Your income statement might be the most relevant document to consider when gauging the health of your business, the efficacy of the sales strategies you're employing, and the state of your company's future. That's why it's vital to understand the items that come up on one, what they mean, and how to find and record them.
Sales returns and allowances account for one of the most important categories you'll find on an income statement. They're integral in tracking the quality of your product, consumers' satisfaction with your business, and the profitability of your sales efforts.
Here, you'll get a picture of what those terms mean, what those figures are used for, and how to record them on your income statement.
What are sales returns and allowances?
A sales return occurs when a buyer sends a product back to a seller for a partial or full refund. An allowance is a retroactive discount a customer receives when they contact a company about a minor but noticeable defect with its product. Both are subtracted from a company's gross sales to calculate net sales.
Understanding your sales returns and allowances and how to find them rests on your understanding of a couple of terms. The first term is debit, meaning an addition to an expense or asset account or a decrease to a liability or equity account. In the context of returns and allowances, it means expanding your returns and allowances account.
The opposite of debiting is crediting, which entails increasing a liability or equity account or decreasing an asset or expense account. In this context, it means increasing your cash or accounts receivable figures — depending on whether the buyer in question paid with cash or credit.
With those terms in mind here's a picture of how to record sales returns and allowances.
How to Record Sales Returns and Allowances
Recording Sales Returns
Recording a sales return means reversing both the revenue recorded at the beginning of a sale and the associated cost of costs of goods sold.
To reverse the return's related revenue, you have to debit your sales returns and allowances account by the amount of revenue generated by the original sale. Then, you have to credit your accounts receivable or cash account by the same figure.
For instance, let's say there's a company that manufactures automatic electric hard-boiled egg-making machines. A buyer saw the product and thought it looked like a UFO — which seemed like the coolest thing ever at the time.
They bought one on the spot for $250 with their credit card, but they were so caught up in the hysteria brought on by the product's next-level spaceship design that they forgot they were allergic to eggs. Upon receiving the machine and realizing how outrageously impractical their impulse buy was, they sent it back.
Once the company received the return and verified that the buyer sent it back within a timeframe that was in keeping with its return policy. It would send the consumer their money back. Then, the company's accountant would debit its return and allowances account $250 and credit $250 to its accounts receivable.
Recording Sales Allowances
Accounting for a sales allowance is fundamentally similar to accounting for a sales return.
Should a customer be offered allowance by a company — whether it's a discount for paying an invoice early, a partial refund for keeping a defective product, or any other sort of minor return — the refund they receive is debited to that company's returns and allowances account. Then, the allowance the customer receives is credited to the company's accounts receivable.
For instance, if a buyer were to purchase the aforementioned hard-boiled egg machine and notice only five out of its six egg-cooking modules are operational, they might ask for an allowance.
The company, in the interest of its commitment to customer service, offers a $20 partial refund. The buyer accepts. The company sends them the money, and its accountant debits $20 to its sales and allowances while crediting $20 to its accounts receivable.
In some cases, companies might not include sales returns and allowances as a separate account. Instead, they record sales returns and allowances by directly debiting their sales accounts before crediting their accounts receivable or cash account.
It's critical to understand sales returns and allowances when determining how your business is doing and where it might be going. If your returns and allowances are disproportionately high relative to your sales, there could be flaws in your product or the public's perception of your company.
Always keep tabs on these items. If you need to know if it's time to shake up your sales process or pay more attention to product quality, sales returns and allowances can provide excellent reference points to help dictate where you need to go.