Setting an accounting and revenue recognition policy for Try Before You Buy items
One question we get from merchant partners is how to setup an accounting policy, including revenue recognition, for Try Before You Buy items. In this article, we'll share our opinion on a suitable way to account for Try Before You Buy sales (we follow this accounting method at Blackcart as well).
We do need to start with a disclaimer - consult with your accountant to determine an appropriate policy for your business. This article is intended as an illustration of one method of accounting that Blackcart has developed with our accounting team.
We'll discuss three topics that comprise a Try Before You Buy accounting policy.
- Revenue Recognition
- Returns Allowance
- Cost of Goods Sold (COGS)
Let's dive in!
1. Revenue Recognition
The concept of revenue recognition is straightforward - sell a product, get paid by the customer, record revenue in your accounting general ledger (GL). However, in practice, revenue recognition can become more complicated due to the dynamics of your business. Accounting standards, which apply to both private and public companies, direct companies to record revenue in the period it was realized and earned, not necessarily when cash was received from the customer. The most current standard in the US is named ASC 606 and applies across all businesses, regardless of industry.
There are 5 steps in determining the right time to record revenue, outlined in the linked article above. We'll discuss #2 'Identify contractual performance obligations' and #3 'Determine the amount of consideration/price for the transaction'.
What about Try Before You Before items?
Many retailers, both online and offline, have determined that the order shipment date is the appropriate time event when the 'performance obligation', sending your product to a customer, has been fulfilled. These retailers use the shipment date as the date when revenue is recognized. Other merchants have decided to use a different date, like the order submission date, as the marker for when the obligation has been fulfilled. Try Before You Buy items can be recognized in the same way as non-TBYB items, as the performance obligation is the same.
For retailers that sell products online, it's been our experience that most use the price of the sale as the 'amount of consideration/price for the transaction'. This would be inclusive of any discounts applied. Try Before You Buy item prices can be recognized in the same way as non-TBYB items, as the customer will be paying the full price for items kept at the end of the trial period. The effect of product returns are not considered in the price of the transaction; returns will be considered separately in the next section.
So far, the opinion is that Try Before You Buy item revenue can be recognized in the same manner as non-TBYB items.
If you want to see some examples of revenue recognition in the wild, many large retailers are publicly listed and you can see their revenue recognition policies described in their financial statements online.
2. Returns Allowance
Almost every business experiences product returns. For any particular customer transaction, it's difficult to guess whether a return will occur. But over a longer period of time, like a month, it becomes easier to estimate the average returns for the average order.
The idea of a returns allowance is to use the actual returns experience of the business to estimate the returns expense for each individual order at the time of revenue recognition. By including this estimated returns expense with each order at the time of recording revenue, the sum of the estimated returns expense across all orders in a period will reflect reality. Whether or not a return occurs on any particular order at a later date will not affect the estimated return expense at the time of the order.
The technical recording of the returns allowance is an increase to a returns expense account on the income statement and an increase in a returns allowance liability account on the balance sheet.
As actual returns come back from customers, the price of the returned items is recorded against the returns allowance balance sheet account, decreasing the liability (with a corresponding decrease to cash for the customer refund). There is no additional impact to the income statement when actual returns are recorded - an estimated expense was already recorded with revenue. Best practice is to reconcile the return allowance liability account on a periodic basis (e.g. monthly). If the estimated returns expense exactly matches the actual returns, there will be a zero balance in the liability account (fist pump!). If the balance is significantly positive or negative, it's time to re-evaluate the returns estimate calculation that's being used.
Try Before You Buy encourages shoppers to try items they may be uncertain about. This could be a new shopper to your brand. Or a returning customer that is trying a new product they haven't purchased from you before. By removing this uncertainty, Try Before You Buy generates higher sales and happier customers. Our merchant partners see a net sales increase of 39% (after considering returns).
While net sales are higher, it's possible that product returns may increase. It's part of the promise to shoppers, that they can send back items they don't want to keep. In our experience with merchant partners, some merchants see no change in their returns rate after implementing Try Before You Buy. Other merchants see an absolute increase of 5-10% in returns.
If you decide to account for a higher expected return rate with TBYB orders, it's appropriate to increase the returns allowance for only Try Before You Buy orders. For merchants where TBYB is a material part of their revenue, they will create a separate returns allowance for TBYB. If TBYB is a less material portion of the overall business, a separate returns allowance may not be necessary.
An illustrative example where return expense increases
|Non-TBYB Order||TBYB Order|
|Revenue (order price)||$105.00||$165.00|
|Estimated returns expense||-$5.00||-$15.00|
The revenue (order price) of a TBYB customer transaction is higher. The estimated returns expense is higher, but the absolute increase in returns expense is far less than the increase in revenue. Therefore, the TBYB order has higher net sales as a result.
At the outset, you'll need to estimate a returns rate for TBYB without any experience in your business. As your business gains experience with TBYB, you can use actual returns data to set your returns allowance policy.
3. Cost of Goods Sold (COGS)
Similar to the first section on revenue recognition, no changes are needed for the COGS accounting for TBYB items. The TBYB items are most likely the same items being sold with upfront payments. The fulfillment process from inventory to shipping the items to customers is most likely the same as well. However inventory and COGS accounting is being done for non-TBYB items should also work for TBYB items.
In summary, we believe the accounting for TBYB items can be substantially the same as non-TBYB items and should not require significant changes to your existing accounting policy. We recommend a separate returns allowance to accommodate higher returns with Try Before You Buy. It can be executed with the same process as the existing returns allowance, but should include a different set of assumptions for TBYB. The rest of the revenue recognition and COGS accounting policies in place for non-TBYB items should remain appropriate for TBYB items as well.
Please consult your own accounting and tax professionals to evaluate the appropriate accounting policy for your business.