How to recognize revenue when rights of return are present
November 22, 2011
Learn about revenue recognition in situations when a right of product return exists.
Sales return is the return of merchandise by a customer. In accordance with generally accepted accounting principles, when a buyer has a right to return a product in the future in accordance with formal or informal agreement, a seller may or may not be able to recognize revenue at the time of sale.
The seller can record the sales revenue at the time of sale if the seller can estimate the rate of product returns (and meet some other requirements – see below). The estimated product return allowances should be recorded at the time of sale as well. However, if the seller is unable to make a reasonable estimate of the amount of future product returns, the seller should wait to record revenue until the loss can be estimated or the return privilege expires.
Examples of factors that might preclude making a reasonable estimate of product returns include:
- A lengthy period for product returns (i.e., in accordance with a product return policy)
- Lack of experience with product returns (e.g., new product, new market)
- Few significant sales with unique terms
- Product susceptibility to obsolescence
- Newness of the product
- Introduction of new products which could lead to the high returns of current products
- Introduction of superior products by competitor(s)
- Channel stuffing (significant inventory level increases in distribution channels)
If the returned merchandise has been used or has deteriorated, such products should be recorded at their net realizable value that depends on the present condition of the products and costs incurred to make them ready for resale. Loss on damaged returned inventory should be recognized as well.
In addition to the lack of ability to reasonably estimate the amount of future product returns, there may be other conditions precluding a company from recognizing revenue at the time of sale when a right of product return exists:
- The seller's price to the buyer is substantially fixed or determinable at the date of sale.
- The buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on the resale of the product. If the buyer does not pay at time of sale and the buyer's obligation to pay is contractually or implicitly excused until the buyer resells the product, then this condition is not met.
- The buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product.
- The buyer acquiring the product for resale has economic substance apart from that provided by the seller. This condition relates primarily to buyers that exist on paper; that is, buyers that have little or no physical facilities or employees. It prevents entities from recognizing sales revenue on transactions with parties that the sellers have established primarily for the purpose of recognizing such sales revenue.
- The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer.