Many entities allow customers to return goods for any reason within a specified timeframe. Returns can be made in exchange for a full or partial refund, a store credit, another product, or some combination of the above. Sales with a right of return create accounting issues because the amount of consideration to which the entity will ultimately be entitled is uncertain.
Many entities also allow customers a trial period or the ability to accept or reject delivered goods on the basis of subjective or objective criteria. These return provisions are referred to as customer acceptance rights. Although customer acceptance rights appear similar to a right of return, these two notions are treated differently in ASC 606. Rights of return affect the total transaction price to be allocated among the performance obligations in step three, while customer acceptance rights change the determination of when control actually transfers to the customer in step five.
Rights of Return
ASC 606 requires that rights of return be treated as variable consideration. Upon transfer of control, an entity that has entered into a contract with a right of return should recognize (1) revenue in the amount of consideration the entity expects to receive after returns are made, (2) a refund liability for the amount the entity expects to return to the customer, and (3) an asset for the goods the entity expects to receive from the customer.
Revenue should not be recorded for the portion of the sale the entity expects to be returned. Instead, this portion should be credited as a refund liability because the entity expects to pay that amount back to the customer. A refund asset should be recognized to reflect the actual value of the goods expected to be returned after considering any expected reduction in the value of the returned goods. Inventory costs that exceed this expected return value of the inventory should be expensed as cost of goods sold.
With this method, revenue recognized at the point of the original sale does not include amounts to which the entity does not expect to be entitled, and the refund asset is not overvalued. Upon lapse of the time period in which returns are allowed, the remaining refund liability and asset should be derecognized by an offsetting entry to revenue and cost of goods sold.
Entities must follow all of the guidance for variable consideration when accounting for rights of return, including applying the constraint. This does not necessarily mean that a company must follow a two-step process of estimating returns and then applying the constraint. As explained by the FASB, a separate consideration of the constraint is not necessary "if the entity’s calculation of the estimated revenue incorporates the entity’s expectations of returns at a level at which it is probable that the cumulative amount of revenue recognized would not result in a significant revenue reversal" (ASU 2014-09 BC215) (see Variable Consideration and the Constraint).
Presentation of Refund Liabilities and Refund Assets
While some may consider it reasonable to present refund liabilities and refund assets on a net basis, the standard explicitly states that these items should be presented separately. Although not explicitly stated in the standard, some accounting firms have argued that refund assets should also be presented separately from inventory (EY, Section 5.4; KPMG, Section 5.4.20).
Customer Acceptance Rights
Customer acceptance is one of the criteria for determining transfer of control in the revenue recognition process. If this criterion is not met, revenue recognition should be deferred. In contracts with specific customer acceptance provisions, this criterion needs careful analysis.
Subjective Criteria for Customer Acceptance
Some customer acceptance rights are based on subjective criteria. For example, some customer arrangements allow for a trial period in which the customer can determine whether they want to keep the product based on their own subjective criteria. When the customer is not committed to pay any consideration until the trial period lapses, revenue should be deferred until the customer has signaled acceptance or the time limit for the customer to reject the product has lapsed (see ASC 606-10-55-88).
Objective Criteria for Customer Acceptance
Customer acceptance rights may instead be based on objective criteria, such as size, weight, or specific performance metrics. If an entity can demonstrate that a delivered product meets the objective specifications in the contract, then control has effectively passed to the customer and the entity should recognize revenue. In some instances, determining that objective customer acceptance rights have been met is a formality because the entity has sufficient experience with similar products being accepted according to the objective criteria in the contract. However, even without such history, an entity may still be able to objectively determine that control of a good or service has transferred to the customer in accordance with the specifications in the contract (see ASC 606-10-55-86).
Under ASC 606, rights of return are treated as variable consideration, so revenue should only be recognized for those goods not expected to be returned. A refund liability, presented separately from the associated refund asset, should be recognized for those goods expected to be returned. At the end of each reporting period, the refund liability should be updated to the amount for which it expects to be entitled in exchange for the goods. Corresponding changes should be made to the transaction price and the amount of revenue recognized in the transaction.
If all other revenue recognition criteria have been met for a contract with customer acceptance rights, an entity should recognize revenue when the customer signals acceptance of the goods or services, the acceptance period lapses, or the entity can objectively determine that the contract specifications have been met. Only in these circumstances can the entity conclude that control has transferred to the customer.
- ASC 606-10-25-30, 55-22 to 55-29, 55-85 to 55-88
- ASU 2014-09: “Revenue from Contracts with Customers.” BC363-BC367.
- Deloitte, “A Roadmap to Applying the New Revenue Recognition Standard.” July 2019. Section 188.8.131.52, Section 8.6.5.
- EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” January 2020. Section 5.4, Section 7.2.1.
- KPMG, Handbook: “Revenue Recognition.” December 2019. Section 5.4, Section 7.5.40.
- PWC, “Revenue from Contracts with Customers.” August 2019. Section, 6.5.5, Section 8.2.