Revenue Recognition with Variable Consideration and Right of Return
On 1 October 20X5, Nile Retail Co. sells 1,000 units of a product to a customer for CU100 each, with a right to return any defective units within 90 days. The cost per unit is CU60. Based on past experience, Nile estimates that 5% of units will be returned. In addition, the contract includes a volume discount: if the customer purchases more than 1,200 units in the year ending 30 September 20X6, the price per unit for all units sold in that period is retrospectively reduced to CU95. At the time of the sale, Nile assesses it is highly probable that the customer will not exceed the threshold, but by 31 December 20X5, the customer has purchased an additional 300 units, making it probable that the threshold will be met. Nile has a 31 December year-end. The entity uses IFRS 15.
1. How should Nile account for the right of return and the volume discount at the date of sale (1 October 20X5) and at the year-end (31 December 20X5)? Provide journal entries and calculations.
Read the worked answer
At 1 October 20X5:
- Revenue recognized = 1,000 units × CU100 × (1 - 5%) = CU95,000.
- Refund liability = 1,000 × CU100 × 5% = CU5,000.
- Cost of sales = 1,000 × CU60 × 95% = CU57,000.
- Right to recover returned goods (asset) = 1,000 × CU60 × 5% = CU3,000.
Journal entries: Dr Cash/Receivable 100,000 Cr Revenue 95,000 Cr Refund liability 5,000
Dr Cost of sales 57,000 Dr Right to recover returned goods 3,000 Cr Inventory 60,000
The volume discount is variable consideration. At 1 October, Nile estimates it is highly probable that no discount will apply, so no reduction is recognized. The expected value is zero because the threshold is not expected to be met.
At 31 December 20X5:
- The customer has purchased 1,300 units in total (1,000 + 300). It is now probable that the threshold will be met, so the transaction price for all units should be reduced to CU95 per unit.
- Nile must adjust revenue for the cumulative effect on the 1,000 units already sold: reduction of CU5 per unit × 1,000 = CU5,000.
- Also, the 300 additional units sold in the period should be recorded at CU95 each (assuming no returns on those).
Journal entry for the cumulative catch-up on the initial 1,000 units: Dr Revenue 5,000 Cr Refund liability (or contract liability) 5,000
For the 300 additional units (assuming sale occurred before year-end): Dr Cash/Receivable 30,000 Cr Revenue 28,500 Cr Refund liability 1,500 (if returns are expected on these as well; otherwise no refund liability).
Note: The refund liability for returns is separate from the volume discount liability. The volume discount is a price concession, not a right of return, so it is recognized as a reduction of revenue with a corresponding liability (or reduction of receivable).
2. Suppose that by 31 March 20X6, the customer returns 80 units (which are defective) and the volume threshold is ultimately met (total purchases 1,500 units). Prepare the journal entries to record the returns and the final volume discount adjustment. Assume the returns occur before the year-end 31 December 20X5? Actually, assume returns occur in 20X6 after year-end. Also, assume that at 31 December 20X5, the estimated return rate was revised to 8% due to new information. How would that affect the 20X5 financial statements?
Read the worked answer
This task has two parts: (a) accounting for actual returns in 20X6 and final volume discount, and (b) effect of revised return estimate at 31 December 20X5.
(a) Actual returns in 20X6: At 31 December 20X5, the refund liability was CU5,000 (5% of 1,000 units at CU100). If the estimate is revised to 8%, the refund liability should be 1,000 × CU100 × 8% = CU8,000. The additional CU3,000 is recognized as a reduction of revenue in 20X5 (adjusting entry). Also, the right to recover returned goods increases by 1,000 × CU60 × 3% = CU1,800, with a corresponding reduction in cost of sales.
Revised journal entry at 31 December 20X5: Dr Revenue 3,000 Cr Refund liability 3,000 Dr Right to recover returned goods 1,800 Cr Cost of sales 1,800
In 20X6, when 80 units are returned:
- The refund liability is settled: Dr Refund liability 8,000 (80 units × CU100) Cr Cash/Receivable 8,000.
- The right to recover returned goods is reversed: Dr Inventory 4,800 (80 units × CU60) Cr Right to recover returned goods 4,800.
- Any difference between the liability and the cash refund is adjusted against revenue. Since the liability was based on 8% (80 units) and actual returns are 80 units, no further adjustment.
Final volume discount: Total purchases 1,500 units, so price per unit is CU95 for all units. At 31 December 20X5, Nile had already adjusted the first 1,000 units by CU5,000 and recorded the additional 300 units at CU95 (assuming they were sold at CU100 with a CU5 discount liability). By the time the threshold is met, all 1,500 units should be at CU95. The cumulative discount on all units is 1,500 × CU5 = CU7,500. At 31 December 20X5, Nile recognized a liability of CU5,000 for the first 1,000 units and CU1,500 for the 300 units (total CU6,500). The remaining 200 units sold in 20X6 would be recorded at CU95 each, so no further adjustment for them. However, if the 200 units were sold at CU100, then an additional liability of CU1,000 is needed. But the question states total purchases 1,500, so the final adjustment would be to recognize the discount on any units not already adjusted. Assuming all units were sold at CU100 and the discount was not yet applied to the 200 units, the entry would be: Dr Revenue 1,000 Cr Refund liability 1,000. But careful: the volume discount is a separate liability from refund liability. So use a separate account, e.g., 'Volume discount liability'.
(b) Effect of revised return estimate at 31 December 20X5: The revision from 5% to 8% is a change in accounting estimate, applied prospectively. It increases the refund liability by CU3,000 and reduces revenue and cost of sales accordingly, as shown above. This affects the 20X5 financial statements: revenue decreases by CU3,000, cost of sales decreases by CU1,800, and profit decreases by CU1,200. The right to recover returned goods increases by CU1,800.