the store credit, Pottery Wiz’s accountant will debit the Accounts Payable account.

To record the store credit, Pottery Wiz’s accountant would make the following journal entry:

Account Titles

Debit

Credit

Sales Returns and Allowances

10.00

Sales Taxes Collected

0.60

      Accounts Payable

8.10

      Sales Discount

2.50

The store’s accountant would also have to decrease the cost of goods sold and record the cost of inventory returned (see the previous section).

At the time the store credit is issued to Jane Smith, the store would give the following credit slip to her:

3. Journal entries for returns of damaged goods to supplier

Let us assume Pottery Wiz purchased the damaged (e.g., with paint defects) cups, returned by Jane Smith, from Pottery Wholesaler on April 25, 20X1.

On May 1, 20X1 Pottery Wiz received and recorded an invoice for these and other cups but has not paid it yet. If the store is able to return the damaged merchandise to Pottery Wholesaler for a refund or credit allowance, at the time of the return to Pottery Wholesaler, the following journal entry is made:

Account Titles

Debit

Credit

Accounts Payable

3.00

      Purchase Returns and Allowances

3.00

By debiting the Accounts Payable account the store reverses (i.e., decreases) its liability to Pottery Wholesaler.

If Pottery Wiz had settled the liability to Pottery Wholesaler with cash before returning the damaged cups, the store’s accountant would debit the Cash account (instead of the Accounts Payable account) when cash reimbursement for the damaged cups is received from Pottery Wholesaler.

If the retail store paid cash and took a purchase discount when originally paying to Pottery Wholesaler, the store’s accountant would only post a debit for the net amount because only the net amount (i.e., total purchase price – purchase discount) would be refunded. For instance, if a 2% discount has been taken when the cups were purchased, Pottery Wiz’s accountant would debit Cash for $2.94 (i.e., $3.00 x 98%), debit Purchase Discounts for $0.06 (i.e., $3.00 x 2%), and credit Purchase Returns and Allowances (or Merchandise Inventory) for $3.00.

Note that Pottery Wiz’s accountant can either credit Merchandise Inventory or Purchase Returns and Allowances. However, unless a business has a small amount of inventory, it is preferred to use the Purchase Returns and Allowances account to track and control the costs incurred in returning merchandise or negotiating purchase allowances. Note also that purchase returns refer to the return of goods by a buyer to a seller. Purchase allowances refer to the reduction in the price of goods shipped by a supplier.

Pottery Wiz can initiate the return of damaged goods and request a reduction of the balance due to Pottery Wholesaler by issuing a debit memorandum. The debit memorandum will inform the supplier that the purchaser (i.e., Pottery Wiz) has debited the supplier’s account on its (i.e., purchaser’s) books. Pottery Wiz will send the original debit memorandum to Pottery Wholesaler and keep a copy for its records. An example of a debit memorandum is shown below:

The store can record the reduction in the Accounts Payable account when it sends the debit memorandum, or it can wait for a credit memorandum from its supplier.

4. Internal controls over merchandise returns

It is very important to design good internal controls over merchandise returns as these transactions impact, directly or indirectly, such accounts as Cash, Inventory, Sales (through Sales Returns and Allowances), Cost of Goods Sold, Accounts Payable, Sales Taxes, etc. For example, two common register disbursement fraud schemes include false refunds and false voids.

In the case of a false refund, a fraud perpetrator creates a fictitious return and pockets cash, or the fraud perpetrator overstates the value of the return and pockets the difference.

In the case of false voids, a fraud perpetrator keeps a copy of the customer’s receipt at the time of sale and later (after the customer has left) uses it to create a fictitious void (i.e., as if the customer returned the merchandise).

Both fictitious returns and false voids can be difficult to prevent and detect, unless appropriate internal controls are put in place. Therefore, a business can implement the following controls (this is not an exhaustive list):

What is the entry to record the return of goods from a customer?

Is customer return a debit or credit?

Is sales returns an income or expense?

Which account should be debited when a customer returns goods?