Rights of Return and Customer Acceptance in ASC 606

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).

George Risk Industries, Inc. SEC Correspondence

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George Risk Industries, Inc. (George Risk) provides a variety of magnetic reed switches made in the USA. In a comment letter in March 2020, the SEC sent George Risk the following request:

You disclose that you recognize product returns as they are received. Please explain to us how this is consistent with the guidance in ASC 606-10-55-22 through 29, or revise your future filings to clearly disclose your compliance with that guidance.

George Risk responded to the inquiry about its dealings with returns explaining the process of how it accounted for returns under the guidance found in the Codification:

In accordance with ASC 606-10-55-22 through 29, a refund liability should be recognized if the entity receives consideration from a customer and expects to refund some or all of that consideration to the customer. A refund liability is measured at the amount of consideration received (or receivable) for which the entity does not expect to be entitled (that is, amounts not included in the transaction price). The refund liability (and corresponding change in the transaction price and, therefore, the contract liability) should be updated at the end of each reporting period for changes in circumstances. To account for the transfer of products with a right of return (and for some services that are provided subject to a refund), an entity should recognize all of the following:

Revenue for the transferred products in the amount of consideration to which the entity expects to be entitled (therefore, revenue would not be recognized for the products expected to be returned)
A refund liability
An asset (and corresponding adjustment to cost of sales) for its right to recover products from customers on settling the refund liability.

Following the guidance found in the Codification, George Risk does not recognize revenue for the products it expects to be returned by customers. Instead, George Risk recognizes these products as a refund liability. This account is then adjusted each period according to changes in circumstances.

Service Refund Liability At Despegar.Com, Corp (Online Travel Booking)

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Although rights of return are most easily conceptualized for tangible goods, the same principles apply to refundable services. Despegar explained that “for refundable or cancellable transactions, the Company applies the guidance in ASC 606-10-32-10 and ASC 606-10-55-22 through 55-29. Therefore, the Company recognizes revenue when the traveler completes the booking and recognizes a refund liability against revenue until the refundable period expires. The refund provision is determined based on past objective historical experience. The Company reverses this provision for any unclaimed refund after the period the reservation becomes non-refundable which is usually after check-in date at which time the Company records revenue” (September 2019 letter to the SEC).

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).

Example A: Right Of Return

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 percent 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):

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. Customer acceptance is determined based on acceptance provisions or clauses within a contract requires careful analysis.

Objective Criteria for Customer Acceptance

Customer acceptance rights may 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).

Non-Objective Criteria for Customer Acceptance

Conversely, if customer acceptance rights are based on non-objective criteria, then the entity is prevented from concluding that the customer has obtained control of the good or service. For contracts without objective criteria, entities wait until formal customer sign-off is obtained to assign control to the customer. In some cases, entities may allow a trial period for customers to determine whether they want to keep the product. When the customer is not committed to pay any consideration until the trial period lapses, control is not transferred until the trial period lapses or the customer accepts the product.

Velo3D, Inc. SEC Correspondence

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Velo3D, Inc. is a leading provider of metal 3D printers. Along with manufacturing and distributing printers, it also provides printer analysis software, site installation, and consumer training in order to operate the printers correctly and effectively. In regard to customer acceptance and control of their product, Velo3D responded to the SEC in an August 2022 comment letter:

The Company advises the Staff that revenue related to the 3D Printer is recognized at a point in time, which occurs upon transfer of control to the customer at shipment. Site installation, testing and customer training are incidental to customer acceptance.

Velo3D determined that customer acceptance, either verbally or in writing, is merely a formality, or rather, it is clear the customer has accepted the printer if they have had it installed and tested, followed by training on how to operate the printers correctly.

Customer Acceptance Rights At Applied Materials, Inc. (Electronics Equipment, Services, And Software)

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“For goods or services delivered to a customer with agreed-upon specifications where the specifications have previously been delivered and accepted by the customer, or have been demonstrated based on repeatable data obtained from the customer and/or Applied [Materials]’ test labs, Applied typically considers the technical acceptance a formality that does not affect the determination of when the customer has obtained control of the good or service. Where Applied does not have prior experience of meeting agreed-upon specifications (for example, in cases of a new product with no history of meeting customer specifications), technical acceptance is considered a requirement before we conclude that the customer has obtained control, as described in ASC 606-10-55-87, and revenue is recognized. The majority of goods and services provided by Applied to its customers involve situations where Applied has prior experience of meeting agreed-upon specifications in a contract as described in ASC 606-10-55-86, and therefore Applied generally recognizes revenue upon delivery, rather than upon customer’s technical acceptance, of a good or service based on its experience with contracts for similar goods or services as outlined above” (February 2020 letter to the SEC).

Conclusion

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.

Resources Consulted

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, Roadmap: “Revenue Recognition.” December 2023. Section 8.6.2., Section 8.6.7.
EY, Financial Reporting Developments: “Revenue from Contracts with Customers.” September 2023. Section 5.4, Section 7.2.1.
KPMG, Handbook: “Revenue Recognition.” March 2023. Section 5.4, Section 7.5.40.
PWC, “Revenue from Contracts with Customers.” November 2023. Section, 6.5.5, Section 8.2.