To understand returns and allowances and how they are tracked on a daily basis, I will first explain the two terms. Next I will explain how the information is organized and the corresponding procedures to follow. Finally I finish with an extensive example of accounting entries and analysis. When you are finished reading you should understand what returns and allowances are; how to track them and how to analyze the information.
When a customer physically brings back the product this is called a return. You will never see returns in a pure service based business. There is no product to bring back.
The reasons for bringing product back can vary and often it is wise to use a coding system with each return to understand why a customer returns an item. In retail it is common to group returns into three major categories:
- Exchanges – swapping for the correct color, size or other characteristic. There is nothing wrong with the product, the customer simply selected the wrong one.
- Defective – the product’s quality is the underlying issue.
- Customer Mistake – the customer made the mistake of buying the product and is returning the product not for an exchange or due to a defective item; but simply because they want their money back. Don’t confused this with exchanges above. The most common error is purchasing too many of a particular item.
A really good bookkeeper can set up the accounting software to track these three reasons. The best tool is a control account with these three codes – 1) E – Exchanges, 2) D – Defective, and 3) M – Mistake.
Allowances are similar to returns except in this situation the customer actually keeps the product. The business is providing a credit for something the business did wrong or an adjustment for lower level service value. This tool is very common in the customized product and service industries.
A good example is a professional firm. Allowances are granted for contractual arrangements for using lower rate staff, tardiness in delivery or errors made by the professional partners. The best example I ever witnessed was a paint store. When they mixed the wrong color, an allowance was granted to the customer so they would keep the paint. Remember we’re talking about five gallon containers sold in batches of 10 containers. So verbal allowances were granted for incorrect hues. This store used both returns and allowances but took it a step further. The mixing technician (usually the sales representative) was coded to the return and allowances ticket in order to monitor performance.
In order to record this data accurately and for the data to create informative reports, the accounts must be organized well.
The organization of the returns and allowances section is done with the chart of accounts. Returns and allowances are revenue types of accounts and customarily end with debit balances in an otherwise credit section of the profit and loss statement. Remember anytime there are accounts with opposite balances than the traditional balance for that type they are reported with parenthesis in the respective financial report. The following is an example from the paint store for one month of revenue.
. Reedsville Paint and Supplies
. Income Statement
. For the Month Ending November 30, 2015
. Paint $97,202
. Supplies/Tools 19,484
. Contract Work 32,011
. Sub-Total Sales $148,697
. Returns and Allowances:
. Returns (1,702)
. Allowances (7,941)
. Sub-Total Returns and Allowances (9,643)
. Net Sales 139,054
Other Revenue 1,201
Total Revenue $140,255
Again, revenue accounts traditionally end in credit balances. Returns and allowances are debit ending balances in revenue and therefore have parenthesis around their values.
Allowances as reported in financial statements is different than how allowances are handled in a construction contract. To learn more read: Allowances in Construction. In construction allowances, as it relates to overall credits, is called ‘Contract Adjustments’ or ‘Contract Allowances’ and is reported in a similar fashion as illustrated above.
When setting up the respective accounts in the chart of accounts; establish the two accounts as revenue accounts after the existing sales accounts so the outcome is reported in a similiar format as above.
In a typical sales transaction there are actually two sets of entries. The first is the recording of the sale and the second entry is the recording of the associated cost. So let’s take a look at an entry for the paint store.
A painter (regular customer allowed to buy on account) comes in to purchase paint and supplies for a new home under construction. This painter is a subcontractor and the contractor’s customer has already selected her colors for the respective rooms, exterior and trim. The order is completed and here is the summary report:
Transaction ID: 201511131009
. Primer Paint $211.72
. Trim Paint 285.40
. Wall Paint 397.15
. Exterior High Grade 303.90
. Supplies 141.90
. Tools 76.00
. Total $1,416.07
The entry to the sales journal looks like this:
The second part of this entry relates to the removal of inventory (paint, supplies and tools) and transferred to cost of sales. This entry is also recorded to the sales journal.
Most retail accounting software combine the two entries as one complex entry.
Now comes the problem. About a week later the painter calls the sales rep and says one of the five gallon buckets of wall paint is obviously wrong and now he has to take time out to bring it back. The sales representative agrees to replace the five gallon bucket with the correct hue and offers a $30 credit on his next order of tools as gesture of goodwill for the inconvience of bringing the paint back. The painter accepts. What is the entry?
This scenerio is both a return (physical product due to defective color) and an allowance for the inconvience it generated for the customer. Notice though the store doesn’t provide a credit against an existing invoice, it is a store credit (a form of a liability) to purchase tools in the future. In this case tools have the best markup so the store minimizes the cost associated with this credit. So let’s look at the return element of the transaction first.
Step – I
Receive the physical item back into the inventory and reduce totals sales by the amount of the original sales price of the bucket. In this case a complex entry in the sales journal as follows:
Step – II
Issue the correct color of paint; again a complex entry.
Now for the allowance issue. This store also uses the sales journal for allowances since it is a function of sales.
Notice how elementary this entry is for the bookkeeper. A good operation includes these credits as side notes in monthly customer statements as a reminder to buy something next time they are in the store. Big chains like Home Depot put their credits on gift cards with the credit electronically loaded.
The value of using returns and allowances is the information it provides. Think about the paint store above; how important is this really? When you think about it, it makes sense. Here are the reasons:
Tracks the Store’s Error Rate
It is normal to mix the wrong color every now and then. So the store sets a tolarance level of 2% of paint sales. In this case, during November the returns were $1,700 on $97,000 of paint sales. The value is well within the tolerance. As long as the value is not rising then there is no need to conduct training and testing of the sales reps (technicians mixing the paint).
Tracks Customer Retention Cost
Allowances are sometimes referred to as retention costs. It is a fee you are willing to pay to keep the customer comming back. In this store’s case, the bulk of the allowances were assigned to the contract work. It is high because they accidentally sheetrocked the family cat into the wall (true story).
Tool to Monitor Salesman’s Performance
I have learned over time that some salesmen are so aggresiv they forego quality for quantity. By simply adding a sales rep ID code to each sales transaction a paint store can monitor their ability to sell. By forcing the sales rep code to returns, management can monitor performance with mixing paint correctly. A report can be printed sorted by sales represenative for total returns; summarized in value and sorted by the highest to the lowest to determine quality of work.
Summary – Tracking Returns and Allowances
Returns and allowances track customer satisfaction in retail and service industries. They are recorded as debit values in revenue type of accounts. This is displayed as parenthesis on the income statement in the revenue section. The sales journal is used to record the source entry for returns and allowances. Use the information to track quality of both product and performance of the sales representatives. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.