Sales Allowance

A sales allowance is a reduction in the selling price that a seller grants after a sale, usually because the goods delivered were slightly damaged, defective, late, of the wrong color or size, or otherwise not quite what the customer ordered. Instead of sending the goods back, the customer keeps them in return for paying less. The seller normally issues a credit memo to confirm the reduction.

In the accounts, a sales allowance reduces revenue. It is recorded in a contra-revenue account, usually combined with returns as sales returns and allowances, which is deducted from gross sales to arrive at net sales. It should not be confused with the allowance for doubtful accounts, which is an estimate of receivables that will not be collected, or with a trade discount agreed before the sale.

Both reduce revenue, but they differ in what happens to the goods. With a sales return, the customer sends the goods back and the seller usually puts them back into inventory or writes them off, reversing the related cost of goods sold. With a sales allowance, the goods stay with the customer, so inventory and cost of goods sold are unchanged; only the revenue and the amount receivable fall. Sellers often prefer allowances for low-value defects because they avoid the cost of shipping, inspecting and restocking returned items.

A furniture wholesaler sells 50 chairs to a café for $8,000 on credit, terms net 30. The chairs cost the wholesaler $5,000. Under a perpetual system it records:

• Debit accounts receivable $8,000; credit sales $8,000.
• Debit cost of goods sold $5,000; credit inventory $5,000.

The café finds that ten chairs have scratched legs but agrees to keep them for a 25 percent reduction on those chairs. The allowance is 10 chairs at $160 each times 25 percent, or $400. The wholesaler records a debit to sales returns and allowances of $400 and a credit to accounts receivable of $400, and sends a credit memo. No inventory entry is made. The café now owes $7,600, and net sales from the transaction are $7,600.

If the café had already paid in full, the credit would go to cash, if refunded, or to a customer credit balance to be used against future orders.

Recording allowances in a separate contra account, rather than simply reducing sales, preserves the gross sales figure and lets managers see how much revenue is being given up because of quality or delivery problems. A rising ratio of allowances to sales can reveal problems with a supplier, a production line, packaging or the shipping carrier. On the external income statement, companies usually show only net sales, but the detail remains in the general ledger for internal analysis.

Under ASC 606 and IFRS 15, expected price concessions are a form of variable consideration. If a seller has a regular practice of granting allowances, it should estimate them when revenue is first recognized and record revenue only at the amount it expects to be entitled to, using a refund liability or similar account for the expected reductions. Small businesses that rarely give allowances often simply record them when granted, which is acceptable when the amounts are immaterial. At period end, allowances granted after the balance sheet date for sales already recorded may need to be accrued so that revenue is not overstated, in line with the revenue recognition principle.

On the buyer's side, the same event is recorded as a purchase allowance, which reduces the cost of the goods bought, much like a purchase return. Because both sides record the event, the seller's credit memo also serves as evidence for the buyer's accounts payable records and for auditors checking the cut-off of revenue.