Question

Huang Industries, Ltd. (HIL) is based in Singapore and manufactures tools used in Asian auto factories. Shanghai Automotive Industry Corporation (SAIC) purchased $ 60 million worth of tools from HIL in a single order that was delivered on June 30, the last day of HIL’s second fiscal quarter. SAIC may return any portion of the order within three months of delivery for a full refund. HIL’s experience with product returns suggests that products that are returned are generally in good enough condition to be restored to inventory and sold at a later date.

SAIC is a long-term customer that aggressively takes advantage of product return rights but is consistent in its behavior. HIL’s accountants estimate that 10 percent of the products shipped to SAIC will eventually be returned.

Part A. Assume that HIL’s gross margin percentage is always 30 percent. Required: How much pretax profit should HIL recognize on the sale in the second fiscal quarter?

Part B. Assume SAIC returned 9 percent of the shipment on September 12. It did not return any additional product before the right of return expired.

Required: Compute the effect of the sale on HIL’s pretax income in the third fiscal quarter. Your answer should include the effect of the product return on September 12 as well as the expiry of the right of return on September 30.

Answer 1

Part A:

Huang will establish a product return liability assuming that 10% of the sales will be reversed. At the time of the initial sale, it will recognize sales revenue equal to 90% of the sales price, or $60,000,000× .9 = $54,000,000.

Matched to this revenue, Huang would recognize a cost of goods sold of $54,000,000 × .7 = $37,800,000.

The following journal entries record the sales transaction on June 30th:

$54,000,000 – $37,800,000 = $16,200,000

Cash   60,000,000

  Sales revenue      54,000,000

  Product returns liability 6,000,000

Cost of goods sold   37,800,000

Product returns asset    4,200,000

Inventory 42,000,000

Part B:

Amount returned: $60,000,000 × .09 = $5,400,000

Cost of returned inventory: $5,400,000 × .7 = $3,780,000

On September 12th

Product returns liability 5,400,000

  Cash    5,400,000

Inventory 3,780,000

  Product returns asset    3,780,000

On September 30

Product return liability 600,000

  Sales revenue        600,000

Cost of goods sold    420,000

  Product returns asset     420,000

Additional profit recorded upon expiry of the right of return:

600,000 – 420,000 = 180,000