Accounting for Returned Inventory

Readers have expressed interest in what to do with returned inventory, so here goes.  Firstly, you need to be aware of the trinity of Bookkeeping, Tax Planning, and Tax Preparation.  Once you understand that there are three distinct viewpoints for every decision, you’ll see how to deal with returns.

Before we go into the trinity, we need to start with the practical options and situations that you have. Some are choices, and some have choices made for you.  The post will then go onto to explain what’s happening from an ‘Accounting’ perspective.

Scenario’s: You get a returned item and…

1. You find it unsellable, it is best to toss it in the garbage, eg crushed packet of chips.
2. You can’t sell it, but you can use it, eg a HDD that has damaged packaging.
3. You can’t sell it, but you want it for yourself, eg a box of Lego.
4. You can’t sell it, but you can donate it, eg you are gated on a product and want it to go to charity
5. You received a partial refund on the item and (any of the above)

Note that when I say ‘can’t sell it‘ it could also mean ‘don’t want to sell it‘. Got it? Let’s go!

In each example above we started out coding the transaction as:

• Purchase price is coded to Cost of Goods Sold (COGS) Account
• Inventory Value increases

What was supposed to happen is that you then sell the item and:

• Sale Account increases
• Inventory Value decreases

Then when you add up the COGS, Sales, and Inventory accounts you get your Gross Profit/Loss.  In order to properly code (for BookKeeping and later tax Prep) this you need to create two more sections within the chart of accounts: Damaged Goods (an expense/inventory contra account) and Donated Goods (an Owners draw account unless you are a C corp…more on that later).

As I go through the scenarios I’m going to use the same purchase price and sale price for consistency.

• Item Cost = $50
• Item Sale price = $75
• You buy two items, one sells for $75, the other has a return issue

Tossed in the garbage

• Starting COGS Value $100
• Starting Inventory Value $100
• Sales $75
• New inventory value $50
• New COGS value $50

<TOSSED IN GARBAGE>

1. COGS Value $50
2. Sales $75
3. Inventory $0
4. Expense Account (Different coding from regular expense, sometimes known as Inventory Contra) $50

If you read the above, you have $100 in costs, and $75 in sales.. therefore you lost $25.  If you think about that practically, you bought $100 in goods, but only received $75 in income, so you lost $25. Despite you making a ‘profit’ on the sale of one item, because the other is in the garbage you netted a loss.

Used for Business

You get a return that you could use, maybe a pen, or a HDD, or something that your home office can make use of.

• Starting COGS Value $100
• Starting Inventory Value $100
• Sales $75
• New inventory value $50
• New COGS value $50

<ABSORBED FOR BUSINESS>

1. COGS Value $50
2. Sales $75
3. Inventory $0
4. Expense Account (Office Expense) $50

You have a very similar situation to the scenario above, the difference is that from an Accounting perspective, you code the expense to your Office Expenses rather than Destroyed/Lost/Damaged Inventory account.  From a tax perspective, the same thing occurs, you lose $25 on the total transaction. If you aren’t using accounting software for this, there’s no difference to you between tossing it and using it.

Used Personally

Maybe a set of Lego that you want to play with.

• Starting COGS Value $100
• Starting Inventory Value $100
• Sales $75
• New inventory value $50
• New COGS value $50

<TAKE ITEM FOR PERSONAL USE>

1. COGS Value $50
2. Sales $75
3. Inventory $0
4. Owner’s Draw $50

Here, you aren’t expensing the inventory, rather you are paying yourself with it, at the cost price paid.  This is very different, because although the draw will reduce ‘profit’ you are increasing personal pass through income.

Donated to Charity

Maybe a set of Lego that you want to give to charity.

• Starting COGS Value $100
• Starting Inventory Value $100
• Sales $75
• New inventory value $50
• New COGS value $50

<DONATE ITEM TO CHARITY>

1. COGS Value $50
2. Sales $75
3. Inventory $0
4. Owner’s Draw (Charity) $50

Note that the account coding type is the same as though you paid yourself.  The Charity wording is only so it leaps out on a Profit Loss statement for later tax prep.  This is an important part of Tax Planning/Tax Law for pass through entities, such as LLC, Sole Prop, S Corp.  The company itself cannot take a deduction, but the individual that the company passes through to can take the deduction on Schedule A (providing they itemize). A C corp can actually deduct, but is limited to 10% of income.

This is important from a Bookkeeping, Planning, and Prep perspective.  What is happening here is that we are coding the account to replicate a different example, which would be:

• Owner buys $50 of Lego for Sale at $75
• Owner donates $50 to personal charity using business bank account (via Credit Card)

In order for the money to properly flow from the business bank account to the owner’s personal choice of charity they must ‘Draw’ from the business.  Many people might miss this and try to claim a deduction as an expense at the company level, which would be incorrect.

Partial refund on any of the above

Let’s say that Amazon grants you $20 towards the cost of $50 for an item that is damaged because they took partial responsibility (didn’t ship it back properly, etc).

• Starting COGS Value $100
• Starting Inventory Value $100
• Sales $75
• New inventory value $50
• New COGS value $50

<Partial Refund>

1. COGS Value $100
2. Sales $95
3. Inventory $50
4. Owner’s Draw (Charity) $50

Note how this is a three step process for clarity?  Here you actually made $20 more in sales, and you still own the inventory, it seems like you are ahead, but your inventory is still damaged. Your COGS is still at $100 because we haven’t ‘written it off’ yet. Let’s absorb that partially refunded inventory to the business use.

<ABSORB INVENTORY>

1. COGS Value $50
2. Sales $95
3. Inventory $0
4. Expense (Office Expense) $50

In this example, you’re Gross P/L is a loss of $5.  The $20 partial refund is a goodwill gesture that must be included in income.  Similarly, if you get a refund (full or partial) and then yourself return the item for a refund, you had sales income.

When to claim?

General accounting principles dictate that inventory write downs should occur promptly.  This isn’t an area where you time things to be more beneficial for a tax year.  Rather, you should address a situation as soon as possible, and then the result should be accounted for at that time.  Some events take longer to determine. For example, if you have not received a reimbursement/refund from Amazon and are fighting for some form of reimbursement (full or partial) then the decision on the unit is in limbo until completed, which could take a returned unit that is in your possession into a future tax year for reporting.

Questions? – I’ll be here in the comments or trolling people on Twitter.