Accounting for Merchandising Businesses

Adjusting Process for Inventory

Inventory lost to theft or damage and inventory returned by the customer require the use of adjusting entries, which involve updating the accounting records to document inventory shrinkage and customer returns and allowances.

Inventory Shrinkage

Shoplifting is one source of inventory shrinkage for a merchandising business. Shrinkage is noted in the adjusting process on the business's accounting records.
Inventory shrinkage is the difference in the amount of inventory on hand per a count from what is recorded. Errors, obsolescence, shoplifting, and damage are all possible contributors to the occurrence of shrinkage. To assess the level of shrinkage, a physical inventory count is required. To ensure that inventory on hand and inventory per the accounting records are harmonized, periodic physical inventory or cycle counts are necessary. In the event that the physical inventory count determines that the inventory on hand is less than the inventory per the accounting records, an adjusting entry must be made to update the accounting records. Shrinkage can be a costly expense that erodes net income, as its occurrence directly impacts cost of merchandise sold. For example, Happy T's counted its T-shirt inventory at the end of the month and determined that it has 600 T-shirts on hand with a value of $6,000. The inventory account, however, shows a balance of 610 T-shirts valued at $6,100. This means Happy T's has experienced an inventory shrinkage of $100. The $100 shrinkage could be caused by several things, including shoplifters, inaccurate entries or errors made during the checkout process, or damaged T-shirts. Happy T's would make an entry to record the shrinkage.

Shrinkage Journal Entry

General Ledger
Date Account Title Debit Credit
Apr. 30 Cost of Merchandise Sold $100
      Merchandise Inventory $100

Merchandising businesses realize that customer loyalty is important for future sales, so they offer refunds or other concessions to customers in anticipation of their customers returning to purchase more goods. When these events occur, such as refunds, adjustments must be made to reduce the customer account or provide a cash refund of the purchase price, returning money to the customer in the form of a cash payment. When goods have been returned, the customer is entitled to a refund of the purchase price. Additionally, the revenue associated with the sale is reduced. Customer returns are recorded in an account titled "sales returns and allowances." The sales returns and allowances account is a contra revenue account that holds customer returns of merchandise or price adjustments for discounts, vouchers for future visits, or other similar offerings. For example, the customer that purchased T-shirts for the company picnic comes back to Happy T's and says that several of the shirts are the wrong size and cannot be used. Happy T's wants to make the customer happy and rectify the situation, so it offers a refund for the shirts in the amount of $100. Happy T's would record an entry if the customer accepted the refund.

Customer Return Journal Entry

General Ledger
Date Account Title Debit Credit
June 18 Sales Returns and Allowances $100
       Customer Refunds Payable $100

If Happy T's was using the periodic inventory system, no additional entry would be required. If Happy T's was using the perpetual inventory system, the returned T-shirts would need to be recorded back into inventory, and an entry would be made.

Perpetual Inventory Merchandise Return Journal Entry

General Ledger
Date Account Title Debit Credit
May 12 Merchandise Inventory $80
       Cost of Merchandise Sold $80

Purchase returns and allowances reflect merchandise returned by the merchandising business or a cost modification due to a product defect. In the example above, a customer returns goods to Happy T's. However, when Happy T's purchases the T-shirts from their supplier, it also may have a difficulty with damaged T-shirts or another problem with the order and request a purchase return or allowance from the supplier.