Whatever your business, it's probable that some sales aren't final. The sales return and allowance accounts track refunds and discounts you give to dissatisfied customers. Returns and allowances on your income statement only indirectly affect your balance sheet.
You don't report an allowance or purchase return on the balance sheet. Instead, you record them in your ledger and then put returns and allowances on the income statement. As they reduce your earnings, this will affect the balance sheet indirectly.
Sales Returns and Allowances Formula
Unlike some number-crunching formulas in accounting, the sales returns and allowances formula is simple. On your income statement, you subtract returns and allowances from gross sales to get net sales. Sales returns are goods returned to the store for a refund; allowances are discounts on damaged items that the customer agrees to keep.
The first step is to record returns and allowances in your accounting ledgers. These can be two accounts or one combined account if the amounts are small. When you make out your income statement, you subtract the journal entries for the accounting period from your sales revenue.
For example, suppose you sell $150 worth of cell phone accessories to a customer. The customer returns the $9 charger a couple of days later because it doesn't work. You'd report $150 in sales and $9 in returns in your ledger and then subtract the $9 and any other returns from the gross sales on your income statement.
Sales returns and allowances are not liabilities, which go on the balance sheet, nor can you simply reduce the amount of sales revenue in your ledgers to reflect returns. Instead, you record returns and allowances in what's called a contra revenue account.
Contra accounts are identified as asset accounts or revenue accounts even though they run in the negative. They exist to provide you and anyone reviewing your finances with extra information, as $150 in gross sales with $9 in returns is more informative than if you merely recorded $141.
For example, suppose returns and allowances normally total 2% of your sales revenue. Last month, it spiked up to 5%. It's worth investigating why and seeing if the problem is solvable.
- Have there been changes to packaging or shipping that result in greater damage?
- Are your suppliers shipping substandard merchandise?
- When your employees ship internet purchases, are they making more errors than usual?
The answers can tell you whether you need better staff training, new suppliers, new packaging or something else,
Credit and Returns
Suppose you sell $57,000 worth of goods this month, and customers return $5,000. The exact entries in your ledger will vary with the details:
- If your customers paid cash, you reduce your cash account by $5,000 and enter $5,000 in the contra account.
- If customers bought on credit, you reduce accounts receivable rather than cash.
- If it was a mix of both, such as $4,000 on credit and $1,000 cash, you adjust both accounts as well as sales returns.
Unless you operate your business on a cash basis, credit and cash purchases both count as sales revenue at the time of purchase. You report the $5,000 sales returns and allowances on the income statement regardless of the basis of the purchase.
Income Statement to Balance Sheet
Your sales returns and allowances don't go on the balance sheet, but they do affect it. Say you're making out your financial statements for the current quarter. Your net income after returns, allowances, cost of goods sold and taxes is $39,000.
That $39,000 becomes part of the assets on your balance sheet as either cash or accounts receivable. It becomes part of the owners' equity as well as retained earnings. If your company issues $9,000 of the $39,000 as dividends, you reduce the assets and equity accordingly.