Warranties
FRS 115 provides more guidance on accounting for warranties.
It defines warranties by:
- Service-type warranties: Warranties that provide the customer with a service
- Assurance-type warranties: Warranties that provide a customer with assurance that the related product will function as the parties intended because it complies with agreed-upon specifications
Warranties that provide the customer with a service
If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is a distinct service because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract. In those circumstances, an entity shall account for the promised warranty as a performance obligation and allocate a portion of the transaction price to that performance obligation.
Warranties that provide a customer with assurance that the related product will function as the parties intended because it complies with agreed-upon specifications
If a customer does not have the option to purchase a warranty separately, an entity shall account for the warranty in accordance with FRS 37 Provisions, Contingent Liabilities and Contingent Assets unless the promised warranty, or a part of the promised warranty, provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.
Factors to consider
In assessing whether a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, an entity shall consider factors such as:
(a) Whether the warranty is required by law—if the entity is required by law to provide a warranty, the existence of that law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products.
(b) 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 because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.
(c) The nature of the tasks that the entity promises to perform—if it is necessary for an entity to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), then those tasks likely do not give rise to a performance obligation.
Warranty that provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.
If a warranty, or a part of a warranty, provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, the promised service is a performance obligation. Therefore, an entity shall allocate the transaction price to the product and the service. If an entity promises both an assurance-type warranty and a service-type warranty but cannot reasonably account for them separately, the entity shall account for both of the warranties together as a single performance obligation.
Obligation due to law
A law that requires an entity to pay compensation if its products cause harm or damage does not give rise to a performance obligation. For example, a manufacturer might sell products in a jurisdiction in which the law holds the manufacturer liable for any damages (for example, to personal property) that might be caused by a consumer using a product for its intended purpose. Similarly, an entity’s promise to indemnify the customer for liabilities and damages arising from claims of patent, copyright, trademark or other infringement by the entity’s products does not give rise to a performance obligation. The entity shall account for such obligations in accordance with FRS 37.
Example
An entity, a manufacturer, provides its customer with a warranty with the purchase of a product. The warranty provides assurance that the product complies with agreed-upon specifications and will operate as promised for one year from the date of purchase. The contract also provides the customer with the right to receive up to 20 hours of training services on how to operate the product at no additional cost.
The entity assesses the goods and services in the contract to determine whether they are distinct and therefore give rise to separate performance obligations.
The product is distinct because it meets both criteria in paragraph 27 of FRS 115. The product is capable of being distinct in accordance with paragraphs 27(a) and 28 of FRS 115, because the customer can benefit from the product on its own without the training services. The entity regularly sells the product separately without the training services. In addition, the product is distinct within the context of the contract in accordance with paragraphs 27(b) and 29 of FRS 115, because the entity’s promise to transfer the product is separately identifiable from other promises in the contract.
In addition, the training services are distinct because they meet both criteria in paragraph 27 of FRS 115. The training services are capable of being distinct in accordance with paragraphs 27(a) and 28 of FRS 115, because the customer can benefit from the training services together with the product that has already been provided by the entity. In addition, the training services are distinct within the context of the contract in accordance with paragraphs 27(b) and 29 of FRS 115, because the entity’s promise to transfer the training services are separately identifiable from other promises in the contract. The entity does not provide a significant service of integrating the training services with the product (see paragraph 29(a) of FRS 115). The training services are not significantly modified or customised by the product (see paragraph 29(b) of FRS 115). The training services are not highly dependent on, or highly interrelated with, the product (see paragraph 29(c) of FRS 115).
The product and training services are each distinct and therefore give rise to two separate performance obligations.
Finally, the entity assesses the promise to provide a warranty and observes that the warranty provides the customer with the assurance that the product will function as intended for one year. The entity concludes, in accordance with paragraphs B28–B33 of FRS 115, that the warranty does not provide the customer with a good or service in addition to that assurance and, therefore, the entity does not account for it as a performance obligation. The entity accounts for the assurance-type warranty in accordance with the requirements in FRS 37.
As a result, the entity allocates the transaction price to the two performance obligations (the product and the training services) and recognises revenue when (or as) those performance obligations are satisfied.
Example
An entity, sells 100 machines to a customer for CU50 each.
Each machine costs CU35.
The entity includes a warranty with the sale to a customer, which provides for full replacement of the drill if it fails to work properly within two years of the date of purchase by the consumer.
The entity considers any defects that arise within 90 days of the date of purchase by the consumer to be a failure to comply with the agreed-upon specifications (i.e., related to a defect that existed at the time of sale).
The entity considers the warranty it provides beyond the first 90 days to be a distinct service.
In this example, the entity provides both an assurance-type warranty (the warranty covering defects in the first 90 days after the sale) and a service-type warranty (the warranty covering defects arising during the remainder of the two-year warranty period).
The total transaction price for the sale of a drill and the service-type warranty is CU50.
The entity estimates the stand-alone selling price of each is CU40 and CU10, respectively.
Based on past experience, the entity estimates that 2% of all machines it sells will fail to comply with agreed-upon specifications within the first 90 days, which will require the entity to replace the machines (at a cost of CU35 per machine).
The entity records the following journal entry to record the sale of 100 machines to a customer and the related warranty liabilities:
Debit Cash/receivables CU5,000 (Total transaction price CU50 x 100)
Credit. Revenue CU4,000 (Stand alone selling price of machine CU40 x 100 units)
Credit Contract liability (service-type warranty) CU1,000 (CU10 x 100 units)
Being recognition of revenue and contract liability for service type warranty
Debit Warranty expense CU70 (2% x 100 x CU35)
Credit Provision for Warranty (assurance-type warranty) CU70 (2% x 100 x CU35)
Being recognition of provision for assurance-type warranty
Debit Cost of revenue CU3,500
Credit Inventory CU3,500
Being recognition of cost of revenue
For the service-type warranty, the entity will derecognise the contract liability and recognise revenue over the 21-month warranty period that follows the initial 90-day quality assurance period (presumably on a straight-line basis over the period, unless a different pattern is expected).
Costs associated with providing the service-type warranty will be expensed as incurred.