Gross sales are the grand total of all sale transactions reported in a period, without any deductions included within the figure. Net sales are defined as gross sales minus the following three deductions:
- Sales allowances. A reduction in the price paid by a customer, due to minor product defects. The seller grants a sales allowance after the buyer has purchased the items in question.
- Sales discounts. An early payment discount, such as paying 2% less if the buyer pays within 10 days of the invoice date. The seller does not know which customers will take the discount at the time of sale, so the discount is typically applied upon the receipt of cash from customers.
- Sales returns. A refund granted to customers if they return goods to the company (typically under a return merchandise authorization).
In total, these deductions are the difference between gross sales and net sales. If a company does not record sales allowances, sales discounts, or sales returns, there is no difference between gross sales and net sales.
All three of the deductions are considered contra accounts, which means that they have a natural debit balance (as opposed to the natural credit balance for the sales account); they are designed to offset the sales account.
A company may elect to present its gross sales, deductions, and net sales information on separate lines within its income statement. However, doing so takes up a considerable amount of space, so it is much more common to see a net sales presentation, where the gross sales and deduction amounts are aggregated into a single net sales line item.
Gross sales can be a misleading figure when reported as a single line item, separate from the remainder of the income statement, since it may considerably overstate the amount of sales, and readers will have no way of knowing the amount of the various sales deductions. Thus, if sales are to be reported separately from the income statement, the amount should be reported as net sales.
The difference between gross sales and net sales can be of interest to an analyst, especially when tracked on a trend line. If the difference between the two figures is gradually increasing over time, it can indicate quality problems with products that are generating unusually large sales returns and allowances.