Rights of return

An entity might transfer control of a product to a customer and also grant the customer the right to return the product. A right of return often entitles a customer to a full or partial refund of the amount paid or a credit against other purchases, or to exchange one product for another.

A right of return is not a separate performance obligation, but it affects the estimated transaction price for transferred goods. Revenue is only recognized for those goods that are not expected to be returned.

The estimate of expected returns should be calculated in the same way as other variable considerations. The estimate should reflect the amount that the entity expects to repay or credit to customers, using either the expected value method or the most likely amount method, whichever management determines will better predict the amount of consideration to which it will be entitled. The transaction price should include amounts subject to return only if it is highly probable that there will not be a significant reversal of cumulative revenue if the estimate of expected returns changes.

Right of return Return privileges can manifest in various forms within contracts, encompassing rights such as the ability to return products for any reason, in case they become obsolete, or as part of trade-in agreements for newer products. Sometimes, these privileges are implicit rather than explicitly stated in the contract. Implicit rights may arise from assurances made to customers during the sales process, legal requirements, or customary business practices. These practices typically aim to address both buyer concerns, such as dissatisfaction or technological obsolescence, and seller priorities, including ensuring customer contentment and mitigating risks associated with product distribution. For instance, a producer distributing products through a network of distributors might allow returns within 120 days of the distributor obtaining control of the products. Beyond this period, neither the producer nor the distributors hold further return rights. However, uncertainties may arise, particularly regarding return levels, especially when introducing a new product into the distributor network. Question How should the producer recognise revenue in this arrangement? Answer The producer must evaluate whether there is a likelihood of a significant reversal of cumulative revenue due to changes in return estimates, based on historical data and other pertinent evidence. This assessment involves determining a threshold level of sales where it’s highly probable that no substantial revenue reversal will occur, necessitating revenue recognition for those sales. For instance, if the producer initially estimates that 70% of sales can be included in the transaction price without significant revenue reversals, revenue would be recorded for that proportion. It’s crucial for the producer to continually reassess its anticipated return rates at the end of each reporting period to ensure accurate revenue recognition.

When products are sold with a right of return (or services are provided with a right to a refund), the entity will recognize revenue at the amount of consideration to which the entity expects to be entitled. Revenue would not be recognized for products that the entity expects to be returned or services refunded. The entity should raise a refund liability and an asset (with a corresponding adjustment to the cost of sales) representing its right to recover the products from the customer.

Restocking fee When customers return a product, entities may impose a “restocking fee” to cover various expenses incurred, such as shipping, quality control, and repackaging costs. Sometimes, these fees also serve to deter returns or compensate for the reduced selling price of returned items. Treating a sale with a restocking fee is akin to handling a partial return right and should be accounted for similarly. For items expected to be returned, the entity’s estimated refund liability equals the consideration paid for the goods minus the restocking fee. Consequently, the restocking fee should be factored into the transaction price and recognized when control of the goods transfers to the customer. An asset is then recorded for the entity’s entitlement to recover the goods upon settling the refund liability. Additionally, the entity’s anticipated restocking expenses should be recognized as a deduction from the asset’s carrying amount, reflecting the costs associated with recovering the goods.

The refund liability represents the amount of consideration that the entity expects to refund to customers. The refund liability is remeasured at each reporting date to reflect changes in the estimate of returns, with a corresponding adjustment to revenue.

The asset represents the entity’s right to receive goods (inventory) back from the customer when it settles the refund obligation. The asset is initially measured at the carrying amount of the goods at the time of sale, less any expected costs to recover the goods and any expected reduction in value. The returns asset is presented separately from the refund liability. The amount recorded as an asset should be updated for changes in the refund liability and for other changes in circumstances that might suggest an impairment of the asset.

Refund obligation and returns asset Entity Q sells 1,000 video games to a distributor at a price of C50 per game. The distributor is entitled to return the video games within 180 days of purchase for a full refund, regardless of the reason. The cost of producing each game is C10. Using the expected value method, Entity Q estimates that 6% of the video game sales will be returned, and it is highly likely that returns will not exceed this percentage. Upon transferring control of the video games, Entity Q has no additional obligations. Question How should entity Q record this transaction? Answer Entity Q should recognize revenue of C47,000 (C50 × 940 games) and cost of sales of C9,400 (C10 × 940 games) when control of the games transfers to the distributor. Additionally, Entity Q should recognize an asset of C600 (C10 × 60 games) for expected returns and a liability of C3,000 (6% of the sales price) for the refund obligation. The returns asset will be presented and assessed for impairment separately from the refund liability. Entity Q will need to evaluate the returns asset for impairment and adjust its value if impairment occurs.

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Could the asset be immediately impaired if the entity expects that the returned goods will have diminished or no value at the time of return? Sometimes, the asset could be immediately impaired if the entity anticipates that the returned goods will have diminished or no value upon return. This situation may arise in industries like pharmaceuticals when products are expected to have expired by the time of return.

Exchange rights

No adjustment to the transaction price is made for exchange rights where a customer can exchange one product for another of the same type, quality, condition, and price. A right to exchange an item that does not function as intended for one that is functioning properly is a warranty and not a right of return.

Warranties

Entities often provide customers with a warranty in connection with the sale of a good or service. The nature of a warranty can vary across entities, industries, products, or contracts. Warranties might be written in the contract, or they might be implicit as a result of either customary business practices or legal requirements.

Compensation and warranty Terms that stipulate cash payments to the customer, like liquidated damages for breaching the contract terms, are typically treated as variable consideration rather than warranties. However, cash payments to customers may be classified as warranties in specific cases, such as direct reimbursements to cover costs paid by the customer to a third party for repairing a product.

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Decision tree to account for warranty obligations

A warranty that a customer can purchase separately from the related good or service (that is, it is priced or negotiated separately) is a separate performance obligation. The fact that it is sold separately indicates that a service is being provided beyond ensuring that the product will function as intended. Revenue allocated to the warranty is recognized over the warranty period.

Warranties that cannot be purchased separately should be assessed to determine whether the warranty provides a service that should be accounted for as a separate performance obligation. Warranties that assure that a product will function as expected and by certain specifications are not separate performance obligations. The warranty is intended to safeguard the customer against existing defects and does not provide any incremental service to the customer. Costs incurred to either repair or replace the product are additional costs of providing the initial good or service. These warranties are accounted for by other guidance (IAS 37) if the customer does not have the option to purchase the warranty separately. The estimated costs are recorded as a liability when the entity transfers the product to the customer.

Is the right to return a defective product in exchange for cash or credit accounted for as an assurance-type warranty or a right of return? A return made in exchange for cash or credit is typically treated as a right of return. However, if customers are provided with the choice to return a defective item for cash, credit, or a replacement product, management needs to estimate the anticipated returns for cash or credit as part of its handling of estimated returns. Returns exchanged for a replacement product are addressed under the warranty provisions.

Other warranties provide a customer with a service in addition to the assurance that the product will function as expected. The service provides a level of protection beyond defects that existed at the time of sale. Judgment will often be required to determine whether a warranty provides assurance or an additional service. The additional service provided in a warranty is accounted for as a promised service in the contract and therefore a separate performance obligation, assuming the service is distinct from other goods and services in the contract.

An entity that cannot reasonably account for a service element of a warranty separate from the assurance element should account for both together as a single performance obligation that provides a service to the customer.

Assessing whether a warranty is a performance obligation Entity R enters into a contract with a customer to sell a smart phone and provide a one-year warranty against both manufacturing defects and customerinflicted damages (for example, dropping the phone into water). The warranty cannot be purchased separately. Question How should entity R account for the warranty? Answer This arrangement involves several components: (1) the smart phone itself; (2) a product warranty covering manufacturing defects; and (3) a repair and replacement service for damages inflicted by the customer. Entity R would address the product warranty according to existing guidance on warranties, recognizing both an expense and a liability for anticipated repair or replacement expenses. For the repair and replacement service, delineated as protection against customer-inflicted damages, Entity R would treat it as a distinct performance obligation, acknowledging revenue as it fulfills this obligation. In cases where Entity R cannot feasibly distinguish between the product warranty and the repair and replacement service, they would amalgamate the two warranties into a single performance obligation.

An entity should consider the following factors when assessing whether a warranty that is not sold separately provides a service that should be accounted for as a separate performance obligation:

1. Whether the warranty is required by law. In that case, the existence of that law indicates that the promised warranty is not a performance obligation. This is because such requirements typically exist to protect customers from the risk of purchasing defective products.
2. The length of the warranty coverage period. The longer the coverage period, the more likely it is that the promised warranty is a performance obligation.
3. The nature of the tasks that the entity promises to perform. If an entity must perform specified tasks to assure that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), those tasks are unlikely to give rise to a performance obligation.

Should repairs provided outside of the contractual warranty period be accounted for as a separate performance obligation? The determination hinges on the nature of the services rendered. Management must evaluate whether these services represent an independent performance obligation or merely an implicit assurance-type warranty surpassing the contractual warranty duration.

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Over what period should estimated warranty costs be accrued when control of equipment transfers over time? The manufacturer furnishes customised equipment where control shifts to the customer gradually. Additionally, the manufacturer offers a one-year warranty on the equipment, commencing upon delivery to the customer. Question Should the manufacturer accrue the estimated warranty costs over the construction period or at the point in time it delivers the equipment to the customer? Answer The manufacturer should generally accrue the estimated warranty costs over the construction period, consistent with the transfer of control of the equipment to the customer.

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Accounting for the lapse of warrants An instance exempt from IFRS 15’s scope involves when an entity issues warrants, options on its own shares, for cash. These warrants qualify as equity instruments per IAS 32, and thus, the funds received upon issuance were credited to equity. If the warrants expire without being exercised, no revenue recognition occurs. According to the Conceptual Framework for Financial Reporting, income, including revenue and gains, excludes contributions from equity holders. The issuance of warrants represents a transaction with equity holders. Even if an equity holder forfeits their claim on the entity’s assets, the equity contribution doesn’t convert into income. Instead, amounts related to warrants classified as equity instruments may be transferred to another equity account, like contributed surplus, upon expiration.

Non-refundable upfront fees

An entity might charge customers a fee at or near the inception of a contract. These upfront fees are often non-refundable and could be labelled as fees for set-labeledss, activation, initiation, joining or membership.

An entity, needs to analyze each arrangement involving upfront fees to determine whether the fee relates to the transfer of a promised good or service. It should not rrecognizerevenue upon receipt of an upfront fee, even if it is non-refundable if the fee does not relate to the satisfaction of a performance obligation. The non-refundable fee is an advance payment for future goods or services and should be included in the transaction price and allocated to the separate performance obligations identified in the contract. It is recognized as revenue as the performance obligations are satisfied.

Upfront fee allocated to separate performance obligations Entity S engages in a contract with entity T for the licensing and development of a drug compound. The terms entail Entity S to conduct research and development (R&D) services aimed at obtaining regulatory approval for the drug compound. In exchange, Entity S receives an initial payment of C50 million, along with fees for the R&D services and milestone-based payments upon achieving predetermined milestones. Entity S determines that the agreement consists of two distinct performance obligations: (1) the license of the intellectual property; and (2) the provision of R&D services. No other obligations are present within the agreement. Question How should entity S allocate the consideration in the arrangement, including the C50 million upfront fee? Answer At the onset of the contract, Entity S is tasked with ascertaining the transaction price, incorporating both fixed and variable components. The fixed consideration encompasses the upfront fee, while the variable consideration comprises the R&D service fees and milestone-based payments, which are estimated according to applicable principles. Upon determining the overall transaction price, Entity S proceeds to allocate this amount between the two performance obligations outlined in the agreement.

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How to account for layaway sales and gift cards? Layaway sales Layaway sales, also known as “will call” transactions, involve the seller setting aside merchandise upon receiving a cash deposit from the customer. While a time frame may be specified for finalizing the purchase, there’s typically no fixed payment commitment. The merchandise is released to the customer once the full purchase price is paid, with the cash deposit and subsequent payments forfeited if the customer fails to complete the payment. The seller must refund the cash paid if the merchandise is lost, damaged, or destroyed before control transfers to the customer. Determining the existence of a contract in a layaway arrangement is crucial. In a typical scenario, a contract might not exist initially as the customer hasn’t committed to fulfilling their obligation (i.e., paying the full purchase price). Revenue recognition for such arrangements should occur only when contract criteria are met or specified events take place. Some layaway sales could resemble credit sales if the customer’s commitment to the purchase is evident and a contract exists. In such cases, determining when control of the goods transfers to the customer is essential. An entity likely retains control of goods if they can use the selected items to fulfill other customer orders and replace them with similar goods during the layaway period. Management should apply bill-and-hold criteria to ascertain the transfer of goods’ control. Regarding gift cards, revenue isn’t recognized at the time of sale since the performance obligation is to provide goods or services when the card is redeemed in the future. The payment for the gift card represents upfront payment for future goods or services. Revenue is recognized upon card redemption when the goods or services are transferred to the customer. Often, some gift card balances remain unredeemed. In such cases, revenue should be recognized proportionately as other gift card balances are redeemed. However, revenue shouldn’t be recognized for consideration received if it’s required to be remitted to a governmental entity and the customer never demands performance.

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IFRS IC agenda decision on listing fees received by a stock exchange In January 2019, the IFRS Interpretations Committee (IFRS IC) issued an agenda decision concerning listing services offered by stock exchanges. Typically, when a stock exchange enters into a contract with a customer for listing, the customer often pays a non-refundable upfront fee. Various tasks, such as reviewing listing applications and processing the listing and admission to the market, need completion by the stock exchange before the customer’s listing. The agenda decision clarified that when an entity charges a customer a non-refundable upfront fee, it should evaluate whether activities performed by the entity at or near contract inception are merely tasks to establish a contract. The conclusion drawn in the agenda decision is that the performance of such activities does not constitute the transfer of a service to the customer. This aligns with the principle outlined in IFRS 15, emphasizing that revenue isn’t recognized when activities undertaken by an entity do not result in the transfer of a good or service to a customer. This includes activities necessary for contract setup or the decision-making process regarding customer acceptance. Furthermore, the agenda decision highlights that the listing service provided to the customer remains the same both at the initial listing and throughout all subsequent listing periods. As a result, the upfront fee is likely to be recognized as revenue over the estimated listing period.

Entities sometimes perform set-up or mobilization activities at or near contract inception to be able to fulfill the obligations in the contract. These activities could involve system preparation, hiring of additional personnel, or mobilization of assets to where the service will take place. Non-refundable fees charged at the inception of an arrangement are often intended to compensate the entity for the cost of these activities. Set-up or mobilization efforts might be critical to the contract, but they typically do not satisfy performance obligations, as no good or service is transferred to the customer. They are disregarded in the measure of progress for performance obligations satisfied over time if they do not depict the transfer of services to the customer. Management should consider whether such costs might be capitalized as fulfillment costs.

Accounting for upfront fees when a renewal option exists

Contracts that include an upfront fee and a renewal option often do not require a customer to pay another upfront fee when the customer renews the contract. The renewal option in such a contract might provide the customer with a material right, as discussed. The revenue recognition period for upfront fees, in arrangements where the customer receives a renewal option, might extend beyond the initial contractual period.

How to determine the appropriate amount to allocate to the material right? An entity offering a customer a material right must ascertain its stand-alone selling price and assign a portion of the transaction price to that right, treating it as a distinct performance obligation. Alternatively, transactions meeting specific criteria may opt for the practical alternative for contract renewals, estimating the total transaction price based on expected renewals. Management’s evaluation of whether an upfront fee provides a material right in the presence of a renewal option should encompass both quantitative and qualitative considerations. For instance, assessing the disparity between the renewal fee paid by the customer and the price a new customer would pay for the same service is crucial. Additionally, an average customer lifespan extending beyond the initial contract period might signal that the upfront fee serves as an incentive for customers to renew the contract. Activity Entity U, which runs health clubs, engages in contracts with customers offering one-year access to any of its facilities. The entity levies an annual membership fee of C60 along with a non-refundable joining fee of C150. This joining fee serves, at least in part, to compensate for the initial activities involved in registering the customer. Customers have the option to renew the contract annually, with the annual membership fee of C60 being the only charge, excluding the joining fee. However, if customers allow their membership to expire, they must pay a new joining fee Question Should entity U account for the non-refundable joining fees? Answer The customer obtains a material right by not having to pay the joining fee upon renewal of the contract, representing the ability to renew the annual membership at a lower cost compared to newly joining customers. This right is factored into the transaction price and allocated to distinct performance obligations within the agreement: providing access to health clubs and the option to renew the contract, considering their individual stand-alone selling prices. Entity U’s registration activity doesn’t constitute a service to the customer and thus doesn’t fulfill a performance obligation. The portion attributed to club access is recognized over the initial year, while the renewal right’s portion is acknowledged upon exercise or expiration. As an alternative, Entity U may allocate the transaction price to the renewal right based on anticipated future services and corresponding consideration. For instance, if Entity U foresees a customer renewing for two additional years, total consideration would be C330 (C150 joining fee and C180 annual membership fees), recognized as revenue over the three years of service provision. Refer to paragraph 11.205 onwards for a deeper examination of this practical alternative and customer options.

Bill-and-hold arrangements

Bill-and-hold arrangements arise when a customer is billed for goods that are ready for delivery, but the entity does not ship the goods to the customer until a later date.

Entities should assess whether control has transferred to the customer, even though the customer does not have physical possession of the goods. Additional criteria have to be met for a customer to have obtained control of the product in addition to the criteria related to determining when control transfers in other situations. For a customer to have obtained control of a product in a bill and-hold arrangement, the following criteria should be met:

1. the bill-and-hold arrangement should have substance;
2. the product should be identified separately as belonging to the customer;
3. the product currently should be ready for physical transfer to the customer; and
4. the entity cannot have the ability to use the product or to direct it to another customer.

What do the bill-and-hold criteria mean? For a bill-and-hold arrangement to be deemed substantive, it must serve a valid purpose. This could manifest if, for instance, the customer requires the arrangement due to limited physical storage space or if previously ordered goods aren’t immediately necessary due to the customer’s production schedule. Crucially, the goods must be clearly earmarked for the customer and cannot be diverted to fulfill orders for other clients. If substitutions occur, indicating lack of control by the customer, revenue recognition should be deferred until delivery or satisfaction of the agreed criterion. Additionally, the goods must be prepared for delivery upon the customer’s request. If the customer can redirect or dictate the use of the goods or derive benefits from them, control is likely transferred to the customer. Conversely, restrictions on the use of the goods or limitations on the benefits signal that control may not have been relinquished to the customer.

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Bill-and-hold arrangement: Industrial products industry Entity V’s request for a bill-and-hold arrangement with Entity W stems from the volatile nature of timelines associated with developing remote gas fields and the lengthy lead times required for drilling equipment and supplies. This arrangement is not unusual, given Entity W’s history of such transactions with Entity V and the established standard terms for such agreements. The drilling pipe, housed separately by Entity W, is fully assembled and prepared for shipment. Importantly, once the pipe is in the warehouse, Entity W cannot repurpose it or direct it to another customer. Per the agreement terms, Entity V is obligated to settle payment within 30 days of the pipe’s placement in Entity W’s warehouse. Entity V will take possession of the pipe when required. Question When should entity W recognise revenue? Answer Entity W should recognize revenue once the drilling pipe is placed into its warehouse since control of the pipe has effectively transferred to Entity V. This conclusion is warranted for several reasons: Firstly, Entity V’s specific request for a bill-and-hold arrangement implies a substantive reason for such an arrangement, indicating the transfer of control. Secondly, Entity W is restricted from utilizing the pipe for fulfilling orders from other customers, further supporting the transfer of control to Entity V. Lastly, the pipe is fully prepared for immediate shipment upon Entity V’s request, reinforcing the notion that control has indeed passed to Entity V. Moreover, Entity W should assess whether a portion of the transaction price ought to be allocated to custodial services, as this could potentially constitute a separate performance obligation.

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Bill-and-hold arrangement: Retail and consumer industry Entity X should not recognize revenue for the 100,000 video game consoles specified in the contract with the retailer by the end of 20X6, as they have not been delivered yet. Despite having the consoles readily available in its inventory, revenue recognition is contingent upon delivery to the retailer, which is scheduled for 20X7. It’s important to note that as of 31 December 20X6, Entity X has 120,000 game consoles in total, including the 100,000 designated for the retailer. While all 120,000 units are stored together and are interchangeable, Entity X has committed not to reduce its inventory below 100,000 units. Question When should entity X recognise revenue for the 100,000 units to be delivered to the retailer? Answer Entity X should delay revenue recognition until the bill-and-hold criteria are satisfied, or until Entity X no longer has physical possession of the game consoles and all other criteria regarding the transfer of control have been fulfilled. While the substantive reason for the bill-and-hold transaction is valid (lack of shelf space), the other criteria for recognizing revenue are not met because the game consoles designated for the retailer have not been segregated from other products.

Where an entity has transferred control of the goods and met the bill-and-hold criteria to recognize revenue it should consider whether it is providing custodial services in addition to providing the goods. If so, a portion of the transaction price should be allocated to each of the separate performance obligations (that is, the goods and the custodial service).

Government vaccine stockpile programs Vaccine manufacturers may engage in government vaccine stockpile programs where they hold vaccine inventory for future use by the government. The transfer of control should be evaluated based on the bill-and-hold criteria outlined in the standard. This assessment involves considerations such as whether the stockpile inventory is clearly identified as belonging to the customer and any requirements to rotate the inventory. Additionally, management must assess whether the government has return rights and if there are other obligations within the arrangement, such as storage, maintenance, and shipping of vaccines. For SEC reporters, the SEC’s interpretative release applies, stating that revenue recognition and appropriate disclosures should occur when vaccines are placed into US government stockpile programs. This is because control of the vaccines transfers to the customer (the government), and the criteria for recognizing revenue in a bill-and-hold arrangement are met. However, this interpretation specifically applies to childhood disease vaccines, influenza vaccines, and other vaccines and countermeasures sold to the US government for inclusion in the Strategic National Stockpile.

Consignment arrangements

Some entities ship goods to another party (such as a dealer or distributor) but retain control of the goods until a predetermined event occurs. These are known as consignment arrangements. Revenue is not recognized upon delivery of a product if the product is held on consignment. A consignment sale differs from a sale with a right of return or put right. The customer has control of the goods in a sale with a right of return and can decide whether to put the goods back to the seller.

Management should consider the following indicators to evaluate whether an arrangement is a consignment arrangement:

1. the product is controlled by the entity until a specified event occurs (such as the sale of the product to a customer of the dealer, or until a specified period expires);
2. the entity can require the return of the product or the transfer of the product to a third party (such as another dealer); or
3. the dealer does not have an unconditional obligation to pay for the product.

Retail and consumer industry In this consignment arrangement between a manufacturer and a retailer, the retailer does not assume title to the products until they are scanned at the register during a sale to a consumer. The retailer is not obligated to pay the manufacturer until the products are sold to the consumer, except in cases where the goods are lost or damaged while in the retailer’s possession. Unsold products, excluding those lost or damaged, can be returned to the manufacturer, and the manufacturer retains the discretion to recall products or transfer them to another customer Question When should the manufacturer recognise revenue? Answer The manufacturer should recognize revenue at the point when control of the products transfers to the retailer. Control is not deemed to have transferred if the manufacturer retains the ability to require the return or transfer of those products. Revenue recognition should occur when the products are sold to the consumer or if they are lost or damaged while in the possession of the retailer.

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Industrial products industry Entity Y should recognize revenue for the cold-rolled steel coils when control transfers to the manufacturer. Control is typically transferred upon shipment when title is passed to the manufacturer. Therefore, revenue recognition would occur at the time of shipment. However, if there are specific indicators that control does not transfer until the coils are consumed by the manufacturer, revenue recognition would be deferred until that point. Additionally, any unused products that are returned should be treated as inventory returns rather than revenue reversals. Question When should entity Y recognise revenue? Answer Entity Y should recognize revenue when the coils are used by the manufacturer. Although title transfers when the coils are shipped, control of the coils has not transferred to the manufacturer because Entity Y can demand the return of any unused product. Control of the steel would transfer to the manufacturer upon shipment if Entity Y did not retain the right to demand the return of the inventory, even if the manufacturer had the right to return the product. However, Entity Y needs to assess the likelihood of the steel being returned and might need to recognize a refund liability in that case.

Repurchase rights

Repurchase rights are an obligation or right to repurchase a good after it is sold to a customer. Repurchase rights could be included within the sales contract, or in a separate arrangement with the customer. The repurchased good could be the same asset, a substantially similar asset, or a new asset of which the originally purchased asset is a component.

Other arrangements that are not repurchase rights In certain arrangements, there might not be a repurchase right, but instead, a guarantee exists in the form of a payment to the customer for any deficiency between the resale amount of the product and a guaranteed resale value. Unlike repurchase rights, this scenario doesn’t involve the entity reacquiring control of the asset. Therefore, the guidance on repurchase rights doesn’t apply. Instead, the guarantee payment should be accounted for following the relevant guidance on guarantees.

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Repurchase rights: call option accounted for as a lease Entity Z sells machinery to a manufacturer for C200,000. The arrangement includes a call option that gives entity Z the right to repurchase the machinery in five years for C150,000. Question Should entity Z account for this transaction as a lease or a financing transaction? Answer Entity Z should treat the arrangement as a lease. The presence of a five-year call period suggests that the customer is restricted in its capacity to control the use of the machinery or to derive most of the remaining benefits from it. Since Entity Z retains the option to repurchase the machinery for a sum lower than its initial selling price, the transaction qualifies as a lease. Accordingly, Entity Z would apply the leasing guidance in its accounting treatment of the arrangement.

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Conditional call rights Conditional call rights, which are not unilaterally exercisable by the seller but depend on specific conditions, require careful assessment in terms of their impact on revenue recognition. While the revenue standard lacks explicit guidance on evaluating such features, judgment is necessary to determine their effect on the transfer of control to the customer. The likelihood of the entity exercising an active call right should not sway this assessment. However, certain conditional call rights may not hinder control transfer. For instance, if the call right only becomes active due to factors beyond the entity’s control, it may indicate control transfer despite the conditional call right’s existence. To evaluate whether a conditional call right affects control transfer, management should consider factors like the nature and likelihood of the conditions being met, as well as whether they depend on the seller’s or customer’s control.

There are three forms of repurchase rights:

• A seller’s obligation to repurchase the good (a forward).
• A seller’s right to repurchase the good (a call option).
• A customer’s right to require the seller to repurchase the good (a put option).

An arrangement to repurchase a good that is negotiated between the parties after transferring control of that good to a customer is not a repurchase agreement. The customer is not obligated to resell the goods to the entity as part of the initial contract. The subsequent decision to repurchase the item does not affect the customer’s ability to direct the use of or obtain the benefits of, the good.

Example Repurchase agreements (1) An entity enters into a contract with a customer for the sale of a tangible asset on 1 January 20X7 for CU1 million. Case A – Call option: financing In Case A, where the contract includes a call option for the sale of a tangible asset, control does not transfer to the customer initially due to the entity’s right to repurchase the asset. Consequently, the arrangement is treated as a financing transaction under IFRS 15. The entity does not derecognize the asset but recognizes the cash received as a financial liability,  Interest expense is recognized over time, reflecting the difference between the exercise price and the cash received, thus increasing the liability. If the option lapses unexercised, as in this case on 31 December 20X7, the liability is derecognized, and revenue of CU1.1 million is recognized.

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Sales with a right of refusal retained by the vendor In sales contracts, vendors sometimes include a provision known as a “right of first refusal.” This clause allows the original vendor to repurchase the asset if the customer receives a genuine offer from a third party in the future and intends to accept it. If exercised, the vendor matches the offer made by the third party.. According to , if a company holds an obligation or a right to repurchase the asset (such as a forward or call option), the customer doesn’t gain control of the asset. This is because the customer’s ability to direct the asset’s use and derive most of its remaining benefits is limited, despite having physical possession. Therefore, if a vendor maintains a right of first refusal, it wouldn’t, by itself, hinder the customer from attaining control of the asset.In the scenario outlined, a right of first refusal permits the vendor to impact whom the customer later sells the asset to, but not the timing, conditions, or terms of such a sale. Consequently, the vendor’s right doesn’t restrict the customer’s capacity to control the asset’s use or acquire most of its remaining benefits.

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Vendor has an obligation to take back or a right to recall a product after a specified date In certain contracts, like those involving perishable goods, the vendor may have the option or obligation to retrieve (and sometimes replace) products if they remain unsold or unconsumed by a specified date. For instance, a pharmaceutical company might need to reclaim unsold drugs for safety reasons, or a fresh produce supplier might reclaim produce to maintain customer loyalty to their brand by ensuring freshness. However, this right doesn’t give the vendor an unconditional ability to repurchase the products at any time; rather, it’s a safeguard to reclaim them after a set date if they remain unsold. If a vendor has such an option or obligation, the customer doesn’t fully control the asset, despite having physical possession of it. In this scenario, until the specified date, the customer is free to use, sell, or consume the product as they see fit. Even if the vendor replaces products after the specified date, the situation remains the same, as the replacement products may not be identical to those returned. Therefore, regardless of whether refunds or replacements are involved, the vendor must account for the right or obligation to reclaim products as a sale with a right of return, as outlined in IFRS 15.

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Sales of commodities with a repurchase agreement over that commodity at its prevailing market price at the date of repurchase When an entity sells an asset but retains an obligation or right to repurchase it (a forward or call option), IFRS 15 specifies that the customer doesn’t gain full control of the asset because their ability to direct its use and obtain most benefits from it is limited, despite having physical possession. In such cases, the contract is accounted for either as a lease (if the repurchase price is less than the original selling price) or as a financing arrangement (if the repurchase price equals or exceeds the original selling price). However, IFRS 15 doesn’t explicitly address the accounting treatment when the repurchase occurs at market price, which could be above or below the original selling price. According to IFRS 15, the repurchased asset can be the original asset, one substantially similar, or another asset where the original asset is a component. The guidance doesn’t necessarily prohibit treating such transactions as sales, especially when an entity sells a quantity of a commodity to a customer but retains the obligation or right to repurchase an equivalent amount at the prevailing market price. The statement in IFRS 15, in the context of a forward or call option, that control has not passed “because the customer is limited in its ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset” suggests that the requirements of that paragraph are based upon the existence of such a limitation. Similarly, IFRS 15 refers to the boards’ decision to require this accounting ‘if an entity enters into a contract with a repurchase agreement and the customer does not obtain control of the asset‘ (emphasis added). As acknowledged in IFRS 15, in circumstances in which substantially the same asset is readily available in the marketplace (which may be the case for a commodity), an agreement to repurchase at the prevailing market price may not constrain the customer’s ability to direct the use of, and obtain substantially all the benefits from, an asset. Accordingly, it’s crucial to assess whether the seller’s obligation or right to repurchase restricts the customer’s ability in such a manner. This determination hinges on a thorough examination of the specific facts and circumstances. If the customer’s capacity to direct the use of the asset and derive most of its benefits is in any way constrained (for instance, by a condition mandating any subsequent sale to include a call option for repurchase), the contract should not be treated as a sale. Instead, it should be accounted for based on its inherent nature (e.g., as a lease or financing arrangement). Additionally, any other elements in the contract, such as payment for transportation, should be separately recognized. If there is compelling evidence that the customer faces no limitations in directing the use of the asset and obtaining most of its benefits, indicating clear transfer of control to the customer, the contract should be recognized as a sale under IFRS 15. Before confirming the recognition of a sale, a thorough evaluation of the arrangement’s terms and other pertinent facts against the indicators outlined in IFRS 15 is necessary, including considerations of legal title and physical possession of the assets. Specifically, for the customer to genuinely acquire control of the commodity, it must be feasible for the customer to easily procure equivalent commodity assets at the appropriate time and location to fulfill the requirements of the forward or call option. Moreover, the price paid must be demonstrably comparable to the prevailing market price at the settlement date, ensuring the customer genuinely enjoys most economic benefits of the commodity. If the repurchase agreement mandates delivery in a location devoid of alternative commodity sources, the customer might be compelled to merely return the same commodity to the entity. In such cases, the customer wouldn’t have effectively obtained control of the asset.

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Sales which include a contingent call option The presence of a right to repurchase an asset typically prevents a customer from gaining control of the asset and thus prevents the entity from recognizing revenue from the sale. This is because the customer’s ability to direct the asset’s use and obtain most benefits from it is limited. In the case of a contingent repurchase option, it’s crucial to assess whether the contingency tied to the call option restricts the customer’s ability to control the asset. When determining the impact of a contingent call option on the customer’s control, it’s essential to consider whether the contingency’s triggering is within the entity’s or the customer’s control. Repurchase options contingent on factors controlled by the entity generally indicate that the customer hasn’t gained control of the asset. In such instances, the contract should be treated as a lease or financing arrangement, aligning with IFRS 15:B66 guidance. Conversely, contingent repurchase options dependent on factors within the customer’s control suggest the customer can decide whether to exercise the call option. For example, if the entity can repurchase an asset only if the customer terminates the contract for convenience (without the entity’s right to terminate), the call option’s trigger lies within the customer’s control. In such cases, the entity might reasonably conclude that the customer has control of the asset despite the contingent call option.

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Example Repurchase agreements (2) An entity enters into a contract with a customer for the sale of a tangible asset on 1 January 20X7 for CU1 million. Case B – Put option: lease In this scenario, the contract includes a put option obliging the entity to repurchase the asset at the customer’s request for CU900,000, while the market value is expected to be CU750,000 on the specified date. The entity must assess whether the customer has a significant economic incentive to exercise the put option to determine the asset transfer’s accounting treatment. Upon evaluation, the entity determines that the customer indeed possesses a significant economic incentive to exercise the put option, given that the repurchase price significantly exceeds the expected market value of the asset at the repurchase date. No other relevant factors affect this assessment. As a result, the entity concludes that control of the asset does not transfer to the customer. This determination stems from the customer’s limited ability to direct the asset’s use and obtain most of its remaining benefits. In accordance with IFRS 15:B70 to B71, the entity accounts for the transaction as a lease in accordance with IFRS 16 Leases (or, for an entity that has not yet adopted IFRS 16, IAS 17).

1. Forwards and call options

An entity that transfers a good and retains a substantive forward repurchase obligation or call option (that is, a repurchase right) should not recognize revenue when the good is initially transferred to the customer, because the repurchase right limits the customer’s ability to control the good. While some such provisions might be deemed to lack substance based on specific facts and circumstances, in general a negotiated contract te,rm is presumed to be substantive.

The accounting for an arrangement with a forward or a call option depends on the amount that the entity can or is required to pay to repurchase the good. The likelihood of exercise is not considered in this assessment. The arrangement is accounted for as either of the following:

1. a lease, if the repurchase price is less than the original sales price of the asset, and upon adoption of IFRS 16, the arrangement is not part of a sale-leaseback transaction (in which case, the entity is the lessor); or
2. a financing arrangement, if the repurchase price is equal to or more than the original sales price of that good (in which case, the customer is providing financing to the entity).

For the analysis, the comparison of the repurchase price to the original sales price of the good should include the effect of the time value of money, including contracts with terms of less than one year.

An entity that enters into a financing arrangement continues to recognize the transferred asset and recognizes a financial liability for the consideration received from the customer. The entity recognizes any amounts that it will pay upon repurchase over what it initially received as interest expense over the period between the initial agreement and the subsequent repurchase. Processing or holding costs might need to be deducted in some situations. The entity de-recognises the liabilide-recognizesises revenue if it does not exercise a call option so that it expires. Example 62 (Case A) of the revenue standard illustrates a similar scenario.

2. Put options

A put option allows a customer, at its discretion, to require the entity to repurchase a good and indicates that the customer has control over that good. The customer has the choice of retaining the item, selling it to a third party, or selling it back to the entity.

The accounting for an arrangement with a put option depends on the amount that the entity is required to pay when the customer exercises the put option, and whether the customer has a significant economic incentive to exercise its right. An entity accounts for a put option as:

• a financing arrangement, if the repurchase price is equal to or more than the original sales price and more than the expected market value of the asset (in which case, the customer is providing financing to the entity);
• a lease, if the repurchase price is less than the original sales price and the customer has a significant economic incentive to exercise that right, and upon adoption of IFRS 16, the arrangement is not part of a sale-leaseback transaction (in which case, the entity is the lessor);
• a sale of a product with a right of return, if the repurchase price is less than the original sales price and the customer does not have a significant economic incentive to exercise its right; or
• a sale of a product with a right of return, if the repurchase price is equal to or more than the original sales price, but less than or equal to the expected market value of the asset, and the customer does not have a significant economic incentive to exercise its right.

Decision tree to be considered when accounting for put options

An entity that enters into a financing arrangement continues to recognize the transferred asset and recognizes a financial liability for the consideration received from the customer. The entity recognizes any amounts that it will pay upon repurchase over what it initially received as interest expense (over the term of the arrangement) and, in some situations, as processing or holding costs.

Similar to forwards and call options, the comparison of the repurchase price to the original sales price of the good should include the effect of the time value of money, including the effect on contracts whose term is less than one year. An entity de-recognizes the liability and recognizes revenue if the put option lapses are unexercised.

Significant economic incentive to exercise a put option

The accounting for certain put options requires management to assess at contract inception whether the customer has a significant economic incentive to exercise its right. A customer that has a significant economic incentive to exercise its right is effectively paying the entity for the right to use the good for some time (similar to a lease).

How should a trade-in credit be accounted for under IFRS 15? A trade-in credit, where a customer can trade in a purchased product for a credit against the purchase price of a new product, presents two potential interpretations: As a put option held by the customer: In this scenario, the seller has an obligation to repurchase the product at the customer’s request, contingent upon the customer purchasing a new asset. This resembles a put option under IFRS 15, where the entity would account for the obligation to repurchase. As a call option held by the customer: Here, the trade-in credit is seen as a call option that allows the customer to purchase a new product in exchange for consideration, which might include non-cash components. Under this view, IFRS 15 applies to call options, and the entity would need to assess whether the arrangement includes a material right. The accounting treatment differs significantly between these two interpretations and depends on whether the trade-in credit is treated as a put option or a call option, highlighting the importance of accurately assessing the nature of the arrangement. Question How should a trade-in right be accounted for under IFRS 15? Answer Determining whether the put option guidance or the material right guidance applies requires careful assessment of the transaction’s specifics. It necessitates judgment and a thorough understanding of the arrangement’s substance. The following factors may indicate the applicability of the put option guidance: If the entity also leases the same assets, discerning whether the trade-in credit promotes sales of the new asset or merely facilitates the return of the old one becomes crucial. Differentiating between the trade-in and leasing arrangements is essential, especially if the entity engages in leasing or selling second-hand assets for more than scrap value. The significance of the expected residual value of the used asset relative to the stand-alone selling price of the new asset is another key consideration. A substantial residual value suggests that the predominant right is the put option, as the entity is inclined to recover and sell the old asset in the secondary market. Conversely, an insignificant residual value might indicate that the customer’s predominant component is a call option to buy a new asset. If the customer faces restrictions in accessing the secondary market under the same conditions as the entity, the importance of the put option may be heightened. Limited access implies that the customer values the put option more, especially if there’s no alternative outlet for the old asset. Additionally, a volatile or illiquid secondary market may further underscore the significance of the put option. In essence, careful evaluation of these factors is essential to accurately determine whether the put option or material right guidance applies to the trade-in credit arrangement.

Management should consider various factors in its assessment, including the following:

• How the repurchase price compare to the expected market value of the good at the date of repurchase?
• The amount of time until the right expires.

Put option accounted for as a right of return In this scenario, Entity A sells machinery to a manufacturer with the provision that the manufacturer can demand repurchase after five years for C75,000. Despite the expected market value of the machinery exceeding this amount at the repurchase date, Entity A provides the put option due to the typical overhaul needed after five years. Entity A can refurbish and sell the equipment to a customer at a substantial margin, making the offer advantageous. Given that the time value of money doesn’t impact the conclusion, this arrangement underscores the strategic use of the put option to address future maintenance needs while ensuring a profitable refurbishment opportunity for Entity A Question Should entity A account for this transaction as a sale with a return right, a lease or a financing transaction? Answer Entity A should treat the transaction as the sale of a product with a right of return, given that the manufacturer lacks a substantial economic incentive to exercise its repurchase right. As the repurchase price is lower than the expected market value at the repurchase date, Entity A should adhere to the model discussed for rights of return when accounting for the transaction. This approach ensures consistency with the treatment of similar arrangements and accurately reflects the economic substance of the transaction.

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Put option accounted for as lease Entity A should classify this transaction as a lease in accordance with leasing guidance. The manufacturer’s option to require Entity A to repurchase the machinery functions as a put option, offering a significant economic incentive to exercise it. As the guaranteed repurchase price surpasses the anticipated market value at the repurchase date, lease accounting is appropriate, aligning with the principle that the repurchase price is lower than the initial selling price of the machinery.