A right to return enables a customer to receive:
- A full or partial refund of any consideration paid;
- A credit that can be applied against amounts owed or that will be owed to the vendor;
- Another product in exchange;
- Any combination of the above.
A right to return may be given for various reasons such as customer dissatisfaction with the product or simply given if the customer changes their mind.
For those items which are expected to be returned, the vendor does not recognize revenue.
Instead, it recognizes a refund liability together with an asset representing item(s) expected to be returned.
Any refund liability is reassessed and updated at each reporting date.
If the realizable value of the item to be returned is expected to be less than the cost of the related inventory, an adjustment is made to cost of sales.
Entity X, a clothes retailer, grants customers a right to return any goods within 4 months of purchase for a full refund or an exchange of goods for equivalent value, if undamaged.
At the reporting date, sales made in the previous 4 months amount to $2 million, with those goods costing Entity X $1.6 million (80% on sales).
Entity X concludes that it is highly probable that goods sold for $1.85 million will not reverse (i.e. it is highly probable there will not be a significant reversal in excess of $150.000).
The journal entries required in order to correctly record the above transactions are:
Dr Cash $2.000.000
Cr Revenue $1.850.000
Cr Refund Liability $150.000
Asset to be returned
Dr Cost of Sales $1.480.000 (b)
Dr Inventory to be returned $120.000 ($150k * 80%)
Cr Inventory $1.600.000