Decoding the EAC opinion on Accounting for sales returns.

Background of the case:

• A company manufactures and sells readymade garments to franchisees across India
• Historical data shows 20-22% of sales are typically returned due to fashion trends
• Currently, the company records sales returns only when goods are physically received back
• Auditors objected to this practice suggesting returns should be estimated and accounted for based on past trends

Key Issue:

Whether the company should:

1. Continue current practice of recording returns only upon physical receipt, or
2. Create a provision for expected future returns based on historical trends

EAC Conclusion:

1. The company's current policy of recognizing sales returns only upon physical receipt is NOT correct.
2. Instead, the company should: Recognize a provision for expected sales returns. Base the provision on best estimates using past experience and relevant factors Include estimated losses and incremental costs for reselling returned goods. Adjust the provision for actual returns between balance sheet date and financial statement approval date and review and update the provision at each balance sheet date.

The EAC deemed this approach appropriate for financial statement preparation, aligning with AS 29 (Provisions, Contingent Liabilities and Contingent Assets) requirements.

Analysis under Ind AS framework:

The treatment would be somewhat different under Ind AS, primarily due to Ind AS 115 'Revenue from Contracts with Customers' which has specific guidance on rights of return.

Under Ind AS 115:

1. For sales with a right of return, an entity should recognize: Revenue for transferred products only to the extent that it's highly probable a significant reversal won't occur. A refund liability for expected returns. An asset (and corresponding adjustment to cost of sales) for the right to recover products from customers.
2. Key differences from the EAC opinion: Recognition of a 'right to recover' asset (not required under previous standards). More specific guidance on measuring the variable consideration. Focus on "highly probable" threshold for revenue recognition.
3. Measurement requirements: The refund liability should be updated at each reporting date. The asset for right to recover should be measured by reference to the former carrying amount less expected costs to recover.
4. Expected returns should be estimated using either: Expected value method (probability-weighted amounts) OR Most likely amount method.

In practice, for the company in question with 20-22% historical return rate would need to recognize:

• Revenue only for 78-80% of sales initially.
• A refund liability for the expected returns.
• A right to recover asset for the returned inventory.
• Regular reassessment of these estimates

So while the basic principle of providing for returns remains, Ind AS 115 provides more detailed guidance and requires more specific accounting entries compared to the earlier AS 9 framework discussed in the EAC opinion.

Implication under the Income Tax Act 1961

Under the Income Tax Act, 1961, the treatment of sales returns would be primarily governed by Section 145 along with relevant judicial precedents. The key aspects are:

Recognition of Revenue:

• Revenue must be recognized on accrual basis for tax purposes if company follows accrual system
• Sales are taxable in the year when they are made, even if there is a right of return attached

Treatment of Sales Returns:

• Returns received during the same financial year: Can be directly reduced from sales.
• Returns received in subsequent year: Can be claimed as deduction in the year in which returns are actually received.
• Cannot be claimed on provisional/estimated basis.
• Must be supported by actual returns and proper documentation

• The principle established is that provision for sales returns based on estimates is not an allowable deduction.
• Timing difference arises between books and tax treatment

Therefore, while accounting standards (Ind AS/AS) require provisioning for expected returns, for income tax purposes, only actual returns are considered for deduction in the year of return.

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