Sale with a right of return

Sale with a right of return

Customers have a legal right to return goods that are faulty, not as described, or unfit for purpose. Even if goods are not faulty many retailers have a goodwill policy allowing returns within a specified period. The level of these returns can be high, especially where sales are made online.

IFRS 15 has prescriptive guidance on how to account for these return rights which requires the estimation not only of the number of expected returns, but also the nature of these returns. These estimates could be difficult to quantify and businesses may need to change their management reporting systems in order to ensure that they have the information needed to implement this new standard.

IFRS 15 defines a right to return as a right that enables a customer to receive:

  1. A full or partial refund of any consideration paid
  2. A credit that can be applied against other amounts owed, or that will be owed, to the vendor by the customer
  3. A different product in exchange, or
  4. Any combination of the above.

It is important to note that, the third point notwithstanding, an exchange by customers of one product for another of the same type, quality, condition and price (for example, exchanging the product for one of a different colour or size) is not considered a return for the purposes of applying IFRS 15. Where an exchange occurs, revenue is recognised on the date of the original sale. This means that estimating expected returns under IFRS 15 could be complex, given the different accounting treatments of exchanges for similar and different items.

How do I account for this under IFRS 15?

Where a right to return exists, IFRS 15 requires sales revenue to be reduced to reflect the expected value of returns using the rules relating to variable consideration. Instead of recognising revenue for these expected returns, a refund liability is recognised. The inventory cost of items expected to be returned are also excluded from cost of sales and instead remain within inventory, adjusted for any potential impairment or restocking costs.

In subsequent periods, the vendor updates its expected levels of returns, adjusting the measurement of the refund liability and the associated inventory asset.

How might this differ from previous practice?

This may be a major change from the approach taken previously, particularly if past practice was to record a refund provision for only the margin earned on the original sale of the items expected to be returned. This is especially the case where recognition of this provision was taken against cost of sales rather than reducing revenue. This change will also represent a ‘grossing-up’ of the balance sheet as the refund liability and inventory cost of expected returns are not off-set.

Example of the potential effect of the new requirements

A retailer sells 100 items for £10, with a cost per item of £8 resulting in a margin of £2 per item. It anticipates that 12 of those items will be returned for a cash refund or exchanged for a different item.

 

Possible previous accounting

IFRS 15 accounting

Revenue

1,000

(100 x £10)

880

(100-12) x £10

Cost of Sales

824

(100 x £8) + (12 x £2)

704

(100-12) x £8

Gross Profit

176

 

176

 

 

 

 

 

 

Inventories

-

 

96

(12 x £8)

Refund liability

24

(12 x £2)

120

(12 x £10)

Although gross profit is unaffected, revenue, which is likely to be a key performance indicator, may be significantly reduced. Therefore, it is clear that estimating expected levels of returns will be a critical estimate, especially for businesses selling to the public.

For help and advice on accounting for returns please get in touch with Scott Knight.

See also IFRS 15 in the spotlight: Accounting for vouchers