Sales Allowance

Updated on January 18, 2024
Article byKhalid Ahmed
Edited byShreeya Jain
Reviewed byDheeraj Vaidya, CFA, FRM

What Is A Sales Allowance?

A sales allowance refers to the price reduction in the actual selling price provided to a customer. It occurs when the product is defective or performs below par with its expectation. It serves to compensate the customer for the defective product. Sales allowances aim to strike a balance between meeting customer expectations and maintaining accurate financial records.

Sales Allowance

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It helps accurately record returned or defective products in financial statements. Moreover, it saves the business from legal disputes, ensures customer satisfaction, and facilitates customer loyalty. Businesses can implement this through financial statement adjustments, issuance of credit memos, and providing account credits or cash refunds.  Therefore, it is a form of sales adjustment that can help maintain customer satisfaction and avoid product returns.

Key Takeaways

  • A sales allowance is a decrease in the selling price given to the consumer as payment for the flawed goods when that product is defective or performs below expectations.
  • Therefore, sales allowances offer benefits such as fostering customer loyalty, increasing cash flows, and identifying defects.
  • Properly managing sales allowances contributes to accurate financial statements and fosters positive customer relationships.
  • One can record sales allowance by recognizing revenue decrease, computing allowance, entering journal entries, revising financial statements, and tracking patterns.

Sales Allowance Explained

A sales allowance is a concession a retailer offers to its customers as a reduction in the selling price of goods. A retailer gives the allowance in different forms like cash refund, issue of credit memo, direct credit to the customer, or even decreasing the price to the lowest level as accepted by the customer. Moreover, it helps one to address dissatisfaction concerning services or goods.

Thus, it acts as a critical tool to retain customer loyalty, protect brand reputation, keep away from litigations, and avoid negative word-of-mouth publicity. They get recorded under “Sales Returns and Allowances” as a contra-revenue entry. Moreover, it has the equivalent effect on sellers accounting as that of sales returns.

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How It Works?

A customer purchases a product from a seller in good condition. However, they encounter some problems after the purchase, or it becomes defective shortly. However, the seller gives them a specific allowance on the selling price of the faulty product. The buyer accepts the offer of the seller’s allowance and keeps the product with them.

Thus, the customer remains satisfied, does not complain publicly, promotes good behavior, and publicizes allowance to others. Further, the allowance helps the seller save on returning costs, a full refund, legal issues, or a dent in its brand reputation. But, it offers certain advantages and disadvantages to both the seller and buyer.

The allowance on sales gets calculated through the percentage of sales method, accounts receivable aging method, specific identification method, & management estimates. These techniques strive to offer a realistic approximation of the potential sales allowances and their effects on the financial statements.

How To Record?

It is important to note any reduction in a firm’s revenue in its financial statements. Therefore, recording sales allowance is essential due to its negative impact on revenue. It could be done in the following manner:

  1. One must ascertain and determine the real reason for offering sales allowance to customers. The reasons may range from broken goods, delivery delays, dissatisfied customers, and more for the return of the products.
  2. Then the business must calculate the discount to be given to the customer, which can be done by bargaining with the customer and reviewing the terms and conditions of the original sale invoice for the rebate limit.
  3. The firm must then use its sales allowance accounting system for creating sales allowance entries or sales allowance journal entries. Moreover, the journal entry must be of the nature of contra -revenue account debiting the sales allowance account and crediting the accounts receivables, which reflect the revenue decrease owing to the customer.
  4. After that, the financial statement must be updated to reflect the sales revenue journal entry. The process involves an adjustment of the revenue recorded in the income statement and updating the accounts receivables on the firm’s balance sheet.
  5. Businesses must track all the granted sales allowance to customers to find any alarming trend in their product’s quality or services. If the sales allowance becomes too large, it might reflect that a business has some serious underlying issues with its customer care service, operation, or manufacturing section. If any such thing comes to the fore, companies must take immediate preventive action to increase revenue and reduce sales allowance.

Examples

Let us use a few examples to understand the topic.

Example #1 

Suppose Solar Television Corporation of New York has a specific inventory of LED TVs with scratches on its screen. It tried to sell it, but no one bought it due to the scratch, so it offered a sales allowance in the form of a discount that would cover the price of repairing the screen on further damage or replacing the scratched screen with a new one. Such type of allowance would get covered under allowance for defects.

Example #2

Suppose, Elevato, a software development company in the US, offers custom software solutions to their clients. The firm recently completed a project for a client, and the agreed-upon price was $10,000. However, during the project’s implementation, there was a delay in delivering the final product due to unforeseen technical issues. As a result, the project was delivered two weeks later than initially promised.

Hence, to compensate the client for the inconvenience caused by the delay, the firm offered them a sales allowance as a discount on the project’s total cost.

Original service sale:

  • Custom software development project price: $10,000

Sales allowance:

  • Amount: $1,000 (to compensate for the delay)

In this case, the firm decided to provide a $1,000 sales allowance as a discount for the delayed delivery of the software.

New total price after sales allowance: Total price = Original price – Sales allowance Total price = $10,000 – $1,000 Total price = $9,000

With the $1,000 sales allowance applied, the client will now pay $9,000 instead of the original $10,000 for the custom software development service.

Offering a sales allowance in this situation demonstrates the firm’s commitment to client satisfaction and willingness to take responsibility for any delays or issues that arise during the project. It helps maintain a positive relationship with the client and can lead to potential repeat business or referrals in the future.

Pros & Cons

  • Pros: It leads to customer loyalty and retention as the customers like the reduced price or compensation. Moreover, this allowance results in higher cash flows as defective inventory does not require a full refund or delays, plus related costs decrease. They also help the seller to analyze the buying trend and identify products with recurring defects or issues.
  • Cons: Customers may perceive it as an unfair practice or duping by the seller. It requires a separate method of tracking and reporting in the accounting ledgers. Otherwise, its exact documentation and record may reflect something other than the revenue reduction in the financial statement.

Sales Allowance vs Sales Discount vs Sales Return

Although sales allowance, discount, and sales return have many things in common, they differ in their aim and situation of occurrence. Hence, let us discuss the difference between these using the table below:

Sales AllowanceSales DiscountSales Return
Such allowance happens when a customer experiences a problem or suffers from a defective product.It is a decrease in the price of a service or product provided to customers for paying the invoice immediately.Sales return happens when a customer gets a refund or credit for returning a product to the retailer.
This helps in addressing customer complaints without any litigation.Moreover, it gets calculated as a percentage of the total invoice value.Therefore, it may happen if the product received by the customer is already broken.
They reduce the selling price of the product.These act as a reward to encourage customers to pay the invoices timely and quickly.Hence, it may also occur if a customer’s expectations still need to be met.
Here, it utilizes the contra revenue account.It becomes helpful in decreasing the time taken to collect payments from customers.Additionally, it arises when an incorrect order reaches the customer.
Hence, it helps safeguard brand reputation and increases customer loyalty.Sales discount plays an essential role in improving a firm’s cash flow.It is a costly affair for the business to accommodate returns.

Frequently Asked Questions (FAQs)

1. How does sales allowance affect the income statement?

The degree of effect on the income statement by the sales allowances depends on a few factors:
– The way it gets recorded.
– If it gets reported separately, it directly decreases the recorded period’s revenue.
– If it gets recorded as a subtraction from the gross sales revenue, it will reduce the firm’s gross profit.
– It has a negative impact on the income statement.

2. Are sales allowances always monetary in nature?

While sales allowances are often monetary, they can also be non-monetary, such as offering additional services, extended warranties, or future discounts on purchases.

3. Are sales allowances legally required?

In most cases, sales allowances are not legally required, but in some situations, consumer protection laws may require businesses to offer refunds or exchanges for defective products. However, offering sales allowances voluntarily can demonstrate good customer service and foster customer trust.

This article has been a guide to what is Sales Allowance. We compare it with sales discount and sales return, explain its examples, and how to record it. You may also find some useful articles here –

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