Reserve for product returns definition
/What is the Reserve for Product Returns?
A business should create a reserve for product returns in situations where there is a right of return linked to the sale of goods. It may not be possible to derive a reasonable estimate of what future product returns may be under the following circumstances:
Changes in demand. Demand levels could change, depending upon technological obsolescence or other factors.
No prior information. The company has little or no historical experience with the sale of the goods in question.
Long return period. Customers are given a long period of time in which to return goods to the company.
Minimal homogeneity. There has been an absence of homogenous transactions in the past from which a returns history could be derived.
Related AccountingTools Courses
The Securities and Exchange Commission (SEC) has created other factors that may also keep a business from reliably developing an estimate of product returns. These factors are:
There are large quantities of inventory in the company's distribution channels.
Competing products now in the market contain better technology, or there is an expectation that they will gain market share.
Much of the company's business is with a single distributor.
The product in question is a new one, with no history of returns.
The company has little visibility into the amount of inventory held by distributors, or of the quantities being sold to customers by the distributors.
The SEC also notes that there may be other issues affecting market demand for products sold by the company, which could interfere with the estimation of a reserve for product returns.
If any of the preceding factors interfere with the ability of a business to estimate the amount of product returns, it should not recognize any of the associated revenue until the ability of customers to return products has expired. The SEC also does not believe that developing a reserve for product returns that is derived from the maximum estimate of returned goods is acceptable. This advice from the SEC is only applicable to publicly-held companies.
Presentation of the Reserve for Product Returns
A reserve for product returns is recorded as a contra-revenue account, so it is paired with and offsets the gross sales line item at the top of the income statement. It may also be aggregated with the gross sales line item, so that only a single net sales figure appears in the income statement.
Auditing the Reserve for Product Returns
Auditing the reserve for product returns involves examining the methods, data, and assumptions a company uses to estimate and account for future product returns. Here are the steps required to audit this reserve:
Understand the return policy and industry norms. Understand the company's terms for product returns, including timelines, conditions for returns, and refund or exchange procedures. Also, assess whether the company's return rates align with industry norms and whether any recent changes in policies could impact the return rates.
Evaluate the reserve estimation methodology. Verify that the company uses a consistent and reasonable method to estimate the reserve. This includes a review of the assumptions used in the reserve calculation, such as historical return rates, seasonal or promotional influences, and the presence of any product-specific factors.
Analyze historical data. Examine historical trends in return rates and volumes, and identify any anomalies or inconsistencies. Compare actual returns in previous periods with the corresponding reserves to assess the accuracy of past estimates. In addition, review any adjustments made to reserves and their justifications.
Test current-year reserve. Perform an independent calculation of the reserve using historical return data and current assumptions to validate the company's estimate.
Perform analytical procedures. Compare the reserve as a percentage of sales with prior periods and industry averages.
Consider external factors. Consider whether economic conditions, supply chain disruptions, or other external factors may affect return rates. Also, investigate any recalls, product defects, or quality issues that could increase returns.
Evaluate disclosures. Ensure that any disclosures related to the reserve for product returns in the financial statements are clear and complete. Confirm the reserve aligns with the applicable accounting framework, including recognition, measurement, and disclosure requirements.
Evaluate materiality and risk. Assess the reserve's materiality to the financial statements. In addition, evaluate whether the reserve poses significant risks of misstatement or fraud, and adjust audit procedures accordingly.
By systematically examining these aspects, auditors can ensure that the reserve for product returns is reasonable, supported by evidence, and accurately presented in the financial statements.