Chapter 4: Appendix P6

Adjusting Entries for Discounts, Returns, and Allowances (Revenue Recognition Rules) New revenue recognition rules require companies to estimate and record expected sales discounts, returns, and allowances in the period in which sales are made. This ensures that revenue is reported at the expected amount to be received and that both sales and cost of goods sold (COGS) are not overstated. Adjustments are made for future sales discounts, returns, and allowances through specific contra accounts. 1. Expected Sales Discounts – Adjusting Entry At the end of the period, companies estimate sales discounts that will likely be taken in the future. The Allowance for Sales Discounts account is a contra asset account, which reduces Accounts Receivable. Example: Z-Mart has $11,250 of receivables, with $2,500 eligible for a 2% discount. The expected future discount is calculated as: Expected Discount=2,500×2%=50 Journal Entry: To record the expected discount, the following adjusting entry is made: • • Debit Sales Discounts $50 Credit Allowance for Sales Discounts $50 This adjustment reflects that Z-Mart expects to receive $50 less in accounts receivable, ensuring both Accounts Receivable and Sales are reported at their expected amounts. Next Period Adjustment: If the company later determines that the allowance for sales discounts should increase from $50 to $80, the difference of $30 will be recorded as follows: • • Debit Sales Discounts $30 Credit Allowance for Sales Discounts $30 2. Expected Returns and Allowances – Adjusting Entries To avoid overstatement of sales and cost of goods sold, companies estimate future sales returns and allowances and adjust both the revenue side and the cost side. Revenue Side for Expected Returns and Allowances: The Sales Refund Payable account is a current liability that reflects the amount the company expects to refund to customers for future returns and allowances. Example: Z-Mart estimates future sales refunds of $1,200. If the unadjusted balance in the Sales Refund Payable account is $300, the company needs to update the account with an additional $900: Required Adjustment=1,200−300=900 Journal Entry: • • Debit Sales $900 Credit Sales Refund Payable $900 This adjustment ensures that sales are reported at the expected net amount, after factoring in future returns and allowances. 3. Expected Returns on the Cost Side – Adjusting Entries On the cost side, companies must estimate the value of inventory expected to be returned. The Inventory Returns Estimated account is a current asset account that reflects the inventory value expected to be returned. Example: Z-Mart estimates future inventory returns of $500. If the Inventory Returns Estimated account has an unadjusted balance of $200, the company needs to increase this balance by $300: Required Adjustment=500−200=300 Journal Entry: • • Debit Inventory Returns Estimated $300 Credit Cost of Goods Sold $300 This adjustment reduces COGS because some of the previously sold inventory is expected to be returned. Summary of Adjusting Entries: 1. Sales Discounts: o Debit Sales Discounts o Credit Allowance for Sales Discounts This ensures sales are reported at the amount expected to be received after discounts. 2. Sales Returns and Allowances (Revenue Side): o Debit Sales o Credit Sales Refund Payable This reduces revenue by the estimated amount of future returns and allowances. 3. Sales Returns and Allowances (Cost Side): o Debit Inventory Returns Estimated o Credit Cost of Goods Sold This ensures COGS is not overstated by accounting for the expected return of inventory. Example Solution for Adjustments: Based on the company’s estimates and unadjusted balances: 1. Sales Discounts Adjustment: o Allowance for Sales Discounts should have a $275 credit balance. If it is unadjusted, the adjusting entry would be: o Debit Sales Discounts $275 o Credit Allowance for Sales Discounts $275 2. Sales Returns and Allowances (Revenue Side): o Sales Refund Payable should have a $870 credit balance. If the unadjusted balance is lower, the entry to adjust it would be: o Debit Sales $870 o Credit Sales Refund Payable $870 3. Inventory Returns Estimated (Cost Side): o Inventory Returns Estimated should have a $500 debit balance. If unadjusted, the adjusting entry would be: o Debit Inventory Returns Estimated $500 o Credit Cost of Goods Sold $500