Revenue adjustments include sales returns, sales allowances, sales incentives, discounts, and bad debts. Warranties and guarantees may be treated either as future revenue or as “aftercosts”, depending on the circumstances; costs related to product defects should be treated as expenses. Practice does not always clearly distinguish between events and transactions that give rise to expenses and those that are more properly treated as adjustments or valuations of revenue.
Through this post we will discuss revenue adjustment and aftercost in accordance with standards. I hope this post will answer lots questions relates to accounting treatment for sales returns, sales allowances, sales incentives, discounts, and bad debts; warranties and guarantees. Enjoy!
Nature of Revenues
Statement of Financial Accounting Concepts (SFAC) No. 6, “Elements of Financial Statements” (pars. 78, 79, and 82), issued in December 1985, defines revenues and gains as follows:
Revenues are inflows or other enhancements of assets of an entity or settlements of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.
Revenues represent actual or expected cash inflows (or the equivalent) that have occurred or will eventuate as a result of the entity’s ongoing major or central operations. The assets increased by revenues may be of various kinds—for example, cash, claims against customers or clients, other goods or services received, or increased value of a product resulting from production.
Similarly, the transactions and events from which revenues arise and the revenues themselves are in many forms and are called by various names—for example, output, deliveries, sales, fees, interest, dividends, royalties, and rent—depending on the kinds of operations involved and the way revenues are recognized. Gains are increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners.
Expenses are defined in paragraph 80 of SFAC No. 6 as out flows or expirations of assets sold or liabilities incurred in the process of earning revenue (as “earning” was previously defined).
Hendriksen and van Breda state that:
[S]ales returns and allowances, sales discounts, and bad debt losses are all more appropriately treated as reductions of gross revenues than as expenses. None of them represents the use of goods or services to generate revenues; each represents a reduction of the amount to be received in exchange for the product.
Merchandise returned by a customer is, in effect, a cancellation of the original sales transaction, in whole or in part, and should be treated as a direct offset to gross sales rather than as a revenue adjustment. To maintain a record of sales returns as well as of the amount of gross sales, however, returns are ordinarily recorded in a contra sales account, “sales returns”.
A special problem arises if the returned merchandise has been used or has deteriorated to a point substantially below its original value. In those cases, the returned goods should be recorded at their net realizable value based on their present condition and estimated costs of making them ready for resale. Losses attributable to returned goods should be recognized as appropriate.
Allowances to customers fall into two general classes, as follows:
- Specific allowances on certain products, such as those for shortages in shipments, breakage, spoilage, inferior quality, failure to meet specifications, or errors in billing or handling of freight.
- Policy allowances, or allowances that the seller makes only because of the possible loss of future business it might suffer in related lines if it did not offer such allowances.
Allowances falling in the first class should be treated as a direct offset to gross sales. Allowances in the second class are generally classified as revenue deductions.
Some vendors provide cash, credits, and other consideration to their customers in the form of discounts, coupons, rebates, and free products or services. For example: deductions from gross invoice prices, order quotations, published price lists, and other forms of discounts may be offered as:
- Cash Discounts. Credit terms often allow customers a cash discount for payment of invoices within a certain period. In the past, cash discounts were sometimes viewed as interest allowances to customers for prompt payment. Sales discounts taken were thus treated as financial expenses; discounts not taken were implicitly included in gross revenue. This accounting can still be found in the literature. The preferred method, however, is to regard cash discounts as revenue adjustments, either by deducting discounts taken from gross sales revenue on the income statement or by initially recording the sales at net prices and treating forfeited discounts as financing revenue. As a practical matter, the amounts involved are usually not material to the financial statements.
- Trade Discounts. Trade discounts are deductions from list prices, allowed to customers for quantities purchased or for the purpose of establishing different price levels for different classes of customers, such as wholesalers and retailers. Trade discounts also are employed to enable vendors to change the effective prices of articles included in catalogs or similar sales publications by the relatively simple process of issuing a revised discount sheet. Revenues should be recorded after deduction of such discounts.
- Employee Discounts. Employees are often allowed special discounts on purchases made through the company. The discount may be limited to the company’s ordinary products or merchandise, or it may extend to clothing, food, and other commodities carried in a general company store for the bene?t of employees and sold to them at cost. If the sales are not recorded net of discounts initially, the total discounts should generally be treated as a revenue deduction. If a discount is in substance additional compensation, it should be treated as an operating expense.
A variety of more complex sales incentive arrangements also are used by companies in the Internet, hospitality, airline, and other industries—for example:
- Free products or services delivered when customers purchase another specified product or service (e.g., 2-for-1 offers).
- Shares of vendors’ stock, stock options, or stock warrants to purchase vendors’ stock.
- “Points” or other credits that can be redeemed for various goods and services after customers have accumulated a specified amount (“loyalty” programs).
- Fees paid to customers to obtain space in customers’ selling areas (“slotting fees”).
- Reimbursements for a portion of customers’ advertising costs relating to vendors’ products or services (“cooperative advertising”).
- Reimbursements up to specified amounts if the customers do not resell the vendors’ products at greater than a specified minimum price during a specified time period (e.g., buydowns, shortfalls, factory incentives, dealer holdbacks, price protection, and factory-to-dealer incentives).
The accounting issues raised by sales incentives such as these concern how vendors should measure the costs of these arrangements and how those costs should be reported on vendors’ income statements.
Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Product
The EITF codified its consensus on these questions in Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Product”. As discussed below, the appropriate accounting depends on the type of consideration offered:
Cash or Equity Consideration
When cash or equity consideration is offered voluntarily and without charge by a vendor to be used in a single exchange transaction or that becomes exercisable by the customer as a result of a single exchange transaction, the cost of the incentive should be measured at the later of two dates: when the related revenue is recognized by the vendor or when the incentive is offered. The costs of these incentives generally should be reported as reductions in revenue. The costs should be reported as expenses, however, when and to the extent that vendors (1) receive, or will receive, identifiable and separable goods or services in exchange and (2) can reasonably estimate the fair value of those goods or services. Exhibits 01-9A and 01-9C of EITF Issue No. 01-9 provide examples of how this guidance applies to various types of sales incentives involving cash and equity consideration.
Other Forms of Consideration
Sales incentives offered to customers may involve consideration other than cash or equity instruments, such as gift certificates and offers of “free” products or services. The consensus to EITF Issue No. 01-9 considers those types of incentives to be separate deliverables and requires their cost to be reported as expenses. Although the consensus does not specify the appropriate expense classification, the SEC staff believes they should be included in cost of sales if they are delivered at the time of the sale of other goods or services. Accounting for sales incentives, such as certain loyalty programs, that offer customers free or discounted goods or services only after reaching a certain level or after being a customer for a certain period of time may be included in the FASB revenue recognition project (see Section 19.4(d)).
Customer’s Accounting for Sales Incentives
The EITF reached a consensus on Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” in November 2002. That guidance applies to consideration (called cash consideration by the EITF) in the form of cash (such as slotting fees and cooperative advertising payments), credits against amounts due, and equity instruments of the vendor, as well as amounts payable only if customers reach a target, such as achieving a cumulative level of purchases or remaining as a vendor’s customer for a specified time period.
The EITF concludes that:
. There is a rebuttable presumption that cash consideration received by customers is a reduction in the price of a vendor’s goods or services. Customers should not report such consideration as revenue but as reductions in their cost of sales.
. The presumption can be overcome if either of two conditions exist:
- Customers provide or will provide to vendors, in exchange for cash consideration, identifiable benefits that are “sufficiently separable” from the customers’ purchases. (Sufficiently separable means that customers (a) would have entered into exchange transactions with other parties to provide the benefits and (b) can reasonably estimate the fair value of the benefits provided to the vendors.) If this condition is met, customers should report the fair value of cash consideration received from vendors as revenue; consideration received in excess of the fair value of the benefits provided to vendors should be reported as a reduction in the cost of sales.
- Customers receive cash consideration that reimburses them for specific incremental identifiable costs they incurred in reselling the vendor’s goods or services. If this condition is met, customers should report the fair value of cash consideration as reductions in those costs; any amounts received by customers in excess of the costs being reimbursed should be reported as reductions in the cost of sales.
. Customers should not report rebates or refunds as revenue if they can reasonably estimate the probable amounts to be received under binding arrangements that specify the amount of cash consideration payable when the customer either:
- completes a specified cumulative level of purchases; or
- remains a customer for a specified period.
In those situations, customers should report the cash consideration as a reduction in the cost of sales.
Using a systematic, rational method, customers should allocate the total cash consideration to the transactions that demonstrate the progress the customer is making toward achieving the target level of purchases or time period. If customers cannot reasonably estimate the probable amount of future cash rebates or refunds, they should recognize the consideration as the targets are achieved. Various factors affect a customer’s ability to make those estimates, such as the length of the period during which a rebate or refund offer is open and the extent of the customer’s experience with similar offers. The EITF did not, however, provide guidance on when up-front nonrefundable cash consideration received by customers should be treated as liabilities or revenue.
The EITF provided additional guidance to resellers about how they should report vendor reimbursements for certain sales incentives, such as coupons and rebates, offered by manufacturers directly to consumers. The consensus to EITF Issue No. 03-10, “Application of Issue No. 02-16 by Resellers to Sales Incentives Offered to Consumers by Manufacturers”, concludes that resellers should account for those reimbursements as reductions in cost of goods sold if the incentives:
- Are available to consumers to reduce the price paid to any resellers of the manufacturer’s products;
- Are paid directly to resellers from vendors (or vendor-authorized third parties) based on the face value of the incentives;
- Are determined solely by the terms offered to consumers by manufacturers (i.e., have no terms affected by other incentive arrangements between the manufacturers and resellers); and
- Arise from express or applied agency relationships between manufacturers and vendors in connection with the sales incentive offered by the manufacturers to consumers.
If a sales incentive does not meet all four of these criteria, resellers should apply the guidance in EITF Issue No. 01-9 and No. 02-16.
According to SFAS No. 114, “Accounting by Creditors for Impairment of a Loan” (par. 8):
A loan is impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due according to the contractual terms of the loan agreement. (As defined in SFAS No. 114, loans include accounts receivable with terms exceeding one year and notes receivable).
SFAS No. 114 applies to all creditors; its applicability to financial institutions. SFAS No. 114 does not apply to large groups of smaller-balance homogeneous loans that are collectively evaluated for impairment. Impaired loans in that category are referred to as uncollectible receivables in this book and are discussed in this section.
Uncollectible receivables are accounts and note receivables that probably will not be collected in the future. Providing an allowance for uncollectible receivables is required under SFAS No. 5, “Accounting for Contingencies”, when a loss is probable and can be reasonably estimated.
Under the allowance method, an allowance account is used to report the estimated uncollectible amount of receivables. The allowance account is reflected as a contra to the controlling (i.e., gross) receivables account, and the individual subsidiary accounts are left intact. When it is decided that a specific amount is uncollectible, it is charged against the allowance account. Bad debt expense is recorded when the allowance account is increased.
Although not acceptable for financial statements prepared in conformity with GAAP, the direct write-off method is acceptable for income tax purposes. Under this method, no allowance is required; instead, uncollectible accounts are written off during the period in which they are determined to be uncollectible. The loss is charged directly to bad debt expense.
Bad debts can be classified on the income statement as:
- a financial expense or loss;
- an operating expense (either selling or administrative); or
- a sales adjustment.
The first view assumes that all customers’ claims are initially valid in the amount of their face value and that subsequent lack of collection is a financing cost that must be borne by the business as a whole. Under the second interpretation, bad debts are considered one of the costs of operating the business. The third alternative recognizes at the outset that a certain percentage of customers’ claims will become uncollectible, that total credit sales are therefore tentative and subject to subsequent adjustment, and that, consequently, no expense or loss should be recognized because no asset has expired or liability been incurred.
When the allowance account is used, there are three methods for estimating its appropriate balance: (1) percentage-of-sales method, (2) percentage-of-receivables method, and (3) aging method. I outlined these methods below:
- Percentage-of-Sales Method – The percentage-of-sales method requires charging bad debt expense and crediting the allowance account for an amount determined by applying an estimate of uncollectibles to sales revenue for the period. It can be used with both accounts and notes receivable, either together or separately. As a practical matter, however, this method can be used advantageously with notes only when the notes are numerous and arise as a regular credit term granted at the time of the sale. Although the uncollectible expense percentage usually should be based on recent experience and applied to credit sales, substantially the same result often can be attained by using a smaller percentage applied to total sales (assuming the relationship of cash sales to credit sales remains fairly constant). The balance in the allowance account may become excessive or inadequate unless there are periodic reviews of probable losses and consequent adjustments of the allowance account as necessary.
- Percentage-of-Receivables Method – The percentage-of-receivables method requires a determination of collection experience. The total of estimated uncollectibles is thus ascertained by applying the loss percentage to total receivables. The allowance account is then adjusted by the amount necessary to bring the existing balance to the required amount. The percentage-of-receivables method also can be used with both accounts and notes receivable. When the notes held are relatively few in numbers and originate in the process of collection of accounts receivable or through loans and advances, the percentage-of-receivables method is an appropriate means of valuing notes receivable. This method often results in a fairly accurate approximation of expected net realizable value of receivables. In terms of bad debt expense on the income statement, however, the method may be deficient in that bad debts are related to all open receivables irrespective of the period in which the claims originated, with the result that uncollectible receivable losses may not be recognized in the period in which the revenue is recorded.
- Aging-of-Receivables Method – The aging-of-receivables method is a variation of the percentage-of-receivables method. The basis for using this method is that the older the receivable, the less likely it is to be collected. The first step in aging receivables is classifying them as to time since (1) billing, (2) end of regular credit period granted, (3) payment due date, or (4) date of last payment. The amount of expected uncollectibles as determined by the aging process becomes the balance to be reflected in the allowance account. The allowance account is adjusted to bring the present balance into agreement with the required balance; the amount of the adjustment is charged to bad debt expense for the period. If properly applied, the aging method, including use of appropriate supplemental information, provides the most accurate approximation of the expected net realizable value of receivables. Like the percentage-of-receivables method described above, the aging method may fail to recognize bad debt expenses in the period in which they arise. In the aging process, bad debts are related to impairment-of-asset values irrespective of the time of the sales activity. Receivables resulting from the most recent sales, for example, may be regarded as fully collectible in the aging process, only to prove uncollectible in the subsequent period. The aging method can be costly and time-consuming when many accounts are involved, although computerized receivables systems have greatly reduced the costs and time required.
Warranties and Guarantees
SFAS No. 5, “Accounting for Contingencies”, (pars. 24 and 25) states:
A warranty is an obligation incurred in connection with the sale of goods or services that may require further performance by the seller after the sale has taken place. Because of the uncertainty surrounding claims that may be made under warranties, warranty obligations fall within the definition of a contingency… . Losses from warranty obligations shall be accrued when the conditions in paragraph 8 are met. [See below.] Those conditions may be considered in relation to individual sales made with warranties or in relation to groups of similar types of sales made with warranties. If the conditions are met, accrual shall be made even though the particular parties that will make claims under warranties may not be identifiable.
If, based on available information, it is possible that customers will make claims under warranties relating to goods or services that have been sold, the condition in paragraph 8(a) [see below] is met at the date of an enterprise’s financial statements because it is probable that a liability has been incurred. Satisfaction of the condition in paragraph 8(b) [see below] will normally depend on the experience of an enterprise or other information. In the case of an enterprise that has no experience of its own, reference to the experience of other enterprises in the same business may be appropriate. Inability to make a reasonable estimate of the amount of a warranty obligation at the time of sale because of signi?cant uncertainty about possible claims [i.e., failure to satisfy the condition in paragraph 8(b)] precludes accrual and, if the range of possible loss is wide, may raise a question about whether a sale should be recorded prior to expiration of the warranty period or until sufficient experience has been gained to permit a reasonable estimate of the obligation.
Paragraph 8 states:
An estimated loss from a loss contingency … shall be accrued by a charge to income if both of the following conditions are met:
- Information available prior to issuance of the financial statements indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the ?nancial statements.
- The amount of the loss can be reasonably estimated.
Obligations Related To Product Defects
SFAS No. 5 (par. 26) states:
Obligations other than warranties may arise with respect to products or services that have been sold, for example, claims resulting from injury or damage caused by product defects. If it is probable that claims will arise with respect to products or services that have been sold, accrual for losses may be appropriate. The condition in paragraph 8(a) [see above] would be met, for instance, with respect to a drug product or toys that have been sold if a health or safety hazard related to those products is discovered and as a result it is considered probable that liabilities have been incurred. The condition in paragraph 8(b) [see above] would be met if experience or other in-formation enables the enterprise to make a reasonable estimate of the loss with respect to the drug product or the toys.