When a business purchases and takes delivery of goods from a supplier and finds that some of them have faults or are not as ordered, it might agree with the supplier to retain the goods and receive a purchase allowance.
The purchases allowance account is a contra expense account meaning that it is normally a credit balance. When offset against the purchases account the purchase allowance reduces the cost of net purchases to the business.
Purchase Allowance Example
A business purchases goods from a supplier which are subsequently found to be faulty. The business agrees to retain the goods and receives a credit note from the supplier for 1,500 to compensate for the problems.
Assuming a periodic inventory system the allowance journal entry is recorded in the accounts as follows.
Journal Entry for a Purchase Allowance
The accounting records will show the following bookkeeping entries for the purchase allowance:
Purchase Allowance Bookkeeping Entries Explained
The amount owed to the supplier would already have been posted as a credit entry in the accounts payable account. The debit to accounts payable shown above reduces the amount owed to the supplier.
The credit note is given by the supplier for the faulty goods and posted to the purchases allowance contra expense account; this reduces the net purchases of the business.
The Accounting Equation
The Accounting Equation, Assets = Liabilities + Owners Equity means that the total assets of the business are always equal to the total liabilities plus equity of the business. This is true at any time and applies to each transaction. For this transaction the Accounting equation is shown in the following table.
In this case a liability (accounts payable) decreases as the amount owed to the supplier is reduced by the purchases allowance credit note, this reduction is balanced by the increase in owners equity. The credit to the income statement for the purchases allowance increases the net income which increases the retained earnings and therefore the owners equity in the business.
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About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years in all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.