diff --git a/erpnext/selling/doctype/sales_order/sales_order.py b/erpnext/selling/doctype/sales_order/sales_order.py
index 8b0ecbf..b2c6ccc 100644
--- a/erpnext/selling/doctype/sales_order/sales_order.py
+++ b/erpnext/selling/doctype/sales_order/sales_order.py
@@ -552,7 +552,7 @@
 	def update_item(source, target, source_parent):
 		target.amount = flt(source.amount) - flt(source.billed_amt)
 		target.base_amount = target.amount * flt(source_parent.conversion_rate)
-		target.qty = target.amount / flt(source.rate) if (source.rate and source.billed_amt) else source.qty
+		target.qty = target.amount / flt(source.rate) if (source.rate and source.billed_amt) else source.qty - source.returned_qty
 
 		item = frappe.db.get_value("Item", target.item_code, ["item_group", "selling_cost_center"], as_dict=1)
 		target.cost_center = frappe.db.get_value("Project", source_parent.project, "cost_center") \
diff --git a/erpnext/stock/doctype/delivery_note/delivery_note.py b/erpnext/stock/doctype/delivery_note/delivery_note.py
index ccc6da4..5a0d772 100644
--- a/erpnext/stock/doctype/delivery_note/delivery_note.py
+++ b/erpnext/stock/doctype/delivery_note/delivery_note.py
@@ -382,8 +382,24 @@
 
 	return invoiced_qty_map
 
+def get_returned_qty_map(sales_orders):
+	"""returns a map: {so_detail: returned_qty}"""
+	returned_qty_map = {}
+
+	for name, returned_qty in frappe.get_all('Sales Order Item', fields = ["name", "returned_qty"],
+		filters = {'parent': ('in', sales_orders), 'docstatus': 1}, as_list=1):
+		if not returned_qty_map.get(name):
+				returned_qty_map[name] = 0
+		returned_qty_map[name] += returned_qty
+
+	return returned_qty_map
+
 @frappe.whitelist()
 def make_sales_invoice(source_name, target_doc=None):
+	doc = frappe.get_doc('Delivery Note', source_name)
+	sales_orders = [d.against_sales_order for d in doc.items]
+	returned_qty_map = get_returned_qty_map(sales_orders)
+
 	invoiced_qty_map = get_invoiced_qty_map(source_name)
 
 	def set_missing_values(source, target):
@@ -403,7 +419,9 @@
 			target.update(get_fetch_values("Sales Invoice", 'company_address', target.company_address))	
 
 	def update_item(source_doc, target_doc, source_parent):
-		target_doc.qty = source_doc.qty - invoiced_qty_map.get(source_doc.name, 0)
+		target_doc.qty = (source_doc.qty -
+			invoiced_qty_map.get(source_doc.name, 0) - returned_qty_map.get(source_doc.so_detail, 0))
+
 		if source_doc.serial_no and source_parent.per_billed > 0:
 			target_doc.serial_no = get_delivery_note_serial_no(source_doc.item_code,
 				target_doc.qty, source_parent.name)
diff --git a/erpnext/stock/doctype/delivery_note/test_delivery_note.py b/erpnext/stock/doctype/delivery_note/test_delivery_note.py
index c3dbb8d..0771d79 100644
--- a/erpnext/stock/doctype/delivery_note/test_delivery_note.py
+++ b/erpnext/stock/doctype/delivery_note/test_delivery_note.py
@@ -564,6 +564,24 @@
 		self.assertEqual(dn.per_billed, 100)
 		self.assertEqual(dn.status, "Completed")
 
+	def test_make_sales_invoice_from_dn_for_returned_qty(self):
+		from erpnext.selling.doctype.sales_order.sales_order import make_delivery_note
+		from erpnext.stock.doctype.delivery_note.delivery_note import make_sales_invoice
+
+		so = make_sales_order(qty=2)
+		so.submit()
+
+		dn = make_delivery_note(so.name)
+		dn.submit()
+
+		dn1 = create_delivery_note(is_return=1, return_against=dn.name, qty=-1, do_not_submit=True)
+		dn1.items[0].against_sales_order = so.name
+		dn1.items[0].so_detail = so.items[0].name
+		dn1.submit()
+
+		si = make_sales_invoice(dn.name)
+		self.assertEquals(si.items[0].qty, 1)
+
 def create_delivery_note(**args):
 	dn = frappe.new_doc("Delivery Note")
 	args = frappe._dict(args)