Companies incur expenses that are essential in helping generate revenues. Of these, the most significant include purchases. Purchases are goods or services obtained or acquired to fund a company’s operations. These differ from other expenses which do not directly contribute to a company’s revenues. Instead, purchases are a part of a company’s part of sales and the direct expense for revenues.
For most companies, purchases include goods purchase, which then they resale or use in manufacturing. It may also include services, although that is less common. Once companies purchase goods, they require them to be of good quality to produce or sell further. Sometimes, however, these goods may not meet those standards. Therefore, companies may return the goods or ask for allowances from their suppliers.
What is a Purchase Return?
When companies purchase goods from suppliers, they may also offer a purchase returns policy. Usually, companies get raw materials or finished goods from external sources. There are several steps involved in this process. Usually, the purchase process begins with a company identifying the need to buy raw materials or finished goods.
Once the company establishes the quality and quantity of goods it needs, it will place an order with a supplier. For some companies, the process may also involve looking for various suppliers and selecting the best option. However, other companies may have a pre-approved list of suppliers from which they purchase goods.
When a company receives the goods it ordered, it will record it as a purchase. The purchase account is an expense account that goes directly into a company’s cost of goods sold. Sometimes, however, goods received may also contain products that don’t meet a company’s requirements. Then, companies may return them to the supplier. These goods are known as purchase returns.
Purchase returns, in short, are goods that a company returns to its suppliers. There are several reasons that a company may return these goods. Some of these include the following.
- Damaged or faulty goods.
- Incorrect order delivered by the supplier.
- Higher quantity delivered by the supplier than the order.
- Received the wrong order or products.
- Supplier delivered the goods later than requested.
What is a Purchase Allowance?
All the above reasons can give rise to a purchases return for companies. Sometimes, however, companies may not return goods to suppliers. For example, the goods may be faulty but still in an acceptable condition. Nonetheless, companies will require compensation in exchange for accepting below standard or faulty goods.
This compensation usually comes as purchase allowances. A purchase allowance is a reduction in the price of goods or services after delivery. However, it does not entail a trade or cash discount. It is not a reduction in the price of goods or services before the delivery. Therefore, it is not a trade discount. Similarly, it does not offer an early settlement discount, excluding it from cash discounts.
With a purchase allowance, the company does not return the goods to its supplier. Instead, it keeps the goods and receives an allowance or a price reduction. It is different from purchase return in this regard. However, it affects the company’s purchases figure in its income statement. Usually, companies record purchase allowances in the same account as purchase allowances.
Like purchase returns, purchase allowances can also occur due to various reasons. These may include the following.
- Lower quality of goods than ordered or agreed.
- Higher prices than agreed charged by the supplier.
- Short shipments.
- Price disagreements between supplier and the company.
What is the accounting treatment of Purchase Returns and Allowances?
In accounting, both purchase returns and purchase allowances are contra expense accounts. A contra expense account is an account in the general ledger paired and offset with a specific expense account. Usually, this account goes against an account that companies use to record an expense initially. In the case of purchase returns and purchase allowances, the expense account is the purchases account.
Some companies may keep two separate accounts for purchase returns and purchase allowances. However, others may maintain both of them under the same account due to their similar nature. Regardless of its presence in the books, both accounts reduce the purchases figure in the financial statements. However, they do not directly impact the purchases account in the general ledger.
The purchase returns and allowances accounts exist due to the accruals concept in accounting. When companies incur an expense, this concept requires them to record it. It does not need a cash settlement to become eligible for recording. Since companies already record the purchase expense, they cannot reduce it unless due to an error. Therefore, they need the purchase returns and allowances accounts to offset it.
How to record Purchase Returns and Allowances?
The above explanation provides a basis to record purchase returns and allowances. As mentioned, these transactions do not impact the purchases account. Instead, they offset it in the financial statements. Therefore, the purchases account will stay unimpacted. Nonetheless, it is crucial to understand how a company records the purchase of products or services.
When a company purchases goods or services, it uses the following journal entries to record it.
|Accounts Payable or Cash||XXXX|
When it returns these goods to the supplier, the accounting entries may differ. Some suppliers may offer exchange products for the returned goods. However, companies do not record this transaction since it results in a net effect of zero. Similarly, it won’t affect the financial statements due to the same reason.
Sometimes, the supplier does not offer goods in exchange, or the company does not exchange. The company may return the goods in exchange for compensation. This compensation may include cash return or reduction in balance with the supplier. The accounting entries for this transaction will be as follows.
|Accounts Payable or Cash||XXXX|
The journal entries for purchase allowances will be the same. However, the purchase returns account will get replaced with the allowance account. Therefore, the accounting treatment will be as follows.
|Accounts Payable or Cash||XXXX|
When presenting the purchases figure in the financial statements, companies must account for purchase returns and allowances. Companies report these accounts as a reduction in the purchases to figure to reach net purchases. The presentation will be as follows.
|Less: Purchase Returns||(XXXX)|
|Less: Purchase Allowances||(XXXX)|
A company, ABC Co., made total purchases of $500,000 during the last accounting period. The company recorded these purchases in its books using the following journal entries.
|Accounts Payable||$ 500,000|
Of these, $75,000 worth of goods were damaged or faulty. Therefore, ABC Co. returned those goods to the relevant suppliers. In exchange, the suppliers agreed to reduce the company’s balance in their books. ABC Co recorded these returns in its purchase returns accounts with the following journal entries.
|Accounts Payable||$ 75,000|
|Purchase Returns||$ 75,000|
Similarly, ABC Co. found more goods to be below standard. However, they were still usable, so the company decided to keep them. In exchange, the suppliers provided the company with a purchase allowance of $25,000 and a reduction in payable balances. ABC Co. recorded the purchase allowances as follows.
|Accounts Payable||$ 25,000|
|Purchase Allowances||$ 25,000|
Overall, ABC Co. presented its net purchases in its financial statements as follows.
|Less: Purchase Returns||$ (75,000)|
|Less: Purchase Allowances||$ (25,000)|
|Net Purchases||$ 400,000|
Purchase returns are goods that a company returns to its suppliers due to various reasons. Similarly, purchase allowances are discounts received for goods already recorded in the accounts. However, these do not represent cash or trade discounts. Both of these accounts represent a reduction in a company’s purchase expense. They are a type of contra expense account.