What type of adjustment is the net sum of positive and negative adjustments
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Net sales is the sum of a company's gross sales minus its returns, allowances, and discounts. Net sales calculations are not always transparent externally. They can often be factored into the reporting of top line revenues reported on the income statement.
Understanding Net Sales
The income statement is the financial report that is primarily used when analyzing a company’s revenues, revenue growth, and operational expenses. The income statement is broken out into three parts which support analysis of direct costs, indirect costs, and capital costs. The direct costs portion of the income statement is where net sales can be found.
Companies may not provide a lot of external transparency in the area of net sales. Net sales may also not apply to every company and industry because of the distinct components of its calculation. Net sales is the result of gross revenue minus applicable sales returns, allowances, and discounts. Costs associated with net sales will affect a company’s gross profit and gross profit margin but net sales does not include cost of goods sold which is usually a primary driver of gross profit margins.
If a business has any returns, allowances, or discounts then adjustments are made to identify and report net sales. Companies may report gross sales, then net sales, and cost of sales in the direct costs portion of the income statement or they may just report net sales on the top line and then move on to costs of goods sold. Net sales do not account for cost of goods sold, general expenses, and administrative expenses which are analyzed with different effects on income statement margins.
Costs Affecting Net Sales
Gross sales are the total unadjusted sales of a company. For companies using accrual accounting, they are booked when a transaction takes place. For companies using cash accounting they are booked when cash is received. Some companies may not have any costs that will require a net sales calculation but many companies do. Sales returns, allowances, and discounts are the three main costs that can affect net sales. All three costs generally must be expensed after a company books revenue. As such, each of these types of costs will need to be accounted for across a company’s financial reporting in order to ensure proper performance analysis.
Sales returns are common in the retail business. These companies allow a buyer to return an item within a certain number of days for a full refund. This can create some complexity in financial statement reporting.
Companies that allow sales returns must provide a refund to their customer. A sales return is usually accounted for either as an increase to a sales returns and allowances contra-account to sales revenue or as a direct decrease in sales revenue. As such, it debits a sales returns and allowances account (or the sales revenue account directly) and credits an asset account, typically cash or accounts receivable. This transaction carries over to the income statement as a reduction in revenue.
In many cases the sales return can be resold. This requires a company to make additional notations to account for the item as inventory.
Allowances are less common than returns but may arise if a company negotiates to lower an already booked revenue. If a buyer complains that goods were damaged in transportation or the wrong goods were sent in an order, a seller may provide the buyer with a partial refund. In this case, the same types of notations would be required. A seller would need to debit a sales returns and allowances account and credit an asset account. This journal entry carries over to the income statement as a reduction in revenue.
Net sales allowances are usually different than write-offs which may also be referred to as allowances. A write-off is an expense debit that correspondingly lowers an asset inventory value. Companies adjust for write-offs or write-downs on inventory due to losses or damages. These write-offs occur before a sale is made rather than after.
Many companies working on an invoicing basis will offer their buyers discounts if they pay their bills early. One example of discount terms would be 1/10 net 30 where a customer gets a 1% discount if they pay within 10 days of a 30-day invoice. Sellers don’t account for a discount unless a customer pays early so notations must be retroactive.
Discounts are notated similarly to returns and allowances. A seller will debit a sales discounts contra-account to revenue and credit assets. The journal entry then lowers the gross revenue on the income statement by the amount of the discount.
Net Sales Considerations
If a company provides full disclosure of its gross sales vs. net sales it can be a point of interest for external analysis. If the difference between a company’s gross and net sales is higher than an industry average, the company may be offering higher discounts or realizing an excessive amount of returns compared to industry competitors.
Companies will typically strive to maintain or beat industry averages. Often returns can be quickly resold without creating issues. Allowances are typically the result of transporting problems which may prompt a company to review its shipping tactics or storage methods. Companies offering discounts may choose to lower or increase their discount terms to become more competitive within their industry.