Under Generally Accepted Accounting Principles, 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.
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.