Revenue Recognition (on Goods approval)

Revenue recognition on goods sent for approval or return, often referred to as sale on approval or sale or return basis, presents unique challenges in accounting. In such transactions, goods are shipped to a customer with the understanding that the buyer has the right to either accept or return the goods within a specified time frame. The uncertainty surrounding the finality of the transaction requires careful application of revenue recognition principles, ensuring that revenue is only recognized when the sale is effectively complete.

Understanding Sale on Approval or Return

In a sale on approval arrangement, the buyer does not assume ownership of the goods until they accept them. The goods remain the property of the seller until acceptance. The seller sends goods to a potential customer, allowing the customer to examine the product and decide whether to purchase it. If the customer does not accept the goods, they are returned to the seller, and no sale occurs.

Such arrangements are common in industries where customers prefer to inspect or test products before committing to a purchase. This practice is frequently seen in industries like fashion, art, machinery, and electronics, where buyers want to ensure the quality and suitability of goods before making a final decision.

Key Accounting Principles:

The primary accounting challenge in sale on approval or return transactions is deciding when revenue should be recognized. This process must align with accounting standards like IFRS 15 – Revenue from Contracts with Customers or ASC 606 – Revenue from Contracts with Customers under U.S. GAAP. The core principle of both standards is that revenue should be recognized when control of the goods or services is transferred to the customer, and the performance obligation is satisfied.

In the case of sale on approval, control of the goods does not pass to the customer at the time of shipment. Instead, control only passes when the buyer accepts the goods or the approval period expires without a return. Until the goods are accepted, the seller retains the risks and rewards of ownership, and therefore, revenue cannot be recognized.

Criteria for Revenue Recognition in Sale on Approval:

For revenue recognition in sale on approval transactions, several key criteria must be met:

1. Customer Acceptance

Revenue is recognized only when the buyer accepts the goods. Acceptance may occur explicitly (the buyer informs the seller that they are keeping the goods) or implicitly (the approval period expires without a return). Until this point, the seller cannot record the transaction as revenue because the buyer has the right to return the goods.

2. Transfer of Control

Control of the goods transfers when the buyer takes legal ownership of the products. In a sale on approval transaction, this does not happen at the point of shipment. The buyer gains control only when they accept the goods and relinquish their right to return them.

3. Revenue Deferral

Until the customer accepts the goods, the transaction is recorded as a deferred revenue or unearned revenue liability in the seller’s books. This reflects the fact that the seller has not yet fulfilled the performance obligation, as the customer has the option to return the goods. Once the customer accepts the goods, this liability is converted into revenue.

Accounting Entries in Sale on Approval:

1. Initial Shipment (Before Acceptance)

When goods are shipped under a sale on approval arrangement, no revenue is recognized initially. Instead, the goods remain recorded as inventory on the seller’s balance sheet, and no accounts receivable is recognized. This reflects the fact that the sale is not yet final and the customer may still return the goods.

Journal Entry (On shipment of goods):

• Debit: Inventory on Consignment/Approval (an asset account)
• Credit: Inventory (regular inventory account)

This entry moves the goods out of regular inventory and into an inventory category for goods on approval or consignment, reflecting that the goods have been shipped but are still owned by the seller.

2. Acceptance by the Customer

Once the customer accepts the goods (either explicitly or implicitly by keeping the goods after the approval period), the seller recognizes the revenue, and the transaction becomes a regular sale.

Journal Entry (Upon customer acceptance):

• Debit: Accounts Receivable (for credit sales) or Cash (for cash sales)
• Credit: Sales Revenue

At the same time, the cost of goods sold (COGS) is recognized to account for the reduction in inventory:

Journal Entry (To record COGS):

• Debit: Cost of Goods Sold (COGS)
• Credit: Inventory on Consignment/Approval

These entries reflect the sale of the goods and the reduction in inventory, as control of the goods has now passed to the buyer, and the revenue is earned.

3. Return of Goods

If the customer decides to return the goods within the approval period, the transaction is reversed. The goods are added back to inventory, and no revenue is recognized.

Journal Entry (For returned goods):

• Debit: Inventory on Consignment/Approval
• Credit: Accounts Receivable (or Cash if payment was received)

This reversal reflects the fact that the sale did not occur, and the goods are now back in the seller’s inventory.

Revenue Recognition Timing:

In most sale on approval transactions, the timing of revenue recognition is crucial. Revenue should only be recognized when the following conditions are met:

1. The buyer has accepted the goods, either explicitly or implicitly.
2. The approval period has expired without the goods being returned.
3. Control of the goods has transferred to the customer, meaning the buyer has the right to use or sell the goods and bears the risks and rewards of ownership.

If these conditions are not met, the transaction should remain as unearned revenue, and no income should be recognized.

Importance of Proper Recognition in Sale on Approval:

Failing to recognize revenue properly in sale on approval arrangements can lead to significant financial misstatements. If a company prematurely recognizes revenue before the customer accepts the goods, it can inflate revenue figures and mislead stakeholders regarding the company’s financial performance. This can result in overstated profits and an inaccurate representation of a company’s financial health.

By adhering to the criteria set out by IFRS 15 and ASC 606, businesses can ensure that their revenue recognition practices are compliant with accounting standards and accurately reflect their performance. This, in turn, fosters greater trust and transparency with investors, regulators, and other stakeholders.