Bookkeeping – Tracking Returns and Allowances (Lesson 39)

Not every customer is satisfied with the product they purchase. The old saying of ‘You can’t please everyone all the time’ is true. This is reality; business management must accept this basic principle. What is important is the trend involved with returns. If they continue to increase from one period to the next, something is amiss. It is management’s job to figure it out; it is your job as the bookkeeper to track this information.

To understand returns and allowances and how they are tracked on a daily basis, the student must understand the meaning of the two terms. Next, it is explained 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.

Returns and Allowances – Returns

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. 

Returns and Allowances – Allowances

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. 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.

Returns and Allowances – Organization

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.

Side Note
Allowances as reported in financial statements is different from how allowances are handled in a construction contract. To learn more read: Allowances in Construction. With 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 similar format as above.

Returns and Allowances – Bookkeeping Entries

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. 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:

Date           ID            Ledger                    Description                                  DR               CR
11/13/15  1009          Sales – Paint           Project #150607-Wayne                               1,198.17
                1009          Sales – Supplies     Project #150607-Wayne                                  217.90
                 Rosario    Accts/Rcvble          20151131009                            1,416.07                     
                                                                                                                  $1,416.07    $1,416.07

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.

Date            ID             Ledger                   Description                                DR              CR
11/13/15    1009         COGS/Paint            73 Gallons                              404.13
                  1009         COGS/Supplies       Plastic, tape, step ladder          89.10
                  1009          Inventory-Paint      73 Gallons – Base Paint                               404.13
                  1009          Inventory -Sup       Plastic, tape, step ladder                                89.10
                                                                                                                  $493.23        $493.23

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 inconvenience of bringing the paint back. The painter accepts. What is the entry?

This scenario is both a return (physical product due to defective color) and an allowance for the inconvenience 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. 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:

Date           ID            Ledger               Description                                                DR                      CR
11/20/15     0309       Returns              5 Gal’s Project #15067-Wayne                 63.70
                   Rosario   A/R                    5 Gal’s Project #150607-Wayne (color)                              63.70
                   0309       COGS/Paint       5 Gal’s #9181                                                                       22.91
                   0309       Inventory-Paint  5 Gal’s Satin White #9181                        22.91                          
                                                                                                                             $86.61                  $86.61

Step – II
Issue the correct color of paint; again a complex entry.

Date          ID         Ledger              Description                                               DR                     CR
11/20/15 0310        Sales-Paint       5 Gal’s Project #150607-Wayne                                       63.70
                Rosario  A/R                   5 Gal’s Project $150607-Wayne              63.70
                0310      COGS/Paint      5 Gal’s #9342                                           22.91
                0310       Inventor-Paint  5 Gal’s #9342                                                                    22.91
                                                                                                                       $86.61              $86.61

Now for the allowance issue. This store also uses the sales journal for allowances since it is a function of sales.

Date           ID              Ledger                 Description                                               DR                      CR
11/20/15    0311          Allowances         Store Credit for Wrong Color                   30.00
                   Rosario    Store Credits       Tool Allowance #0311/0310/0309                                      30.00

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.

Returns and Allowances – Analysis

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. The store sets a tolerance 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 coming back. In this store’s case, the bulk of the allowances were assigned to the contract work. 

Tool to Monitor Salesman’s Performance

I have learned over time that some salesmen are so aggressive 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 representative 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.

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