Question

On January 10, KH sold a mixer it purchased from MU for $80 cash and delivered it to a customer. KH has a 45-day return policy under which a customer can exchange a product for another product of the same type, quality, condition and price. The exchange policy requires that all returned products must be like new. Based on extensive historical experience, KH estimates that 2% of its products will be exchanged by customers for another product of the same price, condition, quality and type. KH estimates the cost of recovering any products will be insignificant. KH does not record any potential volume discounts until they are earned.

Requirements

? Record all initial accounting entries for KH for January 10 based on the current guidance on revenue recognition in ASC 605. Include references to the guidance to support your proposed accounting. Show any calculations you make to support your journal entries.

? Prepare a detailed explanation of each of the five steps of revenue recognition. Record all initial accounting entries for MU for January 10 based on the new guidance on revenue recognition in ASC 606. Include references to the guidance to support your proposed accounting. Show any calculations you make to support your journal entries.

? What, if anything, is the difference in revenue recognized for the month of January under ASC 605 and ASC 606?

Answer 1

Q 1

Accounting Standard Codification (ASC) Topic 605 " Reveneue Recognition When A Right of Return Exists" issued by the Financial Accounting Standards Board (FASB), provides guidance to entities on the accounting treatment for "sale of products, when the buyer has a right to return, whether as a matter of contract, or in accordance with existing practice. A right of return is not accounted for as a performance obligation."

ASC 605-15-25-1

Revenue is recognized as per ASC 605-15-25-1, when a rright of return exists, when all six criteria are met. According to ASC 605-15-25-1 " If an entity sells its product, but gives the buyer the right to return the product, revenue from the sales transaction shall be recognized at time of sale only if all the following conditions are met:

a. The seller's price to the buyer is substantially fixed, or determinable, at the date of sale;

b. The buyer has paid the seller, or the buyer is obligated to pay the seller, and the obligation is not contingent on resale of the product;

c. The buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product." In other words, the seller has no obligation to replace products sold, in the event of theft or destruction.

d. "The buyer acquiring the product for resale has economic substance apart from that provided by the seller;

e. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; and

f. The amount of future returns can be reasonably estimated.

Sales revenue and Cost of Sales that are not recognized at the time of sale because the foregoing conditions are not met, shall be recognized either when the return privilege has substantially expired, or if those conditions are subsequently met, whichever occurs first."

"All the six criteria must be fulfilled for revenue recognition. However, it must be noted that ASC 605-15-25-1 (a) and (f) require companies to use significant judgement in determining when to recognize revenue for products sold under specific arrangements."

Applicability of criteria ASC 605-15-25-1 to the question

In the question, the sale by KH to the end customer, is analyzed as follows to determine whether all the six citeria are met.

a. The seller's price to the buyer is substantially fixed, or determinable, at the date of sale. On January 10 On the date of sale), the selling price to be paid by the customer for the Mixer has not been fixed by the seller, KH, to the customer, but it can be determined. Therefore, criteria (a) is met;

b. The buyer (customer) has not paid the seller,KH,delivery of the product. Howeverm there is an obligation to pay, which can be deduced. Criteria (b) is met, as "though the customer has not paid the KH, the buyer is obligated to pay the KH, and the obligation is not contingent on resale of the product";

c. "The buyer's (Customer's) obligation to KH would not be changed in the event of theft or physical destruction or damage of the product". This condition stipulated by KH is specifically stated in the question. However, it is stated in the question "that the customer shall return the product "like new". Therefore, the return will be accepted by KH if the customer either returns the original product in an undamaged condition or exchanges another product of same type, quality, condition and price.Therefore, condition is met.

d. It is not possible to determine whether the buyer (customer) acquiring the product from KH for resale, has economic substance ( it commands a market price) apart from that provided by the seller Cannot be determined based on given data;

e. The seller (KH) does not have significant obligations for future performance to directly bring about resale of the product by the buyer .Therefore, condition is not met; and

f. The amount of future returns can be reasonably estimated. It has been estimated at 2% by KH as per its Returns policy. Condition is met.

As all six conditions/ criteria have NOT been met, KH cannot recognize revenue at the point of sale. KH has to wait till the return provision expires.

Accounting Entries

When a right of return exists, the seller should account for the transfer of products by recognizing revenue for an amount indicative of the amount which the seller is entitled to.

No Revenue should be recognized for products expected to be returned. However, it is common practice to record full revenue on date of sale, and then pass adjustment entries at the end of the period to adjust revenue for the amount that the seller is entitled to.

On Feb14 (45 days from date of sale). The entry for sale will be made on the expiry of 45 days from delivery Margin for KH $ 20)

Debit Cash $ 100

Credit Sales Revenue $ 100  

On Jan 10 :Entry for recording cost of goods sold. Assuming

Debit Cost of Goods Sold $ 80  

Credit Inventory : $ 80

Hypothetical assumption to demonstrate entries that will need to be made if the customer returns the product within 30 days.

Accounting entries on Feb 10:

i) Debit : Sales Return & Allowances $ 100

Credit: Accounts Payable $ 100

ii) Imapct on Cost of Goods Sold

Debit : Returned Inventory : $ 80

Credit : Cost of Goods Sold $ 80

End of period adjusting journal entries, to record mixer yet to be returned ( applicable only if more than one mixer has been sold), and expected to be returned as per Schedule of Return and Exchange)

Debit : Sales Returns and Allowances ( to the extent of the unreturned Mixers, if any)

Credit : Accounts Payable

and

Debit : Estimated Inventory Returns

Credit : Cost of Goods Sold

(Towards cost of Mixers to be returned, if any)

Note:

Accounts Payable indicates the refund liability that KH expects to pay the customer in future. It is not applicable, in this case.

Estimated Inventory Returns indicates the asset that KH would have the right to recover the product from the customer when the refund liability ( Accounts Payable) is settled.

Q 2

ASC 606issued by the Financial Accounting Standards Board (FASB) titled "Revenues from Contracts with Customers" / IFRS 15 is a converged model for revenue recognition that needs to be applied under both the USGAAP and the IFRS.

The principle underlying ASC 606 states that "an entity should recognize revenue to depict the transfer of goods or services in an amount that refelcts the consideration to which the entity expects to be entitled in exchange for those goods or services."

An entity should initiate the following five steps in order to meet the abovementioned principle, viz.,

"Step 1 : Identify contract with the customer" ;

"Step 2 : Identify the performance obligation/(s) in the contract";

"Step 3 : Determine the transaction price";

"Step 4 : Allocate the transaction price to the performance obligation/(s) in the contract";

"Step 5: Recognize revenue when or as the entity satisfies performance obligations".

The five steps mentioned above are discussed in detail in the following paragraphs:

"Step 1 : Identify the customer"

ASC 606-10-25-1 to 25-8 states that " an entity should account for a contract with a customer only when all of the following conditions ( hereinfater referred to as contract criteria) are met, viz.,

a. The contracting parties hve approved the contract either orally, or in writing, or by implication, in accordance with customary business practices". Further, "the contracting parties are committed to perform their respective obligations".

b. It is possible to identify "the right to goods and services in respect of each party ( contracting parties)";

c. It is possible to identify " the payment terms for the goods and services to be transferred";

d. " The contract has commercial substance" (resale is possible);

e. " Collectability of substantially all of the agreed upon consideration from the customer is probable".

However, a contract does not exist if each party to the contract " has rthe unitlateral enforceable right to terminate a wholly unperformed contract without compensating the other party /(parties)".

Step 2 : Identify perfomance obligations in the contract

ASC 606 -10-25-14 to ASC 606-10-25-22 define performance obligations as " a promise in a contract with a customer to transfer a distinct good or service to the customer, or a bundle of goods or services that are substanitially the same, and have the same pattern of transfer, to a customer".

Performance obligations can either be a "Single Performance Obligation" or "Multiple Performance Obligations".

A contract with a Single Performance Obligation "is that which involves the transfer of only one distinct good or service to the customer".

In this context, a good or service can be termed to be distinct " if

i) a customer can benefit from the good or service on its own, or, together with other resources that a customer has, which are readily available; and

ii) the seller's promise to transfer the good or service can be separately identified from the other promises in the contract."

Multiple Performance Obligations

In this case, each performance obligation should be " allocated a portion of the transaction price, and accounted for separately".

Step 3: Determine the transaction price

ASC 606-10-32-2 defines "transaction price" as "the amount of consideration or payment to which an entity expects to be entitled in exchange for transferring goods or services to a customer, excluding amounts collected on behalf of third parties".

"Transaction Price" includes the following:

a. "Variable consideration";

b. "Constraining estimates of variable consideration";

c. "Existence of a significant financing component";

d. "Non-cash consideration"; and

e. " Considerations payable to the customer".

Step 4 : Allocate the Transaction Price to the Performance Obligation/ (s)

Once the transaction price is finalized, it should be allocated to the performance obligation/(s) as follows:

i) In the case of a Single Performance Obligation, allocate the entire Transaction Price to the Performance Obligation;

ii) In the case of Multiple Performance Obligations, the Transaction Price should be allocated proportionately based on the stand-alone price prevailing at contract inception of each performance obligation.

If the transaction price cannot be identified or determined, then it should be estimated.

Step 5 : Recognize revenue when the Entity satisfies the Performance Obligation

ASC 606 -10-25-23 to ASC 606-10-25-26 discuss the method of recognizing revenue when the entity satisfies performance obligation.

According to the Standard, "  an entity should recognize revenue when (or as) the entity satisfies a performance obligation, by transferring a promised good or service to a customer. An asset is transferred when ( or as) the customer obtains control of that asset".

Control of an assetmay be evidenced "by the buyer's ability to use the asset to:

• produce goods;or
• enhance the value of other assets; or
• pay expenses or settle liabilities; or
• hold on to assets; or
• sell or exchange the good; or
• pledge the asset as collateral for a loan

. A seller may satisfy a performance obligation over a period of time, or at a point of time.

Performance Obligation satisfied over a period of time

ASC 606-10-25-27 to 606-10-25-29; ASC 606-10-25-36 to ASC 606-10-25-37; and ASC 606-10-25-55-5 to ASC 606-10-25-55-10 discuss Performance Obligations that are satisfied over a period of time.

As per this Standard, " an entity transfers control of a good or service over time, and satisfies a performance obligation and recognizes revenue over time, if one of the following criteria is met :

i. The customer receives and consumes the benefit as provided byt he entity's performance, as the entity performs its obligations;

ii. The entity's performance creates or enhances an asset ( e.g., Capital Work in Progress) that the customer controls, as the asset is created or enhanced;

iii. The entity's performance does not create an assset with an alternative use to the entity, and the entity has an enforceable right to payment for performance completed till date.

Performance Obligations at a point in time

As per ASC 606-10-25-30, "if a performance obligation is not satisfied over a period of time, it is deemed to be satisfied at a point in time".

An entity will have to consider the following indicators in order to ascertain whether control has been transferred or passed on to the customer, thereby confirming that the entity has satisfied the performance obligation, viz.,

"i. The entity has a present right to payment for the asset or service;

ii. Customer has legal title to the asset;

iii. Physical possession has been transferred to the customer;

iv. Significant risk and rewards of ownership have been transferred to the customer; and

v. The customer has accepted the asset."

Right of Return and Refund Liability - Journal Entries

ASC 606-10-32-10, and ASC 606-10-55-22 to ASC 606-10-55-29 deal with Right of Return and Refund Liability. As per the Standard "Refund liability should be recognized if the entity receives consideration from the customer, and expects to refund some or all of that considerationt to the customer".  

ASC 606 mandates that entities to account for the Right to Return as "Variable Consideration". ASC 606-10-55-22 to ASC 606-10-55-29 provide guidance for such transactions. As per these Standards, an entity that has entered into a contract with a right to return should, subsequent to transfer of control, recognize:

" 1. Revenue int he amount of consideration that an entity expects to receive after returns are made;

2. A refund liability for the amount that the entity expects to return to the customer; and

3. An asset for the goods that the entity expects to receive from the customer."

An entity should recognize a liability to the extent of the revenue expected to be refunded. Further, "the asset should reduce the cost of goods sold to the extent of the value o goods expected to be returned". When the time period for return lapses, the balance of refund liability and asset should be derecognized by an off-setting entry to revenue and cost of sales.

Journal Entries

1. One date of sale, Jan 10, Vendor MU determines that it is entitled to the full amount on all mixers sold (not given in the question) to KH less 2% which are not expected to be returned. Vendor reckons that it is probable that no significant revenue reversal will materialize for this amount. On this date, the vendor MU will pass the following Journal Entry:

Debit : Cash ( 1 Mixer * $ 80) = $ 80

Credit :Sales Revenue $ 80

Credit : Refund Liability ( If more than 1 Mixer is sold to KH and the agreement in writing evidences a return percentage)  

2. Cost of Goods Sold entry

Debit : Cost of Goods Sold

Debit : Refund Asset

Credit : Inventory

2. On February 1, (within the return period), if KH returns the Mixer for cash ( assumed, no exchange mentioned in the contract between MU and KH):

Debit : Refund Liability

Credit : Cash

and

Debit : Inventory

Credit : Refund Asset

3. On the lapse of the returns period, if vendor MU determines that no return has been made by KH, vendor MU will pass the following entry in its books of accounts:

1. Debit : Refund Liability

Credit : Sales Revenue

2. Debit : Cost of Goods Sold

Credit : Refund Asset.

Q 3. Comparison between ASC 605 and ASC 606 regarding accounting for Right of Return and Refund Liability

As per ASC 605, " a right of return that was generally available to all customers, made it difficult to establish that consideration was fixed or determinable'. This made it difficult to recognize revenue for those transactions.

ASC 605-15-25-1 makes it imperative for all entities to fulfill all criteria so as to recognize revenue at the point of sale. If all criteria are not met, then the entity cannot recognize any revenue until the period of return lapses, or all criteria are subsequently met, whichever is earlier.

The criteria which were required to be met were:

a. The seller's price to the buyer is substantially fixed, or determinable, at the date of sale;

b. The buyer has paid the seller, or the buyer is obligated to pay the seller, and the obligation is not contingent on resale of the product;

c. The buyer's obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product." In other words, the seller has no obligation to replace products sold, in the event of theft or destruction.

d. "The buyer acquiring the product for resale has economic substance apart from that provided by the seller;

e. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer; and

f. The amount of future returns can be reasonably estimated.

The criterion relating to the ability to estimate the returns to be received frequently resulted in companies having to defer revenue recognition that has been substantially earned.

In contrast, ASC 606 adopts a Principles based approach towards revenue recognition. It treats the general right to return as variable consideration. In most cases, this will result in similar treatment under both ASC 605 and ASC 606.

The only difference being that entities which previously determined that they could not make an accurate estimate of returns as mandated by ASC 605, would now be able to recognize revenue earlier if they adopted the new converged revenue model as per ASC 606.

Transactions that were considered too uncertain to make an accurate estimate as per ASC 605, will need to have some some of their variable constraained. However, it is highly improbable that the uncertainity is of such a magnitude as to constrain the estimated revenue to $ 0. Such transactions will recognize some revenues upfront under ASC 606, which was not possible under ASC 605.

The only significant change will arise from the separate gross presentation of refund assets and liabilities from inventory, which will impact the goods expected to be returned, and the consideration that will be refunded to the customer.