A sales transaction is the most important type of transaction in any business because it provides the cash that pays for all business expenses and is the source of profits. "Sales" is the first item listed in an income statement, but its value must be reduced by sales returns and allowances. Improper recording or failure to reflect merchandise returned by customers in your income statement can lead to overstated profits or losses.
Sales returns and sales allowances are two distinct types of transactions, but are normally recorded under a single account title in a company's accounting records. Defective or damaged merchandise returned by customers is classified as sales returns. Sales allowances are given when the customer agrees not to return the merchandise in exchange for a price discount.
In accounting parlance, nominal accounts are transactions that report revenues, expenses, gains and losses. "Sales" is a nominal account because it represents business revenue. Nominal accounts are closed at the end of each accounting year to allow such accounts to start the next accounting year with zero balances.
In an income statement, "sales" is classified as a revenue account and is posted as a credit entry in a double-entry bookkeeping system. Sales returns and allowances are posted in the income statement as deductions from revenue and are recorded as debit entries in the company’s books. Along with sales discounts, the amount of sales returns and allowances is shown as a direct deduction from sales figures in the income statement to produce net sales.
Recording merchandise returned by customers in a separate contra-revenue account in the income statement allows management to monitor returns and allowances as a percentage of overall sales. A high or increasing percentage can reduce profits and undermine operational efficiency. Identifying which products contribute to sales returns and allowances and addressing the underlying problems can minimize deductions from sales.