Customer returns and credit notes in accounting

Customer returns and credit notes in accounting

In the sales lesson we saw that every sale produces two records: one for the revenue and one for the cost of the merchandise delivered. But what happens when the customer returns the merchandise because it arrived damaged, it was not what they ordered, or they simply changed their mind? In accounting the return is not erased in one stroke: a new transaction is recorded that reverses, totally or partially, the two effects of the original sale. This lesson explains, step by step and with a numeric example, the journal entry for a customer return and the role of the credit note that supports it. The focus here is the entry in the books; the operational handling of the return inside an inventory program and the nature of the credit note document are covered in other lessons of this same manual.

The central idea is simple and worth fixing before looking at numbers: if the sale recognized revenue and took merchandise out of inventory, the return must do the opposite, reduce the revenue recognized and make the merchandise available again. Whoever records only the money going out, or only notes that the merchandise came back in, leaves the accounting half done and ends up showing sales and inventories that do not match the reality of the business.

The sale produced two effects and the return reverses both

When the merchandise was sold, accounting recognized two facts. First, the revenue: the sale increased an asset, either cash if the payment was made on the spot or accounts receivable if it was a credit sale, and in exchange recognized sales revenue. Second, the cost: the merchandise left inventory and its cost moved to the cost of goods sold account, the one that is later subtracted from revenue to compute gross profit. A customer return touches exactly those two points, but in the opposite direction.

On the revenue side, the return means that part of what was sold is no longer sold. The business must then reduce the revenue recognized and, at the same time, reduce cash if the money was already refunded or accounts receivable if the customer still owed it. On the cost side, the merchandise that comes back stops being a cost of that sale and recovers its condition of inventory available for a future sale. That is why the entry for a return almost always has two movements: one that reverses the revenue and one that reverses the cost.

How to reverse the revenue: a returns account or a direct reversal

There are two equally valid criteria for reversing the revenue. The first one, and the most recommended when the business wants information, uses a specific account called sales returns, which is a contra revenue account, an account that subtracts from revenue. Instead of touching the sales account directly, the business debits sales returns and credits accounts receivable or cash. At the end of the period, in the income statement, sales appear on one line and sales returns are subtracted from them, so the owner can see how much was actually sold and how much of that sale was lost to returns.

The second criterion is more direct: the same sales revenue account is credited, meaning the revenue is reversed in the account where it was recognized. This criterion is simpler but hides the information about returns, because the reader of the income statement can no longer tell how much was sold and how much was returned. Many small businesses use it for simplicity and it is acceptable; what matters is to be consistent and always apply the same criterion. In this lesson we use the sales returns account, the one that allows the full effect to be seen.

Merchandise that comes back: the cost is reversed too

When the returned merchandise is in good condition and can be sold again, the cost record is reversed. In the original sale the cost left inventory with a credit to the inventory account and a debit to cost of goods sold. In the return the opposite happens: the merchandise enters inventory again, debiting the inventory account, and cost of goods sold is reduced, crediting that account. One important detail: the merchandise that comes back is valued at what it cost, not at the price at which it had been sold. If it were valued at the selling price, inventory would appear inflated and profit would be distorted. The rule is to return to inventory the same value that left it, because it is the cost that is being reversed.

This reversal of cost is the part most often forgotten in practice. It is common to find businesses that record perfectly the refund of money or the reduction of accounts receivable, but leave cost of goods sold and inventory untouched. The result is double: cost of goods sold stays high, because it includes merchandise that is no longer sold, and inventory stays low, because the merchandise that came back does not appear. Those two errors directly affect the profit of the period and the value of inventory on the balance sheet, so reversing the cost is not a minor detail.

Total or partial return

The return can cover the whole sale or only part of it, and the record adapts in both cases. In a total return, the customer gives back all the merchandise on the invoice: the full revenue is reversed and the full cost is reversed, and accounts receivable or cash is adjusted for the total value. In a partial return, the customer returns only some products or part of a line: only the values corresponding to the returned merchandise are reversed. What should never be done is to reverse the full value when only part came back, because that would leave accounts receivable at zero even though the customer still owes for what they kept.

To record a partial return in an orderly way it helps to rely on the original invoice and on the credit note document issued for the returned value: the credit note states exactly how much is being returned and on which products, and the entry must match that value. If the original sale had several products with different costs, the cost that is reversed is the cost of the returned products, calculated with the same inventory valuation method the business uses.

The credit note: the document behind the transaction

No return should be recorded without its supporting document. In commercial practice that support is the credit note that the seller issues to the customer to acknowledge the return or the price reduction. The credit note states the value deducted from the customer account and describes the merchandise returned; with that document, the entry stops being a loose annotation and becomes a supported transaction, just as the invoice supports the original sale. The complete nature of the document is studied in the lesson dedicated to credit notes; here we care about its accounting effect.

The credit note also has a consequence regarding taxes, worth mentioning in general terms: when a sale generated an associated sales tax and then that sale is returned, the tax related to the returned merchandise is also adjusted or reversed in the same proportion, because the tax is computed on the sale that finally stands. The exact form of that adjustment depends on the rules of each country and on the type of document, so in this manual we only point out the principle and leave the details to the business accountant, who knows the current regulation. At the end of the lesson we repeat this recommendation.

Complete step by step example

Let us see the record with a numeric example that is repeated in the tables of this lesson. Suppose the business sold merchandise on credit for $1,200,000 and that merchandise had cost the business $720,000. Later, the customer returns part of that purchase: the returned merchandise has a selling price of $300,000 and had cost the business $180,000. The returned merchandise is in good condition and can be sold again. The following table shows the complete entries, from the original sale to the return, so you can see exactly what is reversed.

Let us review the result of the eight steps. On the revenue side, the sales returns account was debited for $300,000, so at the end of the period net sales will be the original sales minus the returns. The customer accounts receivable decreased by $300,000, because that part is no longer owed. On the inventory side, $180,000 of recovered merchandise came in and cost of goods sold decreased by the same figure. If we compare with the original sale, the return left the transaction as if $900,000 of merchandise had been sold with a cost of $540,000: exactly the original sale minus what was returned, in revenue and in cost, each with its correct value.

When the returned merchandise arrives damaged or unusable

So far we have assumed that the returned merchandise is in good condition and can go back to the shelf. But in reality a part of returns arrives damaged, broken, expired or simply in a condition that prevents selling it again. In that case the merchandise cannot re-enter inventory as a sellable product, and the cost record changes: instead of returning the value to inventory, that value is recognized as a loss. The logic is that the sale is reversed because the customer no longer pays for it, but the business does not recover a product that can generate a future sale either; the cost of that merchandise becomes a loss of the period, of the same kind as the shrinkage and inventory adjustments we studied in the inventory adjustments and shrinkage lesson of this manual.

The record in that case works like this: the revenue is reversed as always, debiting sales returns and crediting accounts receivable or cash. The difference is in the cost: instead of debiting inventory, a loss or expense account is debited, with names such as loss on damaged merchandise, shrinkage or impairment, and cost of goods sold is credited, because that cost no longer belongs to a sale that stands. If the damaged merchandise still has some scrap or spare value, the part that keeps value can enter inventory and only the difference is recognized as a loss. Whether the customer receives a full or partial refund when the merchandise arrived damaged is a commercial matter, agreed according to the business return policy; in accounting, the value that is reversed is the one actually refunded to the customer.

Who pays the freight of the return?

A practical question that arises with returns is who bears the cost of shipping the merchandise back to the business. The short answer is that it depends on the commercial agreement: if the customer returned because the mistake was the business own, the usual thing is that the business bears the freight; if the customer simply changed their mind, many policies charge the freight to the customer or deduct it from the refund. In accounting, when the business bears the freight of a return, that value is not added to inventory nor subtracted from revenue: it is an expense of the period, recorded by debiting a freight or transportation expense account and crediting cash or the account payable to the carrier. If the customer pays the freight, the business records no expense for that concept, because the cost is borne by the one who returns.

Return or discount? Cases in summary

To close the topic it is worth distinguishing three situations that are often confused in practice: the return of merchandise in good condition, the return of damaged merchandise, and the case in which the customer keeps the merchandise but asks for a price reduction. The following table summarizes each case, states whether the merchandise goes back to inventory and shows the corresponding entry. The third case is not a return: since the merchandise does not come back, inventory and cost of goods sold are not touched, and the record looks more like a sales discount.

The difference between return and discount matters because the accounting effect is not the same. In a return the merchandise comes back and both revenue and cost are reversed, two movements; in a discount the customer keeps the merchandise, the sale stands for a lower value and only revenue is adjusted. Recording a discount as a return inflates inventory with merchandise that never came back, and recording a return as a discount leaves inventory without the merchandise that did come back. That is why, before making the entry, it helps to ask one single question: does the merchandise come back or does it stay with the customer?

Common mistakes when recording returns

To finish, let us review the most frequent mistakes. The first one is forgetting the cost reversal and leaving cost of goods sold and inventory untouched, which distorts profit and the inventory value. The second is valuing the returned merchandise at the selling price instead of the cost, which inflates inventory. The third is recording a total return when the return was partial, leaving the customer receivable at zero when it should not be. The fourth is treating a simple price discount as a return, moving inventory that never moved. And the fifth is recording the return without the supporting document, which leaves the books without support and makes any review difficult. All these mistakes are avoided with a simple routine: review the credit note, identify whether the merchandise comes back and in what condition, and verify that the entry reverses revenue and cost for the same values that were recorded in the sale.

To close

A customer return is not the mysterious cancellation of a sale: it is an accounting transaction with clear rules. It reverses the revenue recognized, returns the merchandise to inventory at its cost when it is in good condition, or takes it to a loss when it arrives damaged, and it is supported by the credit note. Distinguishing the return from the discount, and handling total and partial returns well, keeps the income statement and inventory at values that reflect what really happened in the business. If the business records its sales and its returns in a program such as Kardex Tauro, the return transaction is documented and inventory is updated immediately; with this lesson you already know how to review that the journal entry behind that transaction is the correct one. Remember that tax effects follow general principles that each country regulates in its own way and that the values in the examples are illustrative: when in doubt, consult your accountant and verify the current regulation before applying a criterion to your records.