E-commerce Returns Accrual: Best Practices to Estimate Liability and Protect Cash Flow

When to Implement a Returns Accrual System

For an early-stage e-commerce brand, top-line revenue can be a dangerously misleading metric. Seeing a strong sales number in Shopify at the end of the month feels great, but the critical question remains: How much of my top-line revenue is actually going to stick? Without a system to account for future returns, you risk overstating revenue, making flawed cash flow projections, and facing sudden crunches when refunds are processed. Implementing a returns accrual methodology is the key to creating financial statements that reflect reality, giving you, your team, and your investors a true picture of business performance.

For many startups in their earliest days, tracking returns as they happen is sufficient. This cash-basis approach, where you simply record the refund when the money leaves your account, is simple. But as you scale, this method begins to break down. The reason lies in a core accounting concept known as the matching principle, which requires that you recognize revenue and its associated costs in the same period. A sale made in March should have its potential return costs accounted for in March, even if the customer returns the item in April. This prevents a scenario where one month looks incredibly profitable, while the next takes a sudden, unexpected hit from the previous month's sales.

So when is it time to act? The practical trigger for accrual is consistently processing over $50,000 to $100,000 in monthly revenue from physical goods. At this volume, the financial impact of returns becomes material to your monthly reporting. Another indicator is when your historical return rate climbs above 2-3%. While this rate seems small, for e-commerce, average return rates can range from 15% to 30% (Shopify, "The State of Commerce: Returns and Refunds," 2023). A high return rate on significant revenue can create substantial discrepancies between reported sales and actual retained earnings. Furthermore, both US GAAP (ASC 606) and UK GAAP (FRS 102) require companies to estimate and reserve for future returns, making this a compliance necessity as you mature and prepare for audits.

How to Account for Product Returns with a Simple Historical Rate

Many founders hesitate to begin this process because their data feels messy. Information is often spread across Shopify, Stripe, and various spreadsheets, and the idea of a perfect calculation seems impossible. The reality for most Pre-Seed to Series B startups is more pragmatic: start with a simple, defensible estimate. Don't let the quest for perfection prevent you from making a material improvement to your financial reporting. A good estimate is far better than no estimate at all.

This "good enough" method of returns liability calculation focuses on creating a blended historical rate to apply to your current sales. It is an effective first step in moving from cash-based to accrual-based returns accounting. Here’s how to do it:

1. Extract Your Data: Pull your total gross sales and total refunds processed from your primary sales channel, such as Shopify. Select a representative period, such as the last three or six months. A three-month period is often sufficient to smooth out single-month anomalies, while a six-month period can better capture minor seasonal trends.
2. Calculate the Blended Rate: Divide the total dollar value of refunds by the total dollar value of gross sales for that period. This simple calculation gives you your historical return rate as a percentage. For example, if you had $300,000 in sales and $36,000 in refunds over three months, your rate is 12%.
3. Apply the Rate to the Current Month: Multiply the current month's gross sales by this historical rate. The result is your returns accrual amount for the month-end close process. This figure represents the value of sales made this month that you anticipate will be returned in the future.

Consider this simple example for a company calculating its rate based on its first-quarter performance:

• Q1 Gross Sales: $300,000
• Q1 Refunds Processed: $36,000
• Implied Return Rate: 12% ($36,000 ÷ $300,000)

If April sales were $120,000, your estimated returns accrual would be $14,400 ($120,000 * 12%). This approach provides a reasonable starting point and directly addresses the risk of overstating revenue with minimal effort. It is a foundational step in building more sophisticated financial controls.

Formalizing Your Accrual for Audits and Investors

As your business prepares for a Series A or B fundraise, or its first formal audit, the "good enough" method needs to evolve. Investors and auditors will expect a more robust and compliant process for how you account for product returns. This involves two key upgrades: moving from a blended rate to a cohort-based analysis and formalizing the journal entries in your accounting system, whether it's QuickBooks for US companies or Xero in the UK.

A cohort-based model provides a more accurate rate by tracking sales from a specific period (e.g., March sales) and observing how many returns from that exact cohort occur over your return window (e.g., 30 or 60 days). This method isolates variables and accounts for factors like seasonality, product launches, or marketing campaigns that might affect return behavior in a given month. For example, a holiday sales cohort in December may have a different return profile than a typical cohort in July.

More importantly, a formal accrual requires a two-part journal entry at month-end. This is a critical distinction because it correctly adjusts both the revenue side (on your income statement) and the inventory side (on your balance sheet) of the transaction.

Part 1: Accruing the Revenue and Liability Impact

The first entry reduces your recognizable revenue and establishes a liability for the refunds you expect to pay out. This acknowledges that a portion of your sales will be returned and should not be counted as permanent revenue for the period.

• Debit (Increase): Sales Returns & Allowances. This is a contra-revenue account, meaning it directly reduces your gross revenue on the income statement to arrive at net revenue.
• Credit (Increase): Refund Liability. This is a current liability account on your balance sheet, representing your obligation to refund customers for goods sold in the current period.

Part 2: Accruing the Inventory and COGS Impact

The second entry accounts for the value of the goods you expect to receive back as a physical asset. If you anticipate the returned products will be in sellable condition, their value should be moved from an expense back to an asset.

• Debit (Increase): Returned Inventory. This is a current asset account on your balance sheet, representing the value of goods expected to be returned to your inventory.
• Credit (Decrease): Cost of Goods Sold (COGS). This entry reduces the COGS expense on your income statement, as the cost associated with a returned sale is no longer applicable for that period.

This two-sided approach ensures your financial statements are aligned with US GAAP (ASC 606) and UK GAAP (FRS 102). You can also see IFRS 15 for comparable international guidance on revenue from contracts with customers. It demonstrates sophisticated financial controls and builds the investor trust needed to close your next round.

Isolating Hidden Costs to Protect Your Gross Margin

Even with a formal accrual process in place, many e-commerce companies find their gross margin reporting still feels off. This often happens when hidden costs and accounting nuances are overlooked in the accrual process. Failing to isolate these details can derail your forecasting, give you a false sense of your unit economics, and lead to poor capital allocation decisions.

Sales Tax, VAT, and the Net Revenue Base

A primary error is calculating the returns accrual on gross revenue instead of net revenue. For US companies using systems like QuickBooks, your accrual must be calculated on revenue that excludes sales tax. Sales tax is a liability you collect on behalf of a government entity; it was never your revenue to begin with. Including it in your returns accrual base will materially overstate the liability and understate your net revenue.

Similarly, for UK businesses using Xero, the accrual should be calculated on sales figures that exclude VAT. Mistaking gross receipts for true, net revenue is a common error that directly skews gross margin. The rule is simple: if the tax was never your money, it should not be part of your returns reserve calculation.

Non-Refundable Shipping and Payment Processing Fees

The second area to scrutinize is non-refundable costs. When a customer returns an item, you typically refund the full price of the product, but several associated costs are not recoverable. These must be accounted for to understand the true financial impact of returns.

• Original Shipping Fees: You paid a carrier to ship the product to the customer. While you may refund the customer for the product, you do not get that original shipping fee back from FedEx, UPS, or Royal Mail. This is a sunk cost of the initial sale.
• Payment Processing Fees: Payment gateways like Stripe or Shopify Payments typically do not refund their original processing fee (e.g., 2.9% + 30¢) when you process a refund. This fee becomes a hard cost of the return itself.

The Financial Impact of Reverse Logistics

Finally, the accrual must consider the operational costs of handling the return. This is often referred to as reverse logistics accounting. These costs include the labor to receive the package, inspect the item, determine if it can be resold, and place it back into inventory. If the product is damaged, there may be additional costs for refurbishment or disposal. Ignoring these elements means you are underestimating the true cost of returns and, consequently, overstating your gross margin. This inflated margin can lead to misinformed decisions on pricing, marketing spend, and inventory purchasing, ultimately putting your cash runway at risk.

Key Steps to Building a Reliable Returns Accrual Process

Building a reliable returns accrual methodology is an iterative process that scales with your company. It moves from a simple estimate designed for internal management to a sophisticated financial tool that enhances forecasting accuracy and satisfies investor diligence. By mastering how to account for product returns, you gain a more accurate and resilient financial picture, enabling you to manage cash flow effectively and build a more sustainable business.

To begin, here are the essential steps:

• Start Simple, But Start Now: If you are processing over $50,000 a month in revenue, implement a "good enough" accrual using a historical rate. It is far better than doing nothing and provides an immediate improvement to your financial accuracy.
• Separate Revenue from COGS: When you formalize the process, remember the two-part journal entry. Accrual accounting for returns affects both your income statement via revenue and COGS, and your balance sheet via liability and inventory accounts.
• Mind the Taxes: Ensure your calculations in QuickBooks or Xero are based on net sales, excluding US sales tax or UK VAT. This is a fundamental step for accurate gross margin reporting and unit economic analysis.
• Model the Full Cost: The true financial impact of returns includes non-refundable processing fees, original shipping, and reverse logistics. Factor these costs into your internal models to get a clear view of profitability.

For more advanced techniques on modelling these associated costs in detail, you can continue at the Returns & Reverse-Logistics Cost Modelling topic.

Frequently Asked Questions

Q: How does seasonality affect my returns accrual calculation?
A: Seasonality can significantly impact return rates. For example, items purchased as gifts during the holidays may have a higher return rate in January. A cohort-based analysis is the best way to manage this, as it isolates the return behavior of specific sales periods rather than relying on a blended annual rate.

Q: What is a good return rate for an e-commerce business?
A: While rates vary by industry, a general benchmark for e-commerce is 15% to 30%, according to Shopify data. Fashion and apparel often see rates at the higher end of this range, while categories like electronics or home goods may be lower. A rate below 10% is generally considered strong.

Q: How do you account for product returns that are damaged and cannot be resold?
A: When returned inventory is damaged, it cannot be added back to your "Returned Inventory" asset account at full value. Instead, you must write it off as a loss or record it at a lower salvage value. This involves crediting COGS for a smaller amount, or none at all, reflecting the loss of the asset's value.

Q: Can I use a spreadsheet for my initial returns liability calculation?
A: Yes, a spreadsheet is a perfectly acceptable tool for your initial "good enough" returns accrual. The key is to document your methodology and data sources (e.g., Shopify export for a specific date range). As you scale, you will want to integrate this process directly into your accounting software for better control and auditability.