Sales Returns & Allowances: Definition & Examples

Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

Sometimes a customer returns products he/she purchased to a company because they are defective. In this lesson, you will learn more about sales returns and allowances.

What Are Sales Returns and Allowances?

Let's meet Lizzie who owns Lizzie's Lamp Company. Lizzie opened her business a few months ago and is currently dealing with the first customer who returned an order. She's not quite sure how to account for this customer return and would like some help. Let's see if we can help Lizzie with this problem.

Have you ever returned an item to the store because it didn't work or it was the wrong color? This is known as a sales return and it occurs when a customer returns an item that is defective, is the wrong quantity, or for some other reason. When a customer returns merchandise, the seller has to record the return in its accounting records.

A sales allowance is a reduction in the amount that the customer owes the seller due to a problem with the order such as a defect or incorrect quantity. In this situation, the purchaser keeps the merchandise and does not ship it back to the seller.

Accounting for Sales Returns

Many businesses use a sales return and allowances account which is a deduction from sales revenue to record customer returns and allowances granted to customers. The other option is to deduct the return directly from the sales revenue account. The benefit of keeping a separate account is that it allows the business to track the amount of merchandise returned and identify if there is a trend in a particular product that requires further investigation.

Let's assume that Lizzie sells $5,000 of lamps in a month and customers return merchandise worth $750. Lizzie's net sales or sales revenue less sales returns and allowances will be $4,250 ($5,000 - $750). If Lizzie uses a separate returns and allowances account, then her income statement or the financial statement where she records her money she earns from selling her lamps less the cost of selling them will look like this:

Financial Statement Impact of Sales Returns & Allowances
sales returns and allowances income statement

Using the sales returns and allowances account will allow Lizzie to identify problems with a particular product and address them as soon as possible.

Using Sales Returns and Allowances Account for Customer Returns

When a customer returns merchandise, the seller must record the receipt of the goods and put them back into inventory if they are still saleable. Let's assume that Lizzie sold $2,000 of lamps to B. Bright on account (which means that B. Bright will pay for the lamps at some point in the future). The lamps cost Lizzie $1,300 to manufacture.

Let's examine the journal entries that Lizzie would record for the sale of merchandise.

sale entry

One week after receiving the lamps, B. Bright returned $200 of the original order (which cost Lizzie $130 to manufacture) as the lampshades were the wrong color. When B. Bright returns the order, Lizzie must record the reduction in the amount of revenue earned as well as the return of inventory. The journal entry for the return would be:

returns account

You will notice that this entry reduces the amount that B. Bright owes to Lizzie for the order and it increases the amount of inventory that Lizzie has as she can resell the lamps to another customer as they are not damaged.

Using Sales Revenue Account for Returns and Allowances

If Lizzie does not use a sales returns and allowances account, she will deduct the return of lamps from B.Bright from the sales revenue directly.

using revenue account

Notice that Lizzie records the return in the sales revenue account, which will make it difficult for her to determine how much of the sales revenue balance relates to actual sales and how much relates to sales returns. The second journal entry to return the item to inventory is the same whether or not Lizzie uses sales revenue or sales returns and allowances to record her returns.

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