What Is a Purchase Allowance and How Does It Work?
Learn about purchase allowances, a financial adjustment that reduces the cost of goods you've bought and kept, without requiring a return.
A purchase allowance is a reduction in the cost of goods or services a buyer has already acquired. This financial adjustment occurs after the initial transaction is completed and the items received. It allows sellers to compensate buyers for minor issues without requiring the return of purchased items, thereby adjusting the final cost.
Defining a Purchase Allowance
A purchase allowance is a price reduction granted by a seller to a buyer for goods or services previously acquired. This adjustment takes place after the sale is finalized and the buyer has received the merchandise. Unlike a return, where goods are sent back, the buyer retains possession of the items. Reasons for granting an allowance often include minor defects that do not justify a full return, slight damage during shipping, or discrepancies that reduce the value but still allow the buyer to use the goods. The allowance acknowledges a reduction in value while enabling the buyer to keep the product.
How Purchase Allowances are Granted
The process of obtaining a purchase allowance begins when the buyer identifies an issue with purchased goods or services after receipt. The buyer communicates the problem to the seller, initiating a discussion about a potential price reduction. This negotiation aims to resolve the issue without a full product return. Sellers may agree to an allowance to maintain customer satisfaction and avoid the logistical costs associated with returns. The allowance can be provided in several forms, such as a credit memo for future purchases, a direct refund of a portion of the purchase price, or a reduction on an outstanding invoice.
Accounting for Purchase Allowances
From the buyer’s perspective, a purchase allowance directly reduces the original cost of acquired inventory or services. Properly accounting for these allowances is important for accurate financial reporting. This adjustment impacts the buyer’s financial records by decreasing the overall cost associated with purchases.
When a purchase allowance is granted, the accounting entry involves a debit to Accounts Payable if the invoice is unpaid, or a debit to Cash if a refund is received. A credit is made to a contra-asset account, often named “Purchase Allowances,” which reduces the gross cost of purchases on the financial statements.
The balance in the Purchase Allowances account is subtracted from total purchases to arrive at net purchases. This reduction in net purchases lowers the Cost of Goods Sold (COGS) reported on the income statement. A lower COGS results in a higher reported net income for the period, reflecting the true economic cost of the goods retained by the business.
Purchase Allowances Versus Related Concepts
A purchase allowance differs significantly from a purchase return, although both involve a reduction in cost. With a purchase return, the buyer physically sends the goods back to the seller, resulting in a full credit or refund. In contrast, a purchase allowance means the buyer keeps the goods, receiving only a price reduction due to a specific issue or imperfection. Another distinct concept is a purchase discount, a reduction in price offered by the seller to encourage prompt payment of an invoice. Unlike an allowance, which addresses post-sale issues with the product or service, a purchase discount is a pre-agreed incentive related to payment timing, regardless of product quality.