When a customer can send product back for a refund, credit or exchange, the seller cannot book full revenue on the sale. ASC 606 replaces the old returns reserve with three separate pieces: revenue net of expected returns, a refund liability, and an asset for the goods expected to come back. Each is an estimate, and each can be tested against what customers actually return. This post gives the rules, the entries with arithmetic, and the audit plan.
What does ASC 606 require?
Paragraph 606-10-55-22 covers contracts where the entity transfers control of a product and grants a right to return it for a full or partial refund, a credit, or another product. Paragraph 55-23 requires the entity to recognize:
- revenue for the transferred products in the amount of consideration to which it expects to be entitled, so no revenue for products expected to be returned;
- a refund liability; and
- an asset, with a corresponding adjustment to cost of sales, for its right to recover products from customers on settling the refund liability.
Paragraph 55-24 adds that the promise to stand ready to accept returns is not a separate performance obligation on top of the refund obligation.
How is the estimate constrained?
Paragraph 55-25 says the entity applies the variable consideration guidance in 606-10-32-2 through 32-27, including the constraint in 32-11 through 32-13, to find the consideration it expects to be entitled to. Amounts received or receivable that the entity does not expect to keep are not revenue; they are a refund liability. At the end of each period the entity updates its assessment and makes a corresponding change to the transaction price and revenue. Paragraph 55-26 confirms the refund liability is remeasured each period, with the offset in revenue. See variable consideration and the constraint for how the constraint is audited.
How is the return asset measured?
Paragraph 55-27 measures the asset at the former carrying amount of the product (for example, inventory) less expected costs to recover the products, including potential decreases in the value of returned goods. It is updated each period and presented separately from the refund liability. The two are not netted.
Which return-like items are not returns?
Paragraph 55-28 says exchanges of one product for another of the same type, quality, condition and price, such as a different color or size, are not returns under this guidance. Paragraph 55-29 sends defective-product swaps to the warranty guidance; see product warranties and guarantees.
Worked example
A distributor sells 1,000 units at $100 each on credit; cost is $60 per unit. Customers can return units within 60 days for a full refund. Based on its history and a review of current channel inventory, management expects 8% returns, and concludes revenue is not subject to a significant reversal at that level. Units expected back are resalable at cost with no recovery cost.
At sale:
| Entry | Debit | Credit |
|---|---|---|
| Accounts receivable (1,000 x $100) | $100,000 | |
| Revenue (920 units x $100) | $92,000 | |
| Refund liability (80 units x $100) | $8,000 | |
| Cost of goods sold (920 x $60) | $55,200 | |
| Return asset (80 x $60) | $4,800 | |
| Inventory (1,000 x $60) | $60,000 |
Customers return 95 units by the end of the return window. The refund is $9,500 against a recorded liability of $8,000, and the recovered inventory is $5,700 against a recorded asset of $4,800:
| Entry | Debit | Credit |
|---|---|---|
| Refund liability | $8,000 | |
| Revenue (change in estimate) | $1,500 | |
| Cash or accounts receivable | $9,500 | |
| Inventory (95 x $60) | $5,700 | |
| Return asset | $4,800 | |
| Cost of goods sold | $900 |
Final revenue is $90,500 (905 units x $100) and final cost of sales is $54,300 (905 x $60), the same result as if the entity had known the returns at the start. The 15-unit miss on an 80-unit estimate is the number the auditor wants to see tracked year after year.
Audit procedures
Treat the refund liability and return asset as accounting estimates under AU-C 540. An over-stated liability in a strong year is a way to move revenue into the next period.
- Understand the return terms. Read the standard terms and a sample of customer contracts, including side letters, distributor agreements and promotional programs. Extended return rights granted at quarter-end are a revenue-timing risk.
- Test the data. Reconcile the return history used in the estimate to the credit memo register and the general ledger. Test that returns are attributed to the sales period they relate to, not the period in which the credit was issued. Test completeness of the history by product line and channel.
- Evaluate the method. The rate should be segmented where return behavior differs, such as wholesale versus direct, new product versus mature, seasonal. A single blended rate applied to a mix that has changed is a finding.
- Assess the constraint. Obtain management's analysis that revenue recognized (net of expected returns) is not subject to significant reversal. Consider new products, new customers, channel inventory levels and any history of reversing the estimate.
- Use subsequent events. Examine returns and credit memos issued between year-end and the date of the report, matched to pre-year-end sales. This is the strongest evidence for a liability that settles within 60 or 90 days. Under AU-C 540.20, consider whether circumstances changed between the return and year-end.
- Compare to prior-year estimates. Compare last year's estimated rate to the actual outcome. A consistent overestimate across periods is a bias indicator under AU-C 540.32. See retrospective review of prior-year estimates.
- Test the return asset. Agree the cost basis to inventory costing, and test whether returned goods are resalable, need reconditioning or must be scrapped. Paragraph 55-27 requires reducing the asset for expected recovery costs and value declines.
- Check cutoff. Look at the last days before year-end for unusually large shipments to distributors with return rights, and at returns in the first days of the new year. See cutoff testing.
- Check presentation and disclosure. The refund liability and return asset appear separately. Confirm that significant judgments about the estimate are disclosed as the framework requires.
Frequently asked questions
Is a returns reserve the same as a refund liability?
Not exactly. Revenue is reduced at the time of sale, the obligation is a refund liability, and the expected recovery of goods is a separate asset presented gross rather than netted against the liability.
What if returns cannot be estimated?
The constraint applies. If the entity cannot conclude that a significant reversal is not probable, it recognizes less revenue until the uncertainty resolves.
Does this apply to e-commerce sales?
Yes. Retail and online sellers with return windows follow the same entries; see e-commerce audit guide: returns, marketplace revenue and sales tax.
Sources
- FASB, Accounting Standards Update 2014-09, Revenue from Contracts with Customers (Topic 606), paragraphs 606-10-55-22 to 55-29 (sale with a right of return) and 606-10-32-11 to 32-13 (constraint): https://viewpoint.pwc.com/dt/us/en/fasb_financial_accou/asus_fulltext/2014/asu_201409revenue_fr/asu_201409revenue_fr_US/asu_201409revenue_fr_US.html
- AICPA, AU-C Section 540, Auditing Accounting Estimates and Related Disclosures (paragraphs .13, .20 and .32): https://www.aicpa-cima.com/resources/landing/aicpa-professional-standards
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error