There are several issues that have been raised in this case. One of them, for example, is whether the management should allow the right of return to the wholesalers or risk losing the sale? If management does allow the returns, the question becomes how it should be accounted as they have no previous recording experience. One decision made by the management was to raise the candy price by 10% in order to cover up the losses from returns. They decided not to record the expected/estimated amount of losses or returns, since it was already been covered by the raised price of candies.
The main issue now is whether the management’s decision of not recording the estimated returns of merchandize violates the GAAP regulation? We have considered three alternatives. (1) Record the estimated return amount even if it is hard to estimate, (2) Raise the prices and do not record the estimated returns considering it would be immaterial, and (3) Revenue recognition should be deferred until the payment is made. We have searched FASB codification by using the key work “right of return”.
In addition, we have researched Codification topics 605 Revenue Recognition. Four relevant hits have been found. FASB ASC 605-15-15-2 states that sales in which a product may be returned, whether as a matter of contract or as a matter of existing practice, either by the ultimate customer or by a party who resells the product to others. The product may be returned for a refund of the purchase price, for a credit applied to amounts owed or to be owed for other purchases, or in exchange for other products.
GAAP allows the right of return and provides various options to buyer and seller. FASB ASC 605-15-25-1 states that 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 of 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.
If the buyer does not pay at time of sale and the buyer’s obligation to pay is contractually or implicitly excused until the buyer resells the product, then this condition is not met. 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. d. The buyer acquiring the product for resale has economic substance apart from that provided by the seller. This condition relates primarily to buyers that exist on paper, that is, buyers that have little or no physical facilities or employees.
It prevents entities from recognizing sales revenue on transactions with parties that the sellers have established primarily for the purpose of recognizing such sales revenue. e. The seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer. f. The amount of future returns can be reasonably estimated. Thus, if all the above conditions are met only then Gleason candy can record revenue from this sale. As evident from case they are not able to fulfill the last condition which is to reasonably estimate the future returns.
FASB ASC 605-15-25-2 states that if sales revenue is recognized because the conditions of the preceding paragraph are met, any costs or losses that may be expected in connection with any returns shall be accrued. Based on this and previous pronouncement, if they meet all the necessary conditions for recording sales revenue at the time of sale they also need to estimate the losses and the cost that may occur because of the expected returns. FASB ASC 605-15-25-3 states that the ability to make a reasonable estimate of the amount of future returns depends on many factors and circumstances that will vary from one case to the next.
However, any of the following factors may impair the ability to make a reasonable estimate: a. The susceptibility of the product to significant external factors, such as technological obsolescence or changes in demand b. Relatively long periods in which a particular product may be returned c. Absence of historical experience with similar types of sales of similar products, or inability to apply such experience because of changing circumstances, for example, changes in the selling entity’s marketing policies or relationships with its customers d.
Absence of a large volume of relatively homogeneous transactions. Here, Gleason Candy Inc. lacks historical experience and is not able to make reasonable estimates about future returns. They may still be able to take reference from the experience of other entities in the same business Based on the relevant literature cited above, we recommend Gleason Candy should try to estimate the returns from wholesalers by comparing it within the same industry.
According to the criteria set by GAAP they need to fulfill some conditions to record revenue from sales. They just can’t avoid the estimation by raising the prices. If there is no way of estimating than they should not record the revenue at the time of sale. The revenue and cost of sales that are not recognized at time of sale because of the foregoing conditions not being met shall be recognized either when the return privilege has substantially expired or if those conditions subsequently are met, whichever occurs first.
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