Although returns and refunds are disadvantageous for businesses, returns are bound to occur in businesses that sell products. The Reverse Logistics Executive Council conducted a survey involving the reasons for product returns. The 65 consumer electronics companies that completed the survey indicated the primary reasons businesses accept product returns are product defects, advertisement purposes, shipping errors and to balance inventory stock. When a business issues a refund for a product, it must account for this refund on its financial statements.
Sales Returns and Allowances
"Sales returns and allowances" is an account on the income statement that is referred to as a contra revenue account -- that is, it moves in the opposite direction as revenue. Businesses use this account when customers return merchandise due to a defective product or any other reason. This account reduces the company's net sales.
Accounts receivable is an account on the balance sheet. This account reflects the amount of sales the business has made on credit, as opposed to cash sales.
Credit Sales Refunds
If a customer purchased a product on credit and returns that product for a refund, the business would have to make specific adjustments to its financial statements. The company would first make a debit entry to sales returns and allowances that equals the exact amount of the purchase. It would credit accounts receivable by the same amount. By debiting sales returns and allowances, the company indicates on its income statement that its revenue is reduced by the amount of the refund. By crediting accounts receivable, the company indicates on its balance sheet that its money inflow from credit sales is reduced by the amount of the purchase.
Cash Sales Refunds
If the customer purchased a product in cash and returns it for a refund, the company would make a debit entry to sales returns and allowances that equals the exact amount of the purchase. The difference with a cash refund is that instead of making a credit entry to accounts receivable, the company would credit cash by the amount of the purchase. By crediting cash, the company indicates on its balance sheet that its cash is reduced by the amount of the purchase.