Discuss the application of the allowance method for sales returns
SALES RETURNS: AN APPLICATION OF THE ALLOWANCE METHOD
Accountants use the allowance method when, at the time of sale, they can estimate with reasonable reliability the effects of events that will affect future cash flows. Application of the allowance method reduces reported earnings in the period of sale to reflect expected net cash collections.
Sales returns affect net cash collections when a customer has the right to return a product for a refund, and the firm can reasonably estimate the amount of returns at the time of sale, U.S. GAAP and IFRS require that the firm use the allowance method to estimate and recognize the effects of returns.Specifically, the selling firm debits a revenue contra account for expected returns to reduce current period revenues to the estimated amount that will not be returned. By reducing current period revenues, the firm measures revenues based on the amount of cash it expects to collect from current period sales. Both U.S. GAAP and IFRS preclude revenue recognition when customers have the right to return goods unless the firm can reasonably estimate the amount of returns and it uses an allowance method to incorporate those estimates into income computations.
The Sales Returns account is a revenue contra account, accumulating subtractions from gross revenue. The debit to Sales Returns reduces Sales Revenue, Net, and therefore reduces income. The Allowance for Sales Returns account is also a contra account; like the Allowance for Uncollectibles, it accumulates subtractions from Accounts Receivable, Gross. The balance in the Allowance for Sales Returns is the firm's estimate of the receivables that it will cancel or the cash that it will pay to satisfy customers who return their merchandise.
Sellers also use the allowance method to account for product warranties, which promise the customer the right to repair or replacement if the purchased product is defective. The firm must be able to reasonably estimate expected warranty costs at the time of sale. If it cannot, it must delay revenue recognition until it can estimate the costs or learns their actual amount.
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