Financial Reports: How to Read the Income Statement for Sales Adjustments
Not all products sell for their list price. This will be accounted for on the income statement in the financial report. Companies frequently use discounts, returns, or allowances to reduce the prices of products or services.
Whenever a firm sells a product at a discount, it needs to keep track of those discounts, as well as its returns and allowances. It’s the only way the company can truly analyze how much money it’s making on the sale of its products and how accurately it’s pricing the products to sell in the marketplace.
If a company must offer too many discounts, it’s usually a sign of a weak or very competitive market. If a company has a lot of returns, it may be a sign of a quality-control problem or a sign that the product isn’t living up to customers’ expectations. The sales adjustments help a company track and analyze its sales and recognize any negative trends.
As a financial report reader, you don’t see the specifics about discounts in the income statement, but you may find some mention of significant discounting in the notes to the financial statements. Here are the most common types of adjustments companies make to their sales:
Volume discounts: To get more items in the marketplace, manufacturers offer major retailers volume discounts, which means these retailers agree to buy a large number of a manufacturer’s product so they can save a certain percentage of money off the price.
One of the reasons you get such good prices at discount sellers like Wal-Mart and Target is that they buy products from the manufacturer at greatly discounted prices. Because they purchase for thousands of stores, they can buy a large number of goods at one time. Volume discounts reduce the revenue of the company that gives them.
Returns: Returns are arrangements between the buyer and seller that allow the buyer to return goods for a number of reasons. Most people have returned goods that they didn’t like, that didn’t fit, or that possibly didn’t even work. Returns are subtracted from a company’s revenue.
Allowances: Gift cards and other accounts that a customer pays for up front without taking merchandise are types of allowances. Allowances are actually liabilities for a store because the customer hasn’t yet selected the merchandise and the sale isn’t complete. Revenues are collected up front, but at some point in the future, merchandise will be taken off the shelves and the company won’t receive additional cash.
Most companies don’t show you the details of their discounts, returns, and allowances, but they do track them and adjust their revenue accordingly. When you see a net sales or net revenue figure (the company’s sales minus any adjustments) at the top of an income statement, the company has already adjusted the figure for these items.
Internally, managers see the details of these adjustments in the sales area of the income statement so that they can track trends for discounts, returns, and allowances. Tracking such trends is an important aspect of the managerial process. If a manager notices that any of these line items show a dramatic increase, she needs to investigate the reason for the increase.
For example, an increase in discounts may mean that the company has to consistently offer its products for less money, which then may mean that the market is softening and fewer customers are buying fewer products. A dramatic increase in returns may mean that the products the business is selling have a defect that needs to be corrected.