Sales Returns and Allowances

Sales returns and allowances is a contra account to sales revenue that records two kinds of reduction in a seller's revenue: sales returns, where customers send goods back for a refund or credit, and sales allowances, where customers keep faulty or unsuitable goods in exchange for a lower price. The account has a debit balance, the opposite of the sales account's normal balance, and is subtracted from gross sales to give net sales.

Keeping returns and allowances in a separate account, rather than reducing sales directly, lets managers see how much revenue is being lost to dissatisfied customers, product defects or shipping problems. Many businesses keep two separate accounts for returns and for allowances; the combined account is common in smaller businesses and in textbooks.

Each return or allowance is normally supported by a credit memo issued to the customer. The entries differ depending on whether the goods come back:

• For a return of goods sold on credit, the seller debits sales returns and allowances and credits accounts receivable, or cash if it gives a refund. Under a perpetual inventory system, it also debits inventory and credits cost of goods sold for the cost of goods that can be resold.
• For an allowance, only the first entry is made, because the customer keeps the goods and inventory is unchanged.
• Damaged returned goods that cannot be resold are recorded at their net realizable value, often zero, with the rest of the cost remaining in cost of goods sold or charged to a loss account.

An electronics distributor's gross sales for the year are $3,200,000. During the year customers return goods invoiced at $96,000, which had cost $64,000 and are all put back into stock, and the distributor grants allowances of $24,000 for cosmetic damage. Sales returns and allowances total $120,000. If customers also took $16,000 of sales discounts, net sales are $3,200,000 minus $120,000 minus $16,000, or $3,064,000.

The return rate is $120,000 divided by $3,200,000, or 3.75 percent of gross sales. If the industry norm is about 2 percent, managers would investigate which products, customers or warehouses account for the excess.

Under ASC 606 and IFRS 15, a right of return is a form of variable consideration. When a seller expects some goods to come back, it should not wait for the returns to happen. Instead, at the time of sale it recognizes revenue only for the goods it expects to keep sold, records a refund liability for the expected refunds, and records an asset for the right to recover the returned goods, measured at their former carrying amount less expected recovery costs. Estimates are updated at each reporting date.

Suppose a retailer sells $500,000 of goods costing $300,000 in December and expects, from experience, that 4 percent will be returned in January. It recognizes revenue of $480,000, a refund liability of $20,000, cost of goods sold of $288,000 and a returns asset of $12,000. This avoids overstating December's revenue and profit, in line with the revenue recognition rules.

On a multiple-step income statement, sales returns and allowances may be shown as a deduction from gross sales, but most published statements show only net sales. Analysts and auditors pay close attention to returns after a period end. A spike in returns early in a new year can indicate that sales were pushed through too aggressively before the year end, a practice known as channel stuffing. Retailers with generous return policies, such as online fashion sellers, may see return rates of 20 to 30 percent, so accurate estimation has a large effect on reported revenue. On the buyer's side, the same transactions are recorded as a purchase return or allowance.