It is a common practice in many industries for vendors to 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 there is uncertainty as to the amount of consideration to which the entity will ultimately be entitled. The accounting for these kinds of returns may have similar results to the treatments under the old standard, but the approach to determining amounts recognized will be different.
In some industries, it is also a common practice to offer returns that are specific to a contract or a customer. For example, some industries allow their customers a trial period, or they may allow their customers to accept or reject delivered goods on the basis of either subjective or objective factors. These kinds of return provisions were frequently referred to as “customer-specific rights of return,” under the old standard, and are classified as “customer acceptance rights,” in the new standard. The accounting for these kinds of returns is anticipated to be the same as under Accounting Standards Codification (ASC) 605.
This article will outline the accounting treatment for rights of return under ASC 606. It will also identify a potential practice issue under the new standard, and provide a comparison with current revenue recognition guidance under ASC 605.
General Rights of Return
The Boards initially considered requiring treatment of rights of return as performance obligations, but decided the additional information provided would not justify the additional costs. Instead, ASC 606 requires entities to treat rights of return as variable consideration. ASC 606-10-55-22 through 55-29 provide implementation guidance for these kinds of transactions. 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.
The liability should be recognized for the amount of revenue expected to be refunded, and the asset should reduce the cost of goods sold by the value of the goods expected to be returned. In this way, revenue recognized at the point of the original sale does not include amounts to which the entity does not expect to be entitled. Upon lapse of the time period when returns are allowed, the remaining refund liability and asset should be derecognized by an offsetting entry to revenue and cost of sales.
Entities must follow all of the guidance for variable consideration when accounting for rights of return, including applying the constraint. An entity must determine the likelihood and magnitude of a future revenue reversal, and only recognize revenue to the extent that a significant reversal of revenue will not be probable in future periods. For a more detailed discussion of variable consideration and the constraint, see Variable Consideration and the Constraint.
Vendor Y enters into a contract on December 1 with a customer to provide 100 widgets for total consideration of $1,000. The terms of the contract (which are consistent with Vendor Y’s practices) allow for returns for any reason for up to 60 days for a full refund in either cash or store credit. Vendor Y has significant historical experience with customers of this type, and expects an average of 3% of all widgets to be returned.
Analysis. On the date of the sale, Vendor Y determines that it expects to be entitled to the full $970 for the 97 widgets not expected to be returned. Vendor Y determines that it is probable that no significant revenue reversal will occur for this amount. At this date, Vendor Y would make the following entries (assuming the carrying cost per widget is $5):
….Sales Revenue:……………. $970
….Refund Liability:…………… $30
….Refund Asset: ….$15
On December 31, the customer returns one of the widgets for cash, and the following journal entries will be made:
Refund Liability: ….$10
….Refund Asset: ……………….$5
In the year-end financial statements, Vendor Y will have remaining refund liabilities of $20 and refund assets of $10 relating to this sale.
At January 31, the customer has made no further returns and the return period has passed, so Vendor Y would make the following journal entries:
Refund Liability: ….$20
….Sales Revenue: ……………..$20
….Refund Asset: ……………….$10
Customer Acceptance Provisions
The accounting for customer acceptance rights (previously “customer specific rights of return”) is not expected to change under ASC 606. Previously, the authoritative guidance was found in Staff Accounting Bulletin (SAB) 104, but similar guidance has been incorporated in ASC 606-10-55-85 through 55-88. There are generally two types of customer acceptance. In the first type, some customer arrangements will allow for a trial period, or they may allow for customer acceptance based on subjective criteria, with satisfaction of the criteria determined by the customer. While these provisions may seem different, they are treated similarly because in both cases the customer essentially has control over whether or not to accept the product.
In other cases, the customer or the contract may specify objective criteria that will result in the acceptance of the good to be delivered. If the entity cannot objectively determine that the goods meet the criteria, or if it is the customer’s prerogative to accept the goods once received, then revenue recognition should be deferred until the customer has accepted the received goods, or the time limit for the customer to reject the goods has passed. If an entity can objectively demonstrate that the specifications in the contract have been fulfilled, then control has effectively passed to the customer and the entity should recognize revenue on the sale.
Diversity in Thought
Accounting for a right of return has not received significant discussion from the Transition Resource Group (TRG). However, there is at least one question that may lead to diversity in practice. This issue concerns the application of rights of return with the portfolio approach.
Issue 1: How is the treatment different for a right of return at the contract level as opposed to the portfolio level?
When an entity primarily engages in large contracts that include many goods to be delivered, it may be easy to apply an estimate of returns by applying the percentage expected to be returned across all products. If an entity engages in a large number of transactions with customers who purchase only one or a few products at a time, it may become impossible to know which customers will return their products and which will not, even when the entity can predict with very high accuracy the aggregate number of returns it will receive.
In each contract with one product, there are only two possible consideration amounts. If all of the contracts are relatively homogenous from the point of view of the entity, then the entity would likely reach the same conclusions about the appropriate transaction price and the appropriate constraint for each of the contracts. If the entity wishes to limit itself to only using transaction prices that are possible (as many practitioners feel is appropriate), then the entity will have to choose to either allocate the entire transaction price to one product or constrain the transaction price to $0. Either method could badly skew the amount of revenue recognized.
For these reasons, there are still discussions about the appropriate treatment of variable consideration and rights of return at the contract level (the reader is once again referred to our article on variable consideration). As the guidance currently stands, the portfolio approach is best when possible. Using the portfolio approach, it is possible to account for an estimated percentage of contracts that will end in a return without knowing in advance which contracts will ultimately end in a return of the product.
Comparison to 605
Under ASC 605, a right of return that was generally available to all customers made it difficult to conclude that consideration was fixed or determinable, which made it difficult to recognize revenue on some transactions. ASC 605-15-25-1 required entities to meet each of five criteria to recognize any revenue at the point of sale, or recognize no revenue whatsoever until the return provision expires or until all of the criteria were met, whichever came first. An entity was required to:
- Determine the price at the date of sale,
- Receive payment, or have the right to receive payment,
- Have no obligation to replace products in the event of theft or destruction,
- Meet certain economic substance tests,
- Be able to estimate the returns to be received.
These criteria, and particularly the criterion to be able to estimate the returns to be received, frequently led to companies being required to defer revenue that had substantially been earned.
In comparison, ASC 606 takes a more principles-based approach and treats general rights of return as variable consideration. In many cases, this will lead to similar treatment under both standards. However, entities who have previously determined they could not make an estimate accurate enough to meet the requirements for earlier recognition under ASC 605 may find that they will recognize revenue earlier as they apply the new revenue model to these transactions. It should be noted that transactions that were deemed too uncertain to reliably estimate under ASC 605 will likely need to have some of their variable consideration constrained, but it would be rare that the uncertainty would be so great as to constrain the estimated revenue to $0. These transactions will recognize some revenue upfront, which was not permitted under ASC 605.
The accounting for transactions which include a general right of return under the new revenue standard is a significant theoretical change from current practice, but many companies will find that the new treatment will result in a similar practical effect on financial statements. One significant change will arise from the separate, gross presentation of refund assets and liabilities from inventory, which will reflect the goods expected to be returned and the consideration that will be refunded to the customer.
Companies that currently have too much uncertainty to recognize revenue upfront under ASC 605 will probably see the most significant changes to their financial statements as they will generally recognize much more revenue upfront under ASC 606 than is currently allowed. The accounting for customer-specific rights of return, or customer acceptance provisions, is not expected to undergo any major change.
- ASC 606-10-55-22 to 55-29.
- ASU 2014-09: “Basis for Conclusions.” BC 363-367.
- Deloitte, Revenue from Contracts with Customers: “Roadmap to applying ASU 2014-09.” February 2015. Section 7.1.2, “Sale with a Right of Return.”
- EY, Financial reporting developments: “Revenue from contracts with customers.” Revised August 2016. Section 5.2.2 “Rights of return.”
- KPMG, Issues In Depth: “Revenue from Contracts with Customers.” May 2016. Section 10.1 “Sale with a right of return.”
- PWC, “Revenue from Contracts with Customers.” August 2016. Section 8.2 “Rights of return.”