Special Transactions in Inventory (Accounting) - Explained
Returns, Allowances, Discounts, and Transportation Costs
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Table of ContentsWhat are the Special Transactions in Inventory?Special Transactions for the PurchaserHow to Account for Purchase Returns and Sales?Accounting for Inventory AllowancesAccounting for a Purchase Discount? Accounting for Transportation CostWhat are the Special Transactions for the Seller of Inventory?Special Transactions for the SellerWho Pays the Cost of Transportation? How to Make a Journal Entry for Transportation Costs? How to Record the Return of Sold Inventory? How to Account for an Allowance for Cost of Defective Product? How to Recognize Sales Discounts?
What are the Special Transactions in Inventory?
Below we are going to discuss how to create journal entries for the following special transactions:
- Transportation Costs
How these transactions are handling is unique for the purchaser and the seller. We address each side of the transaction below.
Special Transactions for the Purchaser
How to Account for Purchase Returns and Sales?
A return is something a buyer purchases and takes back. If we purchase some inventory and something goes wrong - we need to return it.
The effects of the return is the opposite of the original purchase transaction. If we purchase it one way and we put it in our books as a journal entry one way; then, if we return it , it's going to be the opposite. The debit become a credit the credit becomes a debit.
For example, when inventory is purchased the merchandise inventory account is debited - meaning our inventory goes up. Our cash goes down so it's credited.
If we returned, Cash or Accounts Payable (depending on how you paid for it) is going to be the debit - because it goes back up. Then merchandise inventory is going to be the credit, because it goes down.
Accounting for Inventory Allowances
Allowances is when the company allows you to keep the inventory at a discount or without paying for it. I'm not returning the inventory; rather, the company simply refunds part or all of the purchase amount.
To record this, the journal entry would still be the same. It's not going to change because we don't care about the physical inventory, we care about the value of the inventory. We're still losing the value of the inventory, and we're getting it off of our accounts payable or our cash.
So, our Cash (goes up) or our Accounts Payable (goes down) will be debited by the amount of the allowance. Our inventory will be credited for the value of the allowance.
Accounting for a Purchase Discount?
A purchase discount is a cash discount applied to a purchase. There are different types of discounts:
- Customer discount - A customer discount is a sale price on items. The store is incentivizing you to buy. If you buy it, you get a discount off the normal full price. For the purchaser, the discount is taken off at the time of purchase, so you're not really going to see it in the journal entries.
- Trade discount - A trade discount is a little bit different. If you purchase a higher quantity of an item, you get a discount price per item on the bulk sale. This is primarily targeting resellers (distributors or retailers) of the item. The seller is again incentivizing you to purchase a larger quantity. Again, the amount of discount will generally not appear in the journal entries.
- Cash discount - A cash discount incentivizes the customers to pay earlier. This one only happens when you're paying on account. As the Buyer, you are using your Accounts Payable. The seller provides you with. terms like, 2/10, net 30. This means that you get a 2% discount if you pay within 10 days. If no, the full payment is due within 30 days.
For the purchaser, if you pay during the discount period, the inventory account is decreased by the discount amount.
The first things, I'm going to debit the entire amount of accounts payable for the entire amount of the invoice without the discount.
Next, I'm going to credit Cash for the payable amount minus the discount amount (the amount that I'm actually paying).
Remember, our debits and our credits have to equal. Right now, they're not because the accounts payable is a certain amount and the cash is that amount minus the discount.
The third thing that I have to do is credit inventory. I'm lowering the value of my inventory by whatever that discounted amount is. This will balance the debits and credits.
Remember, the inventory account is the purchase value of all inventory. It does not means the actual or retail value of it.
Accounting for Transportation Cost
The responsible party or the paying party if you're the responsible then you are the one paying of the freight cost.
From the buyer's side, if the risk is of loss during transit (that is the point of shipment) is assumed by the buyer it's called FOB (Free-On-Board) Shipping Point. If the Buyer does not assume responsibility until delivery, then it is called FOB Destination.
The purchaser would take that cost of shipment and put it into our inventory because that is part of the cost of the inventory to get it to our facility.
We would credit Cash and debit Inventory.
What are the Special Transactions for the Seller of Inventory?
The special transactions that happen with the sale of inventory to customers include:
- Cost of Transportation
- Returns, and
Each is discussed below.
Special Transactions for the Seller
Who Pays the Cost of Transportation?
The party responsible for paying the freight cost depends on which party assumes this risk. If the Buyer assumes the risk of loss or liability upon shipment, it is known as FOB Shipping.
If the risk of loss during the transit is assumed by the seller - meaning it ends at the destination point - then the shipping terms are known as FOB (Free-on-Board) destination. So, the seller maintains the risk or the liability for loss up until the point that it's delivered. The seller is the one that's specifically paying for it.
How to Make a Journal Entry for Transportation Costs?
WIth FOB Shipping, if you are the responsible party, you can add the cost of transportation into the inventory cost and expense it when the goods are sold.
As the seller, with FOB Destination, the process is a bit different. We've already sold the inventory when we ship it. So, I can't add the cost of shipping to inventory costs. This is an additional expense that I bear. I'm going to have to expense this in its own account, and I'm just going to call it something like delivery expense or transportation expense.
So if it's FOB shipping, we're going to put it into inventory if you are the responsible party. If you're not the responsible party, you do nothing,
If it's FOB destination, and you're the responsible party, we put it into delivery expense.
How to Record the Return of Sold Inventory?
A sales returns is when a seller sells an item of inventory and then the item is brought back. The effects of the return are the opposite of the original purchase.
We're going to claim this one as sales returns and allowances. This is kind of a side account that lets us know that this is what we sold and this is what was brought back. This is why we use a different account that simply reducing sales revenue.
So, we debit the account Sales Returns.
We debit inventory, as inventory increases.
Then you credit Cash and Accounts Receivable (whichever one you used).
Finally, you credit the cost of goods sold.
How to Account for an Allowance for Cost of Defective Product?
An allowance reduction is the cost of defective or unaccepted merchandise that a seller issues.
If we give an allowance, we're not actually getting the inventory back. We're taking it off of our revenue.
To do this, first, we debit sales returns and allowances for that amount.
Then we credit our cash or accounts receivable (however they paid).
Note: I'm not touching COGs. And, I'm not touching inventory.
How to Recognize Sales Discounts?
Companies routinely give discounts to purchasers who pay within a specified period. For example, 2/10/ net 30, means a 2 % discount if the purchaser pays within 10 days of receipt of the invoice. So, we need a method of accounting for this 2% discount.
From the original sale, we are going to receive cash when it is paid, so we debit the Accounts Receivable. We are selling inventory, so we credit inventory. We have an expense for the goods, so we credit the COGs. Then we debit sales revenue.
To account for the allowance, wee debit the Sales Discount account, which is increased by the discount amount.
Finally, I'm going to take it out of my accounts receivables as a credit for the total amount.
Note: I'm not putting it into sales revenue. It'll affect revenue, but I'm putting it into discounts specifically because again I want to show what I did sell in total in revenue. This is what I had to take off because of a discount.
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