Sales with right of return should not be recognized as revenue due to the contingent refund liability.
True
False
The correct answer and explanation is:
Correct Answer: True
Sales with a right of return should not be fully recognized as revenue immediately because of the contingent refund liability. According to the revenue recognition principle under both IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles), revenue is recognized when it is earned and realizable. In the case of sales with a right of return, the seller cannot be certain of the exact amount of revenue that will be realized due to the possibility of product returns.
The contingent refund liability arises because the seller may have to refund the customer if the product is returned. To account for this uncertainty, companies are required to estimate the potential returns and recognize revenue only to the extent that it is probable that a significant reversal of revenue will not occur. This means that revenue is recognized only when the return period has passed, or a reasonable estimate of future returns has been made.
This estimation of returns involves assessing past return patterns, the nature of the product, and customer behavior. Once the expected returns are estimated, the company will recognize the revenue for the portion of the sale that it expects to retain, and set up a corresponding liability for the returns. The liability reflects the expected refunds to customers and is adjusted as necessary based on the actual returns experienced.
If the right of return is significant, the company may also have to recognize the revenue over time rather than all at once. Therefore, recognizing sales with the right of return as full revenue without consideration of the refund liability could misstate the company’s financial position, as it would not reflect the possibility of a future refund obligation. This aligns with the cautious approach of accounting, ensuring that revenue is only recognized to the extent that it is reliable and not subject to future reversal.