To understand sales returns and the unique accounts that are used for them (Refund liability and Inventory estimated returns), let’s start by reviewing the journal entry for the sale of goods. It raises gross profit (in green) by taking this form:

A/R (or cash) $Retail

Sales revenue $Retail

COGS $Cost

Inventory $Cost

Now let’s look at actual returns of goods that were sold in the same period. They reduce gross profit (in purple) by taking this form:

Sales returns $Retail

A/R (or cash) $Retail

Inventory $Cost

COGS $Cost

The second entry is almost exactly the reverse of the first. This makes sense: we have the goods in-hand again, so we’re restoring the financial statements to what they were as if the original sale had not occurred. It is essentially a reversing entry.

Now let’s look at an entry for estimated returns. It reduces gross profit (in purple). Notice how it has a similar structure to the one prior:

Sales returns $Retail

Refund liability $Retail

Inventory estimated returns $Cost

COGS $Cost

Both the actual returns and estimated returns reduce gross profit exactly the same way: lowering revenue and raising COGS.

Notice the accounts in blue. The way these are used reminds me of how wash (or clearing) accounts are used. Wash accounts are used to hold money temporarily because the regular account associated with the money can’t be used yet for some reason. For Refund liability, the regular account that can’t be used yet is A/R or cash (depending on how the refund is given to the customer). For Inventory estimated returns, the regular account that can’t be used yet is Inventory. In both cases, we can’t use A/R (or cash) or Inventory because this is an estimate for returns we think we will get back in a future period, and since it’s an estimate we don’t have the goods in hand yet. But we still must reduce gross profit in the current period since we sold these goods in this period.

What happens when we receive goods from a customer, where the goods were purchased in the prior period? That’s where we use our Wash-type accounts of Refund liability and Inventory estimated returns. We put some money in those accounts with the prior entry because we couldn’t put it with A/R (or cash) or Inventory at that time. Now it’s time to do that. Notice the accounts in blue below. See how they are the reverse of the blue ones above? How we are moving the money from Refund liability to A/R to give back to the customer? How we have recorded the return of goods by lowering Inventory estimated returns and raising Inventory?

Refund liability $Retail

A/R (or cash) $Retail

Inventory $Cost

Inventory estimated returns $Cost

Notice too how gross profit is not reduced in this entry. It was reduced in the entry above for estimated returns (purple and blue).