Both sales returns and sales allowances reduce gross sales on your income statement to arrive at a net sales figure. Although different, they are commonly included in the same account under the title of "sales returns and allowances." Sales returns are recorded when customers return defective or unwanted products for full refund. Sales allowances are recorded when customers are induced to keep defective or unwanted products for a price reduction.
The sales returns and allowances account is called a contra revenue account because it works in the opposite direction of revenue accounts: Its balance reduces regular revenue accounts. Isolating sales returns and allowances helps management identify and control leakages in the revenue stream. Some costs associated with returns and allowances are simply not recoverable. Return shipping and restocking costs cannot be recovered. Damaged or defective goods could be markers of quality assurance issues. Therefore, contra revenue accounts do not merely signal a reduction in gross sales. They may indicate underlying problems with customer satisfaction, production or misappropriation of company assets.
The sales return and allowance account merits close scrutiny. You may be vulnerable to fake refunds and voids in the absence of adequate controls. A fake refund involves the creation of a phony return slip or credit memorandum that allows the perpetrator to pocket the cash. Fake voids require that the culprit keep a customer's receipt that can be used later to create a "void," which indicates the customer returned the merchandise. The sales return and allowances account can also be a tempting lure to fraudulently enhance revenue when revenue falls short of expectations. Case in point: the practice of channel stuffing, in which revenue is booked when merchandise ships to distributor warehouses that are already overflowing with merchandise. Sales and revenue appear healthy for financial reporting purposes, but the merchandise is subsequently returned a short while later.
Sales returns and sales allowances are different from temporary price reductions. While they all have the effect of reducing gross sales, temporary price reductions are treated differently. These are planned, temporary and usually intended for promotional purposes. Unlike sales returns and sales allowances, they are not reflected in accounting records. They are integral to the selling price agreed between the buyer and seller at the time of sale.
Regardless of the size of your business, it's sound practice to institute routine auditing of your sales returns and allowances account, including strong internal controls to guard against unwanted surprises. Sales allowances are not as vulnerable as sales returns to employees who might be inclined to fraudulent activity. However, excessive sales allowances might indicate quality problems with your merchandise. Excessive sales returns could indicate quality issues or misappropriation of assets. You may find it helpful to discuss loss prevention with experienced professionals for your industry. Your accountant can also be an excellent resource.