 Hello and welcome to this session in which we will discuss sales returns and allowances. What are sales returns and allowances and when do they occur? Well, sales returns and allowances occur when the customer is unhappy with the product. So you sold the product to a customer, they are unhappy with the product. So what can the customer do? Well, one thing they can do is they can actually physically return the product. So the customer returned the product physically and they can return the product for various reasons. It's the wrong size, the wrong color, the product was damaged during shipment or for any other reason. That's what sales return is. I know it's pretty straightforward concept, but nevertheless I have to explain it. Allowances are a little bit different. Let's assume you shipped a product to a client. Well, the product was damaged during shipment or it was the wrong color, the wrong size. Well, the customer might call and complain that you send them the wrong size or the wrong color. Well, what you can do is this. You'll tell them, look, you keep the product and I will give you a 20% discount. So no return of the actual product. So you don't return the product. So if you purchase the product for $100, now we're going to deduct $20 from your bill and now you owe us $80. So this is what a sales allowance is. The seller grants a credit for the buyer. For various reasons, whatever that reason is. However, the customer don't return the actual product. Now, why am I emphasizing this point? Because that's the difference between sales return and sales allowance from a journal entry perspective. From a journal entry perspective, there's no inventory involved for the sales allowance. And just make a note of this. So this way, if you understand how sales return is recorded, then you will understand sales allowance is actually it's easier because you don't have to worry about the inventory part. So what happened when when someone returned the product or that you give them an allowance? Well, you can do one of the following. You can refund their money with their partial or full for anything that they paid. You can reduce their accounts payable, which is for you. It's an account receivable for them. It's an accounts payable. You tell them, look, you're going to owe me $20 less or 20% less, or you can exchange the product for another product. So this is this is basically what actually happened in the real world. So when do we record the sale? So if we sell something, if we give the customer the right to return it, and that's an important concept for revenue recognition, if they can return it, is this really a sale? Or do we have to wait until the return period has ended? Well, let's assume a company made a sale today and gave the buyer the right to return the product within 45 days for any reason. Well, what's happened is this? Do we have a sale today? Or do we wait for the 45 day period to expire? That's the question. Well, here's the rule. Very simple. As long as the company that's selling the product can estimate the amount of returns and allowances, then you have a sale today. What does that mean? It means the company they have experience, they make they made similar sales in the past, and they know from experience, for example, 5, 7, 8, 2% of their sales are returned or they give they give the customer some allowance. Now, how do they estimate? Well, past experience, they are experienced in this business. And believe me, once you run a business, once you have a business, especially for several several years selling your product, you will have an idea. What should your sales returns and allowances should be? You may not be 100% accurate, but you can estimate. So the business can estimate. You could use industry average. You can have your best guess. Basically, this is my best guess. You can ask an expert consultant in that industry, if this is a new product, what do you think? The best way to illustrate this concept is to actually look at an example, showing you how sales and sales allowance sales returns and allowances work. Before we look at an example that involves sales returns and allowances, I would like to remind you whether you are a student or a CPA candidate. Take a look at farhat lectures.com. I don't replace your beloved CPA review course. That's not my intent. I don't obviously replace your accounting course. My motto is saving CPA candidate and accounting students by providing you additional resources for your accounting courses. This is a partial list of them, lectures, multiple choice, true, false exercises that are aligned with your courses aligned with your chapters. Also, my CPA material is aligned with your record, Wiley, Roger, Gleam and Myles. So it's very easy to go back and forth between my material and your CPA review course. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with others. It helps me a lot. Connect with your Instagram, Facebook, Twitter and Reddit. The best way is to look at an example. Let's take a look at this example. January 20th, X1, Adam Company sells 100 tablets for $1,000 each on account to Best Seller Inc. BSI. And Adam gives BSI the right to return any unsold tablet for 45 days from the day of the purchase. The cost for Adam for each tablet is $600 and Adam can estimate that based on 100 sales, 100 units sold, 5% or 5 units will be returned. How did Adam now, based on past experience, no cost incurred for Adam for that return for reselling the return product? So let's assume the customer returned the product. Adam don't incur any additional cost for putting that product back on the shelves and reselling the product. And the return tablet, we're going to assume they are in saleable condition to kind of illustrate the point. If they are not in saleable condition, we might experience loss. But we don't cover this topic here because it's not covered on the CPA exam. It's not covered in your accounting courses. Once you have to deal with it in the real world, you will know how to record the return inventory if you incur the loss. But we're going to keep it simple again for educational purposes, for illustration purposes. So on January 25 five days later, BSI returns three of the tablets because the word wrong color. Well, that's fine. We kind of expected this. So what do we do on January 20 when we make the sale? When we make the sale, we're going to debit a count receivable for 100,000, which is 100 tablets times $1,000 each. That's for the sales transaction. We're going to credit cost of goods sold 60,000 credit inventory 60,000. Our cost for each unit, Adam's cost $600. Therefore, we debit cost of goods sold and reduce our inventory by 60,000. That's the day of the sale. Five days later, January 25, the customer returned the product. Now think of the return entry as the opposite of January 20. Because think about it, sales return is the opposite of a sales. Now with a small twist, but it's basically the opposite. So here's what we do. Well, we credited sales when we make the sale. When we have a return, we're going to debit, not sales, we're going to debit sales returns and allowances. Sales returns and allowances is a contra revenue. Therefore, we're debiting this account to increase in it. Technically, as if we are debiting sales, we're going to credit because we returned the day returned three units. We're going to credit account receivable for BSI $3,000. Simply put, now BSI owes us $3,000 less because they return three units, three tablets. Also, we're going to put the three units back on the shelves. We're going to have either debit return, return inventory, or simply inventory. But some companies, they want to keep track of the return inventory separately. Although return inventory and inventory are the same, but you may want to keep that separately. Now why 1800? Because they returned three units. And for us, for the company, the cost of each unit is $600. If you compare January 25th entry to January 28th, you will see that it's the reverse of the sale, except we don't debit sales directly, we debit sales returns and allowances. Now, this is the entries that we made on the prior slide. And Adam Company happens to prepare their financial statement on a monthly basis. So by the end of January, Adam will prepare their financial statements and they determine based on January 20th. Remember, initially they think it's going to be five tablets returned. Already, the customer returned three. They still think the two remaining will be returned. They still believe that. Now, what would Adam Company have to do? Adam Company will have to prepare what's called an adjusting entry to reflect the return of the two tablets. So here's what we do. We debit, we debit sales returns and allowances $2,000 just like as if they returned them. And we credit allowance for sales returns and allowances also for $2,000. We don't credit a counter receivable because we're not sure they may never return it. So we're not going to reduce their bill until it actually happens. So what we do is we debit allowance for sales returns and allowances. This is a counter, a counter receivable. So we don't reduce the receivable directly. We increase an account that's going to reduce the receivable by $2,000. Also what we do, we estimate that we're going to have returned inventory of $1,200. Why $1,200? Because they are returning two units. We estimate they're going to be returning two units and the cost for us is $600. So we debit estimated inventory returned and we credit cost of goods sold for $1,200. So this is what we do. We return our cost. We assume it's going to be returned to us and we're going to assume the inventory is still in good shape. Estimated inventory return is an asset. It's basically an inventory account. Also we keep track of that separate than the inventory, but nevertheless it's an inventory account. Now the best way to put this picture together is to actually look at how all these transactions affected the income statement, affected the balance sheet. Let's take a look at the income statement first. For the income statement here, I made an error. This is $100,000. I just noticed this, not $10,000. So sales is $100,000. That sales goes on the income statement. Then we deduct from sales. Sales returns and allowances. Well, we have $3,000 actually returned and $2,000 of sales return and allowances. It's going to be estimated. Therefore, we reduce sales by $5,000. Sales minus sales returns and allowances will give us net sales. Now also if we have sales discount, it reduces sales as well. Then cost of goods sold. What is our cost of goods sold? Initially, we recorded $60,000. Then we reduced it by $1,800. Then we reduced it by $1,200. Now $60,000 minus $3,000 is $57,000. What is our gross profit? $95,000 minus $57,000. It's going to give us gross profit of $38,000. This is how these accounts affect the income statement. Let's take a look at the balance sheet. On the balance sheet, we're going to have an account receivable of $97,000. Why $97,000? Well, we started with an account receivable of $90,000. The customer actually returned three units. So $100,000 minus $3,000. Our account receivable is $97,000. Then remember, we estimated that an additional $2,000 allowance for sales return and allowances should be recorded. Remember, this is a counter, a counter receivable. Therefore, we reduce our receivable by an additional $2,000. Therefore, the net receivable is $95,000. Now if we have any bad debt allowance for bad debt, it's going to reduce the receivable and gives us accounting receivable net. But we're only focusing on allowance for sales returns and allowances. Then the return inventory, the estimated return inventory also appear on the balance sheet. So what I wanted to show you is all the transaction that took place here, how they affected the financial statements. Now what I also wanted to ask you is what I also want to discuss with you is what if BSI actually paid cash? Well, if BSI actually paid cash, we would have debited cash when they paid. And when the return occur, we would have credited cash. Or if we don't pay them immediately, we owe them the money we credit accounts payable. That's all what we do differently if that's the case. Because if they paid cash and returned the product, they expect us to pay them cash. So either we pay them cash immediately, all will tell them give us 10 days and we'll pay it and we'll record it as accounts payable. So bear in mind, this is what we will do under those circumstances. Okay. So here what we do too, rather than allowance, we're going to have, if they paid us cash, we'll have an accounts payable because now we think we're going to owe an additional $2,000. Why? Because if they actually return it, well, guess what? We already recorded the liability. Now we paid the liability off. So we don't credit cash because we don't know whether that two additional unit will be materialized in a sense that it's going to be returned 100%. What should you do now? You should go to my website farhatlectures.com, work MCQs and look at additional resources. Sales returns and allowances is a topic that influence the revenue recognition process. You want to have a complete picture about the revenue recognition process. Invest in your courses, invest in your accounting career. Don't shortchange yourself. The CPA exam is worth it. Your accounting courses are important. Invest in yourself. Good luck. Study hard. And of course, stay safe.