Accounting for refunds: the essential guide

When you’re in business, you’ll almost certainly encounter refunds - whether that’s money you have to give back to customers, money suppliers give back to you, or even money back from the taxman (HMRC).

If you’re not sure how to include these in your accounts, our chief accountant, Emily Coltman FCA will help you in this handy guide.

Refunds to customers

How you treat these will depend on what you’ve sold to the customer originally; goods or services.

Refunds for sales of goods

Suppose you sent some goods to a customer who then decides they no longer wish to keep the goods, or perhaps the goods were damaged in transit.

If the customer sends the goods back to you, remember that you’ll need to increase your “stock in hand” records at that point.

Let’s say you sell red T-shirts and you sent 10 to a customer, leaving you with 50 in hand. Your customer then sends you back 1 of them after the package was ripped in transit and the T-shirt was stained. You need to remember to amend your stock count to show 51 T-shirts in hand.

Next, you need to think about how much the returned item is worth. You will need to record it in your stock list as worth the lower of cost (how much you originally bought it for) and net realisable value (how much you can sell it on for).

If the item is so badly damaged you’ll have to scrap it, then remove it from your stock count again and treat it as having a value of £0.

In the case of the stained red T-shirt, you may be able to wash it and re-sell it for a lower price. In that case, assuming that price is still higher than what you originally bought it for, you can record the returned T-shirt as being worth its original cost.

Refunds for sales of services

For a service, there’s nothing physical to give back to your customer, so all you need to think about is…

Creating a credit note

If you are refunding money to a customer, you will almost certainly need to create a credit note, unless the customer has overpaid you and you are simply giving them back that overpayment without re-stating the original invoice.

Make sure the credit note complies with HMRC’s requirements if your business is registered for VAT.

Timing of the refund

In your accounts

If you are using the accruals basis to draw up your accounts, include the refund (which will reduce the value of your business’s sales) at the point when you were due to repay the money to the customer. This is the date at which you should date your credit note.

If you are preparing your accounts on the cash basis, include the refund at the point where you physically refunded the money to your customer.

For VAT purposes

The VAT on the credit note will reduce the amount of VAT you are paying to HMRC.

If you are accounting for VAT on the invoice basis, the credit note will be included on your VAT return on the date of the invoice.

If you are cash accounting for VAT, the refund would go on your VAT return when you physically pay the customer back.

And finally…

It’s worth keeping track of customers who persistently ask you for refunds. Do you want to keep doing business with customers who ask you for refunds again and again? Maybe that is their way of trying to negotiate a discount!

Refunds from suppliers

Conversely, you may need to ask a supplier to refund you for faulty goods, or services that did not come up to the advertised standard.

Refunds for goods

If you are sending goods back to a supplier, remember to reduce the count of stock you have on hand.

Let’s say you build computers and have ordered in some chips from a supplier. You order a batch of 100 chips. However, 10 of those chips turn out to be faulty, so you send them back. Make sure that your stock records show that you only have 90 chips available, otherwise you could find yourself accepting a project only to find you do not have enough chips for it.

Make sure that you also include only the price of 90 chips as an asset, or a cost, in your accounts, depending on whether you account for your stock purchases using the perpetual or periodic inventory method. You may record this as a purchase of 100 and a refund of 10, or an overall purchase of 90, depending on how quickly you sent back the 10 faulty chips, but be sure that your post-refund stock value is for 90 chips, not 100. 

Refunds for services

There is nothing physical to send back here, so use the value of the refund to reduce the value of the cost on your profit and loss account.

Let’s say your solicitor sends you a bill for £1,000 + VAT but part of their advice proves to be incorrect and they agree to refund you £250 + VAT. Assuming your business is registered for VAT and not using the VAT flat rate scheme, your legal and professional fees cost account would show a bill for £1,000 and a later refund of £250, resulting in an overall cost of £750.

Timing of the refund

In your accounts

If you are using the accruals basis to draw up your accounts, include the refund when any goods go back to the supplier, or otherwise when you are due to receive the refund. For instance, if the refund is due in March but you receive it in April, include it in your accounts in March. This may require you to enter a bill credit note dated in March.

If you are using the cash basis of accounting, include the refund as a reduction of your cost at the date you physically received the cash.

For VAT purposes

Assuming you are not using the VAT flat rate scheme, the VAT on a refund to a supplier will reduce the amount of VAT you can reclaim from HMRC, increasing your VAT bill.

If you are invoice accounting for VAT, include the value of the refund on your VAT return for the period during which the bill credit note falls.

If you are cash accounting for VAT, include the value of the refund on your VAT return for the period during which you were repaid.

For example, if: 

• you are preparing your VAT returns to end on 31st March, 30th June, 30th September and 31st December each year, and
• you are invoice accounting for VAT, and 
• you receive a bill credit note dated 1st May 

the value of that bill credit note, and any VAT on it, would be included on your VAT return that ends on 30th June.

Refunds from HMRC

If you’re due a refund of tax (apart from a sole trader’s income tax, since this doesn’t form part of your business’s accounts), make sure you post journal entries to show the refund is expected.

For instance, if you’re running a limited company and your corporation tax bill was originally £5,000, but HMRC investigated your CT600 and found that actually the company only owed £4,900, remember to post journal entries to debit the corporation tax liability and credit the corporation tax cost in the profit and loss account. This will show that you expect to receive some money back, and that the cost you originally included has reduced.

If you paid your corporation tax bill early and HMRC pay you some interest on that, speak to your accountant for how best to treat that. They may suggest that you use that interest to reduce the cost of corporation tax on your profit and loss account or they may have an alternative idea.

If you are looking for software to help you prepare and send credit notes to your customers, record bill credit notes from your suppliers, and include the accounting and tax effects at the right time, why not give FreeAgent a try?