 In this presentation, we will talk about sales returns and the transaction related to them, the debits and credits that will be recorded when the merchandise is returned. In order to do this, we first want to talk about the sale of merchandise and review that journal entry because in essence, when the merchandise is returned, we want to start from this journal entry and then reverse it, making a few modifications with that reversal. So when we make the sale, what happens is that we're going to sell the merchandise here and we're going to receive not money at the point in sale, but an IOU. Two things are happening. Remember, when that happens, we can think of it as two separate journal entries happening. The first being similar to a service company where accounts receivable will be increasing because we have not yet received the money and sales, our revenue account will be increasing. And then the other side, the side that is different than what we see in a service company will be that inventory will be decreasing because we sold it and the cost of goods sold, the expense related to us selling that inventory will be going up. When we think about the return, when the customer returns to merchandise, we are in essence wanting to start with this process, this journal entry and then reversing it. Looking at that journal entry more fully, this is the first half of it, the sales half, where we said we're going to do the same thing as we would for a service company in that we are increasing the accounts receivable and we're increasing the revenue account for a merchandiser that often is called sales. If we post that out, then the receivables are going up. Here's the debit increasing the receivable. And then here's the credit increasing the sales. Both receivable and sales are going up, increasing net income here. Then the other side of that transaction will be the reduction of the inventory because this is a merchandising company where we have inventory, which must be reduced. So we're going to credit the inventory to make it go down and record the related cost of goods sold. And this is often the piece that most students have problems with. What is this expense? What is this cost of goods sold? That's the expense related to us consuming the inventory in order to help us generate revenue. So we are going to record that that's going to increase the cost of goods sold, which will decrease the net income. And then we'll have the merchandise inventory going down. So these two journal entries related to the sale of inventory will of course be reversed in essence with a minor change when the inventory is returned. So if we go down to the return transaction then we're going to say, okay, some of that inventory was now returned. The customer returned $300 worth of the sales price of the inventory. And that's received here. So what would the journal entry be? Well, we're going to have two components again and we're going to basically reverse what we did last time. The accounts receivable is going to go down. The IOU is going to decrease because of course we never got payment in this case. What happened is they owed us money, they never paid us, but they gave the merchandise back and therefore we're just going to say, okay, you don't owe us money anymore, the accounts receivable will go down. Then the sales return is going to go up. Now this is the minor tweak that we have to put in place here. We'll see this with the journal entry, but note that last time we had sales increasing when we made the sales, sales or revenue or income account increased. This time what's happening is we're not decreasing the sales account because the sales account typically only goes up. What we're going to do instead is create this contra account, the contra account called sales returns and allowances. And it's going to be increasing, acting like kind of a expense account. However, it's really kind of a contra sales account. So the way to think about that is basically that, okay, we want to reverse sales, meaning we want sales to go down. But sales never goes down, it's just kind of a rule. We don't typically make sales go down. Therefore, in order to make this happen, in order to make this sale not really happen because it didn't really happen because this $300 of sales that we recorded in the past was returned and we're never going to get paid for it. We're going to create a contra account, which is going to be called sales returns and allowances netting out against the income account. And that's how we're going to reduce basically the sales. So that's the minor tweak that we need to make. Then the other side of it cost of goods sold and the inventory. Inventory is probably easier to think about first. Inventory is going up because, of course, we got it back. We got the inventory back. Now, if the inventory was damaged or something, we might have to write it off as it was damaged. But if it's not, if it's just a return, then, of course, inventory is being received and therefore inventory is going to go up. Now, it's not going to go up by the $300. We'll see the journal entry so the numbers will change. But the $300 applies to our sales price here. And then the other side of it, the most confusing component, most of the time for most students, is that cost of goods sold will be going down. And this should look unusual because cost of goods sold is an expense and like sales typically only goes up. But unlike sales, we're not going to make that a rule that we never break. In this case, we're pretty much breaking that rule. We're going to say the expense is going down because we didn't really incur the expense. We sold it. We got it back. And therefore we're going to decrease the expense account, the cost of goods sold account. Let's see that in terms of journal entries. If we start with our trial balance over here and we're going to say that there was a return that had a sales price of $300, we're going to record the reversal then of the transaction. Now, remember, if you think back to the actual transaction, when we made the sale, that's the easiest way to do it, the first component of it similar to a service company would be debit accounts receivable and credit the sales or revenue account. So all we're going to do first, you want to think we're going to reverse that, meaning we're going to credit the accounts receivable to make it go down. That makes sense because we never got the money. The IOU is right here in receivables. This customer, we're saying they owe us money, but they don't anymore because they paid it, they gave the merchandise back, therefore we'll reduce the receivable. We'd also say this sales account is too high because we made a sale of $300 that didn't really happen because the merchandise was returned. So you would think we'd want to reduce that with a debit, which is what would be the exact reversal. But that's what the exception is. We don't decrease this account because there's basically a rule saying the revenue account never goes down. It just goes up until we close it out in the closing process. Instead, we're going to make this account right below it. It's going to be pretty much connected to this account. It's pretty much going to be the credit half of this account and it's going to act like an expense going up in the debit direction, bringing down net income. But when we record it on the income statement, it will be in the sales section. It'll be recording net sales, not net income, net sales, which will be sales minus these two contra sales accounts. So this will be the journal entry here. If we record that out then, we're going to say that the sales returns and allowances is going to be debited and that's going to increase the sales returns and allowances. Once again, acting like an expense, kind of similar to the cost of good sold expense, it going up in the debit direction, bringing net income down. But really it's kind of reversing the sales item here. And then we've got the receivable. So it's a debit balance. We're going to do the opposite thing to it. We're going to credit it, making it go down and down to in this case, 8,150. The effect on the account and equation as it's going down, liabilities remaining the same and the equity going down, why? Because the contra account here is going to be increasing and the contra sales account is increasing, decreasing net sales, which is decreasing net income, which decreases total equity. If we see that completed here, we can see the transaction with all the numbers filled out and we can see that net income is going down. So it started here, it's going down by this 300 to here. The second component of the transaction, remember when we made the sale, there's two pieces, one the sales piece that we just reversed. When we make a sale, we debit accounts receivable, we credit sales or inventory. Then the other component when we make the sale is debit cost of good sold and credit the merchandise inventory. So once again, the first component of the sales to debit the accounts receivable and credit sales, we just reversed that. The second component when we make a sale is to debit cost of good sold, credit the merchandise inventory. Now we're just going to reverse that. So if you think about the normal sales transaction, you just reverse it. As we do here, we're going to reverse that process and we're going to debit the merchandise inventory. Probably the easiest component to think about because the merchandise inventory is being received. We got it back. So the merchandise inventory is here, has a debit balance, we got it back, therefore it will be increasing. Note that it's not going to be the same dollar amount, of course, because we sold it for 300, which would be on the invoice. But the cost to us is something lower than that, hopefully, because we sold it out of profit. And therefore we got to be mindful of that. And then the second component is going to be the accounts receivable or the cost of goods sold. And that's going to be the expense related to us selling it. And this will be the most confusing component typically and it should look funny because it's making an expense account that typically only goes up, go down in this case. So we can see the cost of goods sold never really happened because it relates to us the cost of us selling the inventory and we got the inventory back. So we made it go up by 230 when we made the sale. Now we need to reverse it because it's not going up and we're going to reverse that out at this point, crediting it. If we post this, then we see the merchandise inventory with a debit balance of 11,500 going up in the debit direction by the 230 to an ending balance of 11,730. We see the other side then being to cost of goods sold. This is a credit, that's a debit, those are opposites. Therefore the debit balance of 6,500 will be going down in the credit direction to an ending balance of 2,000, 6,270. The effect on the accounting equation will be that the assets are increasing because we got the merchandise back, which is an asset, liabilities remaining the same and the equity section will be increasing. Usually the most confusing component being the equity section, why is it increasing? Because cost of goods sold and expense is going down which is kind of unusual, the expense is going down. Remember that the net income is calculated as revenue minus expenses. Therefore, if the expense is going down, revenue minus expenses is going up for net income and the total equity therefore also going up. We see all the numbers here, we can see everything filled out and we can see that net income here is going from the 101,650 before up by this 230, this change related to the cost of goods sold here to 101,880. So these are gonna be the two journal entries that are reversed are happening here when we have a return of merchandise. So remember what you wanna do when you have a return, think about the sale first, think about what we are reversing. When we made the sale, there's two things happening, two journal entries. One is that we made the sale and typically if we make it on account we debit accounts receivable and we credit the revenue account typically called sales if it's a merchandiser and two, we decrease the merchandise inventory with a credit and we debit the cost of goods sold. When we reverse those then we're just gonna reverse those with a minor tweak. One, the first journal entry reducing the accounts receivable with a credit and the other side not going to sales, we're not gonna be debiting sales but instead creating another account, a contra account called sales returns and allowances. So here's the minor tweak that we will be making. The second component will be reducing the cost of goods sold account which is probably the most confusing component and it will be increasing the inventory. So the second component, we would think of it as completely reversing what we did before and or you can think of it as the merchandise inventory is going up because we got inventory back and then the other component of it will be the cost of goods sold. This is usually the most confusing one because it should seem a little bit weird because we're decreasing an expense account something a bit odd. If we consider the effect on the assets and the net income, we can see that these two components of the journal entries, if we put these journal entries together, here's the two journal entries, the sales returns and allowances, the accounts receivable, the first half of the return journal entries and then the merchandise inventory going up and the cost of goods sold going down, the second component, these two components are the inventory or the asset type of accounts. So we can see the net of course between them two, the accounts receivable is going down, so that's a negative in terms of assets and we can see that the inventory is going up. So we got the inventory back but of course the accounts receivable is going down, the accounts receivable is over the inventory or more than the inventory and therefore there's a net decrease of the $70. When looking at the net income component, we can see that the sales returns and allowance is going to be an income statement type of account. Now this one's a little bit more confusing because we get mixed up on these equations. Remember that the net income is revenue minus expenses. Sales returns is not the same thing as sales. Sales returns is going to be the contra account that is going to be increasing, the contra account is going to be increasing but it's going to be bringing down the sales. So it's really bringing down sales, it's bringing down revenue and therefore revenue minus expenses being net income, it's bringing down the net income. The other side of it's going to be the cost of goods sold and the cost of goods sold is going down because we're reversing, remember the cost of goods sold account and so remember that's an expense and the expense is decreasing and therefore the net income which is going to be revenue minus expenses is going up from the cost of goods sold decreasing, the net then is going to be a decrease in net income of $70. And in essence you can kind of think of this as what's happening of course is we're reversing, we're getting rid of the sale, there's two pieces to it. The sales component is going down, it's going down by the contra account the sales returns going up and of course we made the sales for higher than the cost of the goods sold. So the sales are being eliminated and the expense related to it are being eliminated and that results in a decrease in the net income. Of course when we look at the two things here when we look at the asset component and the net income component they are the same they are going to be equivalent this is what happened net to total assets and this is what happened net to net income as well as equity.