Returns, Allowances and Discounts in Accounting

In the revenue section of every income statement (profit and loss statement) is an adjustment group to sales. This group reflects the value related to the actual sale of the product or services. This adjusting group is composed of three significant types of adjustments to sales. The first are returns, items returned to the store reflecting either broken or incorrect purchases made by the customer. The second adjustment to sales reflects allowances. Allowances are adjustments to normal sales reflecting defective items or courtesy adjustments for failure in delivering the product or service in a timely fashion. The final adjusting item are discounts. Discounts are usually composed of volume based or marketing campaign adjustments to sales.

The reason this adjusting section is so important to management is that it identifies possible process issues in your organization. It also indicates the success of certain marketing campaigns or the value significant customers have as it relates to total sales. The following sections describe each of the adjusting items and how management should interpret the information presented in this section of the income statement. The following illustrates what a normal detailed formatted income statement looks like and how each of the three adjusting line items are presented in the revenue section of the income statement.

XYZ Supply Company
Income Statement
For the Quarter Ending March 31, 2015

Total Sales $ZZZ,ZZZ
Adjustments:
Returns                                  $ZZ,ZZZ
Allowances                              Z,ZZZ
Discounts                                Z,ZZZ
Sub-Total Adjustments    (ZZ,ZZZ)
Net Sales ZZZ,ZZZ
Other Revenues ZZZ
Total Sales and Revenue $ZZZ,ZZZ

Other revenues include such items as penalties, surcharges, or charges related to auxiliary types of services or products. To learn more about the difference between revenue and sales, read the following: Revenue and Sales – What is the Difference?

Since the adjusting section relates to sales, it adjusts sales to reflect net sales. Now let’s learn about the respective adjustments in more detail.

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Returns

All of us have stood in line to return a product to our local department store. The reasons vary, but most often it is because we buy the wrong item. That is, it’s our mistake. But sometimes folks return items because the item is broken, i.e. it came that way. This line of information is critical for merchandisers, especially merchandisers with more expensive types of products. A good example would be a store that sells kitchen ware or small household appliances. Why is this so important?

Well, many of your larger merchandisers will break the returns down into two distinct groups. The first group reflects customer mistakes. As a merchandiser you would really only need to monitor the growth rate for this group. Depending on the nature of your business, it should settle into a certain value as a percentage of total (sometimes referred to as gross) sales. If this ratio begins to increase, it might be a sign that the sales staff is forcing the wrong product onto the customer. Some re-education of the sales reps is required if customer returns increase as it relates to the wrong kind of purchase. It might also indicate the wrong overall product line if appears to be a similar brand or line of products.

The other form of a return is merchandise that is broken or has a warranty issue. It is generally important to track this information as this form of return can be a clear sign of a quality issue with a particular brand or product line. If brand related, the merchant may want to consider discontinuing the brand or substituting the brand with a higher quality product. This may also be an indicator of overall delivery of value to your customer. Remember in business, there are three distinct purposes. The first is earning a profit, the second is employment security for staff and the third is providing the product or service to the consumer that the consumer desires. This merchandise based line of information in returns assists in evaluating the third purpose of business.

To ascertain this information, often returns are either coded with a letter indicator for each line of data or the entire dollar amount is coded to a sub-line of information reflecting either customer related or merchandise related issues as follows:

Total Sales                                           $ZZZ,ZZZ
Adjustments:
Returns:
    Customer Based      $Z,ZZZ
    Merchandise Based    Z,ZZZ
    Sub-Total Returns              $ZZ,ZZZ
Allowances                           Z,ZZZ
Discounts                              Z,ZZZ
Sub-Total Adjustments   (ZZ,ZZZ)

Are you beginning to notice the information feedback this section of the income statement generates? Well, there is more.

Allowances

Unlike returns, in allowances there is no physical return of the product. Typically allowances are seen in business operations whereby the customer is a recurring and regular business relationship. Rarely are allowances issued to the final consumer. In this system, the product is sold to business operations that modify the product or include the product in their package to the final consumer. A good example is an electrical supplier. Here, the bulk of their customers are electricians operating over a vast geographical area. These electricians purchase all the various parts (wire, outlets, switches, transformers, circuit breakers, panels etc.) from the electrical supplier. But in addition the electrical supplier has retail based outlets. The allowances line is generally oriented towards the businesses and not so much for returns but more for contractual arrangements. It is a tool used to mitigate poor performance or defective parts sold to the electricians.

There are different types of allowances. The most common type of allowance is due to defective parts or noncompliance in the contracted agreement. As it relates to defective parts, sometimes the supplier delivers the wrong size or the wrong color. The end-user whether a business or final customer calls for an allowance related to the defective element. If the defective item is absolutely unusable, then the customary process is to return the item. If a return, record this information in the returns section of the adjustments group. But if only partially unusable, say the wrong tint in the paint or the color scheme is slightly off; the end-user may request an allowance to even the deal and they keep the product. This is pretty much always granted as the cost to pick up the defective part and restock the shelf far exceeds the allowance that may be granted.

In the service industry, allowances are often issued for inexperienced providers of service. Lawyers may adjust a bill by providing an allowance in the form of dollars per hour off the regular rate charge for new associate charges or for entering into new areas of practice.

Another form of an allowance relates to bad debt. As a business owner you know of the term ‘Allowances for Bad Debt’. IT IS NOT RECORDED HERE. The goal of this section of the income statement is to report on the ability to make sales in a successful manner. Failure to collect the debt (receivables) is an issue related to cash management and this is unrelated to sales. Allowances for Bad Debt are typically recorded in the expenses section of the income statement.

Discounts

One of the more helpful and underutilized lines of information relate to discounts. Discounts are the financial value given to the customer based on several different categories. The following are just a few of the more common forms of discounts:

Volume – the most common form of discounts, volume discounts are traditional reduction in amounts owed due to customer purchases reaching certain minimum thresholds or contracted dollar amounts.You often see volume discounts in the supplier networks. As an example using the electrical supplier above, they may have a program where a discount is provided to the electrician if they purchase more than X feet of electrical wire.
Customer Retention – to prevent customers moving onto a new supplier or merchandiser, suppliers may desire to retain certain customers. A general discount is offered. Typical discounts can be 1 to 2% on the overall invoice value.
Geographical Expansion – when a company desires to expand their operation, they may offer discounts to customers in certain zones or at a new store.
Marketing/Advertising Campaign Related – have you ever eaten at the local fast food place with their BOGO? Buy One Get One free! Well this is a form of a discount. Other examples of campaign related include coupons, specific product based, and referrals.

Just as I explained up in the returns section, you may wish to break out your discounts based on different categories. Those related to volume and retention I would create a line item and call it customer based, and those related to expansion and marketing would have their own line item and I would refer to these as ‘Campaigns’ . This way you can see how much each costs you as the owner or manager in your operation.

I’ve been asked about early pay discounts. This is where the customer takes advantage of a discount to pay their invoice early. You see this type of offer in larger corporations where customers purchase thousands of dollars in regular intervals. Again, as in the allowances section above, early pay discounts is a function of capital and debt maintenance. Some companies will include this as ‘Other Expenses’ down after regular expenses. Some may include this in Other Revenues as an offset. Since this isn’t really a function of sales, but a function of cash management, I prefer to include this as ‘Other Expenses’ down towards the bottom of the income statement (profit and loss statement).

Presentation Format

The following is a highly detailed adjustment section to an income statement related to a supplier. This model is used as the baseline for the ‘Application of Adjustments in Management Analysis’ section below:

XYZ Supply Company
Income Statement
For the Quarter Ending March 31, 2015

Total Sales $ZZZ,ZZZ
Adjustments:
Returns:
    Customer Based $Z,ZZZ
    Merchandise Based   Z,ZZZ
    Sub-Total Returns $ZZ,ZZZ
Allowances Z,ZZZ
Discounts:
    Volume/Retention Z,ZZZ
Campaigns   Z,ZZZ
    Sub-Total Discounts   ZZ,ZZZ
Sub-Total Adjustments (ZZ,ZZZ)
Net Sales ZZZ,ZZZ
Other Revenues:
Delivery Fees ZZ,ZZZ
Contract Compliance ZZ,ZZZ
Penalties/Surcharges    Z,ZZZ
Sub-Total Other Revenues ZZ,ZZZ
Total Sales and Revenue   $ZZZ,ZZZ

You will rarely see this presentation format for retail types of stores or in service based operations. This presentation format is more common with suppliers especially those with retail outlets. It really comes down to cost effectiveness related to the value the information brings to the reader of the report. In operations that sell less than $1,000,000 per year, this type of presentation format is way too detailed. A more consolidated presentation format is warranted. Also, the software used to present as shown above has to be set up correctly and this costs money. A good presentation format for an operation selling less than $1,000,000 per year would look more like this:

Jim’s Pet Store
Income Statement
     For the Month Ending March 31, 2015
Total Sales                                                       $ZZ,ZZZ
            Returns & Discounts    (ZZZ)
            Net Sales $ZZ,ZZZ

For larger operations with sales in the $1,000,000 to $10,000,000 range, you may see something along this line of presentation format:

Marty’s Marine Products & Service
Income Statement (Sales Section Only)
     For the Month Ending March 31, 2015
Total Sales $Z,ZZZ,ZZZ
Adjustments:
Returns                                  $ZZ,ZZZ
Allowances Z,ZZZ
Discounts                                Z,ZZZ
Sub-Total Adjustments    (ZZ,ZZZ)
Net Sales Z,ZZZ,ZZZ
Services:
Repairs & Installs                 ZZZ,ZZZ
Maintenance/Storage    ZZ,ZZZ
Sub-Total Services   ZZZ,ZZZ
Total Sales and Services $Z,ZZZ,ZZZ

The key to the presentation format is that as the organization increases in the volume of sales, it needs to adjust this section of the financial report for a clearer understanding of what is happening in the business operation. I’m sure many of you are wondering how this extensive presentation format provides value. The following section explains this in more detail.

Application of Adjustments in Management Analysis

I consider this to be the fun part of having well-organized information. It really allows the interpreter to discover areas of opportunity. Remember, throughout my articles I advocate the feedback loop method of improving operations. This section helps to drive home this point.

To set this up, I’m going to insert some real numbers to help us out. I’m going to use the format as presented above in the supplier illustration. Except here, this is an example related to a paint supplier and retail store: ‘We Cover It’.

Benjamin owns a paint store in the local town. The area is growing and there is new construction happening in several developments. Benjamin’s business is named ‘We Cover It’ or WCI for short. Benjamin purchases his paint from a national supplier that provides him with generic cans and he places his own label on the can and buckets. WCI has accounts with general contractors, painters, the local government and the military base nearby. In addition, WCI has a retail front on the main road and in the back is the warehouse. His average monthly income statement related to the Sales and Revenue Section looks like this:

We Cover It
Income Statement (Sales & Revenue Section)
Period Ending March 31, 2015

		Paint		Tool/Supply		Total
Sales		193,487		18,412		211,899
Adjustments:
Returns	12,481		761		13,242
Allowances	6,322		–		6,322
Discounts	2,322		118		2,440
Sub-Total Adjustments		(21,125)		(879)		(22,004)
Net Sales		172,362		17,533		189,895
Revenues		1,018		–		1,018
Total Sales and Revenues		173,380		17,533		190,913

In this business, Benjamin knows the biggest issue relates to the wrong color. Often customers bring the paint back because it’s the wrong tint. As a gentleman his policy is to be gracious and refund the money. Notice in the returns section the amount of returns related to paint exceeds 6.4%. It averages between 6.3 and 6.7%.

In April, Benjamin hires a new paint mixer to mix paint for the customers. He wonders at month’s end, how is this guy performing for me? Well, this is where analysis comes in handy. The following are April’s results:

We Cover It
Income Statement (Sales & Revenue Section)
Period Ending April 30, 2015

		Paint		Tool/Supply		Total
Sales		255,711		24,090		279,801
Adjustments:
Returns	11,191		1,095		12,286
Allowances	5,422		100		5,522
Discounts	3,459		221		3,680
Sub-Total Adjustments		(20,072)		(1,416)		(21,488)
Net Sales		235,639		22,674		258,313
Revenues		1,212		–		1,212
Total Sales and Revenues		236,851		22,674		259,525

The total adjustments section hasn’t really gone down a whole lot. But total sales are up which is normal for springtime activity in the paint business. Benjamin looks at the returns for paint and notices that although they are down a little, as compared to total paint they have decreased to 4.38%. Wow, that is significant, because on an annual basis, a paint mixer will mix up to $750,000 worth of paint. The savings in returns equates to a little over 2%. 2% of $750,000 is $15,000. It appears that the new hire is instrumental in the savings. Benjamin decides to test his theory and has the store manager arrange for the new hire to spend more of his time mixing paint and the other mixers to perform other services in the interim to see if this is true.

The key to all this is evaluating the cause and effect for changes in the organization. The financial information presented, if presented appropriately, can indeed confirm or deny your thought processes. I would further elaborate that there is a high likelihood that indeed the new hire has generated these savings. Notice how the allowances which relate to defective color tints with the contractors have also decreased and as a percentage of paint, have gone from 3.27% to 2.12%. This is comparable to the average decrease as evaluated in the returns line of data.

Do you believe this could be more valuable if we divided the returns into customer based returns and merchandise based returns? Highly unlikely in this situation as it is rare for customers to return paint based on the quality of the product. Your average person can’t really equate the quality of paint; however, they sure can tell when the color is wrong! There really isn’t a need to breakdown the returns section into more details.

There is more we could do with this information to help out the owner. But for now, I wanted to illustrate a basic approach towards analysis as it relates to the ‘Adjustments’ section of the income statement. My goal is to illustrate to you that at some point, there is value to a more thorough and detailed presentation format.

Summary – Returns, Allowances and Discounts

A revenue section of the standard income statement (profit and loss statement) is typically divided into two main sections. The first is sales and the second is other revenues. The sales sub section has and adjustments area related to returns, allowances and discounts. Returns reflect both customer and merchandise (defective product) based. Allowances relate to business to business types of transactions are provided related to purely defective items or performance issues by the seller of the product. Allowances are rarely provided to the final consumer of the product. Discounts relate to either relationship issues with customers, typically long-term relationships or they are provided to brand new customers via coupons or territory expansion.

If properly recorded and enough volume of sales, the adjustments section of the income statement can provide proof that certain policies are effective or are detrimental to the organization. With proper analysis of this section, management can make better or well-informed decisions to improve operations. Act on Knowledge.

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