IFRS 15 Warranty Treatment

Warranty sometimes lures us into buying a product or service. Warranty for two, five, or ten years on several products and services ranging from a backpack to an electronic gadget. Warranties assure of quality in a sense that the said product works, and in a manner as specified in the contract of sale.

Companies may provide customers with a warranty in connection with a sale of a good or service. The nature of the warranty can vary. They may be called a standard warranty, a manufacturer’s warranty, or an extended warranty. Regardless of the name these generally assure that the product or service will function as expected.

Warranties that can’t be purchased separately must be assessed to determine whether the warranty provides a service that should be accounted for as a separate performance obligation.

Warranties against product defects are not performance obligations. These types of warranties will continue to be accounted for as a cost accrual under the new revenue standard. However, sometimes warranties include a service element that protects defects that existed at the time of sale such as protecting against wear and tear for a while after the sale or against a certain type of damage. The additional service provided in a warranty should be accounted for as a separate performance obligation assuming the service is distinct from the other goods and services in the contract. This will require some warranties to be separated into being assurance element and a service element. Today there is diversity in practice concerning the accounting of warranty obligations that include a service element.

While some companies separate the service element from the assurance type warranty, others account for the entire obligation as a cost accrual. Under the new revenue standard companies that cannot reasonably account for the service element of a warranty separate from the assurance, the element should account for both as a single performance obligation that provides a service to the customer. Some arrangements also provide for cash payments for the customer, for example, liquidated damages for failing to comply with the terms of the contract. These arrangements should be accounted for as variable consideration as opposed to warranty expenses. However, cash payments to customers might be accounted for as warranties in limited situations such as direct reimbursement for costs paid by the customer to a third party for the repair of a product.

Finally, a warranty that the customer can purchase separately from the related goods or services i.e., its price in 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 prod will function as intended. Revenue allocated to the warranty would typically be recognized relatively over the warranty period.

Before accounting for warranties, the type of warranty needs to be determined.

Types of warranties under IFRS 15

There are two types of warranties under IFRS 15 viz., Assurance-type warranties and Service-type warranties.

While assurance-type warranties are the ones promising the customer that the delivered product is as specified in the contract and will work as specified in the contract, Service-type warranties provide something in addition to mere assurance, for example, some extra services.

The assurance-type warranties do not give rise to any separate performance obligation and only a provision is accounted for warranty repairs under IAS 37.

While the Service-type does give rise to a separate performance obligation as they provide additional service to the customers and are accounted for under IFRS 15.

In assessing whether a contract contains a service in addition to the assurance that the product complies with agreed-upon specifications, judgment may be needed. A vendor considers factors such as:

• Whether the warranty is required by law – if required by law then this indicates the warranty is not a separate performance obligation

• The length of the warranty coverage period – the longer the coverage, the more likely it is that the promised warranty is a performance obligation

• The nature of the tasks that the vendor promises to perform – if the vendor must perform specified tasks to assure that a product complies with agreed-upon specifications (e.g., a return shipping service for a defective product), then those tasks are unlikely to give rise to a performance obligation.

If a customer does not have an option to purchase a warranty separately, it is accounted for per IAS 37 unless the part or all of that warranty provides the customer with a service in addition to an assurance that the goods or services comply with agreed-upon specifications.

Warranty Expense Recognition

From an accounting perspective, according to the Financial Accounting Standards Board (FASB), warranty expenses should be recognized when they are probable and can be estimated.

While recording the event in the financial statements, the company will debit (charge) the warranty expense account and credit (accrue) a liability account when the product is sold to a client.

Provided the product is defective and needs to be replaced, the company would reduce both the liability and inventory accounts because it would issue the replacement product out of its inventory. If the defective product needs to be repaired or refunded, the cost incurred reduces the liability account.

Warranty expense is recognized in the same period as revenue for the sold products if there is a probability that an expense will be incurred and if the company can estimate the amount of the expense. The practice is referred to as the matching principle when all expenses relevant to a product sale are recognized together in the same period.

The income statement is impacted by the full amount of warranty expense when a sale occurs, even if there are no warranty claims during the period and is part of COGS. When claims appear in subsequent accounting periods, the costs incurred will reduce the warranty liability account.

Warranty Expense Calculation

To estimate the warranty expense for a company, we need to know three main things:

• Number of units sold during a particular accounting period
• Percentage of the sold products that will probably need a repair or a replacement based on previous experiences
• The average cost of repairing or replacing products under warranty

To calculate the warranty expense, first, estimate the number of product units that will need to be repaired or replaced by using the following formula:

No. of units sold* percentage of defective units

Afterward, compute the cost of repairs or replacement for the defective units:

Units to be replaced or repaired*cost per unit to repair or replace

Accrual:

The accrual should take place in the same reporting period in which the related product sales are recorded. By doing so, the financial statements most accurately represent all costs associated with product sales and therefore indicate the true profitability associated with those sales. If the period covered by the warranty is changed by management, this will alter the warranty expense not only for those sales in the current period but also for sales in prior periods whose warranties have now been extended into the current period.

Warranty Claims:

If the cost of warranty claims were to instead be recognized only when the company processes actual claims from customers, the costs may not be recognized until several months after the associated sales. The financial reporting under this approach would yield inordinately high initial profits, followed by depressed profits in later months, for as long as the warranty period lasts.

If there is no information from which to derive a warranty estimate for use in an accrual, consider using industry information about warranty claims. This is especially useful when other products in the industry are similar to those sold by the company.

If the amount of warranty expense recorded is significant, expect the company’s auditors to investigate it. If so, develop a history of the actual cost of warranty claims, and calculate the relationship between costs incurred and the related amount of revenue or units sold. This information can then be applied to current sales levels and forms the basis for a justification of the amount of accrued warranty expense.

Warranty claims for <1 year

If a warranty claim period extends for longer than one year, it may be necessary to split the accrued warranty expense into a short-term liability for those claims expected within one year, and a long-term liability for those claims expected in more than one year.

Do the local state laws require the warranty?

It is a general practice that the warranties are regulated by local state laws, and laws vary across the globe. If the answer to this question is yes, it is most likely that the type of warranty is assurance-type, and you will not be obligated for separate services.

Is the warranty period longer than what state laws have prescribed? If the answer is yes, it is most probable that the warranty is more likely to be a service-type warranty.

Accounting Treatment For Warranties

Assurance-Type Warranties

The matching principle of accounting requires the business entities to record the expenses related to the revenue at the time of revenue generation.

Under this principle, the assurance-type warranties are treated as an expense related to the sale of goods.

At the time of the sales, the warranty expenses are debited. A provision for the warranties is credited, which goes under the liabilities in the balance sheet.

Later on, if a certain warranty is claimed, the liability for warranty expense will be debited, and cash, inventory, or spare parts account will be credited depending on the scenario. The entry for the exercise of warranty is as follow:

Service-type Warranties

The service-type warranties are purchased by the buyer along with the price of the product. As a result, the unearned warranty revenue is credited while cash is debited. The journal entry for the service type warranty will be:

Date          Description                  L.F                        Debit($)                       Credit($)

            Cash/Bank Account                                       Xxx

              Unearned Warranty Revenue Account                                                 Xxx

(Service-Type Warranty Sold Along With the product)

Repair or maintenance:

When the customer comes for repair or maintenance of the product, the revenue is realized, and the revenue earned is made.

The revenue earned account is credited, and the liability as unearned warranty revenue is decreased, therefore, debited.

The journal entry is as follow:

Date          Description                  L.F                            Debit($)                                     Credit($)

 Unearned Warranty Revenue Account                                  Xxx   

                               Warranty Revenue Account                                                                     Xxx

(Revenue recognized on the service-type warranty)