Reserve for Product Returns

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Reserve for Product Returns

GAAP accounting requires that a company create a reserve for product returns in sales transactions where a right of return exists. Under GAAP, the following factors may impair a company’s ability to make a reasonable estimate of product returns:

Demand changes. Susceptibility of the product to such external factors as technological obsolescence or changes in demand.
No history. Absence of historical experience with similar types of sales of similar products. This is a particularly common issue for start-up companies and companies selling new or significantly modified products.
No homogeneity. Absence of a large volume of relatively homogenous transactions.
Return duration. Long periods in which a product may be returned.

In addition, the SEC has developed a list of factors that may preclude a company from developing a reliable estimate of product returns, which are:

Channel stuffing. Excessive levels of inventory in a distribution channel.
Competing products. Newly-introduced competing products having either superior technology or an increased level of expected market acceptance.
Distributor dominance. A large proportion of the company’s business, sales and marketing with a particular distributor.
New product. A new product for which there is no historical return information.
Obsolescence. New product introductions that will increase the amount of returns of current products.
Sales visibility. Lack of visibility into the inventory levels in a distribution channel or the amount of sales to end users.
Other. Other factors affecting market demand and trends in that demand for the company’s products.

If a sales transaction cannot meet all of the above conditions, a company cannot recognize any of the revenue associated with the transaction until either the conditions have been met or the return privilege has substantially expired, whichever occurs first. The SEC does not feel that creating a reserve for product returns based on the maximum possible amount of returns is an acceptable alternative method.