Reversing entries (Goods returned)

Reversing entries are an essential part of the accounting process, specifically when dealing with goods returned by customers. When goods are sold and subsequently returned, the original accounting entries that recorded the sale and the associated cost of goods sold (COGS) need to be reversed to ensure the financial records accurately reflect the company’s position. Reversing entries help to correct the financial impact of the returns by adjusting revenue, inventory, and other accounts involved in the original sale.

Understanding Goods Return in Accounting

In business, it’s common for customers to return goods for a variety of reasons—defects, dissatisfaction, incorrect items, or other issues. When this happens, the seller must adjust its financial records to account for the reversal of the sale. Without reversing entries, the company’s financial statements would overstate both revenue and expenses (COGS), leading to inaccurate reports of net income, inventory, and accounts receivable.

There are typically two key financial components involved in a goods return:

1. Sales and Revenue:

When goods are returned, the revenue that was originally recognized from the sale must be reversed. This is because the customer no longer owes the company money for those goods, and the sale is essentially nullified.

2. Cost of Goods Sold and Inventory:

Similarly, the cost of the goods sold needs to be adjusted. When goods are sold, they are moved from inventory and recorded as an expense (COGS). When the goods are returned, they are added back to inventory, and the COGS must be reduced to reflect the return.

Purpose of Reversing Entries:

Reversing entries are used to correct previous transactions. In the case of goods returns, these entries ensure that the company’s revenue and expenses are adjusted accordingly, maintaining accurate financial reporting. Without reversing entries, companies risk overstating their sales, COGS, and net income.

Reversing entries are typically made at the end of the accounting period or when the return occurs. They allow for accurate financial statements by adjusting for any sales returns, discounts, or allowances that may have occurred after the initial sale was recorded.

Accounting Process for Reversing Entries: Goods Returned:

When goods are returned, a few key steps are followed to reverse the impact of the original transaction:

1. Reversing the Sales Revenue:

The first step in recording a goods return is to reverse the revenue that was recognized at the time of the original sale. This involves recording a debit to a Sales Returns and Allowances account (a contra-revenue account) and a credit to Accounts Receivable or Cash, depending on whether the customer had paid or was yet to pay.

2. Reversing the Cost of Goods Sold (COGS):

The next step is to adjust the cost of goods sold to reflect the returned inventory. This involves debiting the Inventory account (to add the returned goods back to inventory) and crediting the Cost of Goods Sold account, which reduces the expense previously recognized for the sale.

3. Sales Tax Adjustments (If Applicable):

In jurisdictions where sales tax is charged on goods, a return would also necessitate a reversal of the associated sales tax. This step ensures that the sales tax liability is correctly reduced in accordance with the goods returned.

4. Recording Any Restocking Fees or Discounts:

In some cases, companies charge a restocking fee for returned goods or provide a refund that is less than the original sale amount. These transactions must be accounted for accordingly, often by recording an entry to a specific Restocking Fee revenue account or adjusting the amount credited back to the customer.

Journal Entries for Goods Returned:

Here is a breakdown of the typical journal entries used to reverse the original sale and reflect the goods return:

1. Reversing the Sale

When goods are returned, the sales revenue needs to be reversed:

Journal Entry:

• Debit: Sales Returns and Allowances (for the value of the returned goods)
• Credit: Accounts Receivable or Cash (for the same value)

This entry cancels out the sales revenue that was previously recognized. The Sales Returns and Allowances account is a contra-revenue account, meaning it reduces the total sales reported on the income statement.

2. Reversing the COGS

Next, the cost of goods sold associated with the return must be reversed:

Journal Entry:

• Debit: Inventory (to add the returned goods back to stock)
• Credit: Cost of Goods Sold (for the cost of the returned items)

This entry restores the inventory that was removed when the goods were originally sold and decreases the COGS, reflecting that the sale has been undone.

3. Reversing Sales Tax (If Applicable)

If the original sale included sales tax, that tax must also be reversed. The sales tax would have been recorded as a liability when the sale was made, so the return reduces that liability:

Journal Entry:

• Debit: Sales Tax Payable (to reduce the liability for sales tax)
• Credit: Cash or Accounts Receivable (depending on the original transaction)

Example of Reversing Entries:

Consider a scenario where a company sells goods worth $1,000 to a customer on credit. The cost of the goods sold was $600. After a week, the customer returns the goods. The following reversing entries would be made:

1. Original Sale:
   • Debit Accounts Receivable: $1,000
   • Credit Sales Revenue: $1,000
   • Debit COGS: $600
   • Credit Inventory: $600
2. Return of Goods:
   • Debit Sales Returns and Allowances: $1,000
   • Credit Accounts Receivable: $1,000
   • Debit Inventory: $600
   • Credit COGS: $600

Importance of Reversing Entries for Goods Returned:

• Accurate Financial Reporting:

Reversing entries ensure that revenue, expenses, and inventory are correctly reported. If a company fails to reverse entries for returned goods, it risks overstating its sales and net income, leading to inaccurate financial statements.

• Transparency for Stakeholders:

Accurate accounting for goods returns ensures that stakeholders, including investors, creditors, and regulators, have a clear picture of the company’s financial health. Overstating revenue or understating COGS due to unrecorded returns can lead to distrust or legal repercussions.

• Compliance with Accounting Standards:

Both IFRS and GAAP require that companies accurately account for sales returns. Reversing entries help businesses comply with these standards, ensuring that financial statements are prepared according to recognized accounting principles.

• Inventory Management:

Proper reversing entries ensure that the company’s inventory levels are accurately reported. Failing to account for returned goods could lead to overstatements of inventory costs or understatements of available stock.