Construction warranties

Construction warranties – This part relates to a complete explanation of IFRS 15 Revenue from contracts with customers in respect of Engineering & Construction contracts, see Revenue from Engineering & Construction contracts.

The nature of a warranty can vary across reporting entities, industries, products, or contracts. It could be called a standard warranty, a manufacturer’s warranty, or an extended warranty. Warranties might be written in the contract, or they might be implicit as a result of either customary business practices or legal requirements. Construction warranties

Terms that provide for cash payments to the customer (for example, liquidated damages for failing to comply with the terms of the contract) should generally be accounted for as variable consideration, as opposed to a warranty.

The decision tree below summarizes the considerations when determining the accounting for warranty obligations under IFRS 15 and IAS 37 Provisions. Construction warranties

Construction warranties

(1)1 If the contractor provides the customer with the option of purchasing the warranty separately, the warranty should be treated as a distinct performance obligation, and a portion of the transaction price would be allocated to it (‘Extended warranty’). Construction warranties

Likewise, (2)2 if the warranty provides additional services (such as a certain number of years of maintenance), that service component qualifies as a distinct performance obligation, and a portion of the transaction price would be allocated to it. Construction warranties

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. Construction warranties

Warranties that cannot be purchased separately must be assessed to determine whether the warranty provides a service that should be accounted for as a separate performance obligation. If (3)3 the warranty is solely an assurance-type warranty (that is, a warranty against latent defects), there is no distinct performance obligation, so any inherent warranty embedded in the contract would be reflected in the performance obligation for the respective good or service and would not be considered a separate performance obligation. Construction warranties

The service provides a level of protection beyond defects that existed at the time of sale, such as protecting against wear and tear for a period of time after sale or against certain types of damage. Judgment will often be required to determine whether a warranty provides assurance or an additional service. Construction warranties

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. A reporting 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. Construction warranties

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 in accordance with IAS 37 Provisions if the customer does not have the option to purchase the warranty separately. The estimated costs are recorded as a liability when the reporting entity transfers the product to the customer.

Should repairs provided outside of the contractual warranty period be accounted for as a separate performance obligation? Construction warranties

It depends. Management should assess the nature of the services provided to determine whether they are a separate performance obligation, or if there is simply an implied assurance-type warranty that extends beyond the contractual warranty period.

The period over which to accrue estimated warranty costs when control of equipment transfers over time

Builder Co. constructs a customized factory for which control transfers to the customer over time. Builder Co. provides a one-year warranty on the equipment, which begins once the factory is handed over to the customer at finalization.

Should Builder Co. accrue the estimated warranty costs over the construction period or at the point in time it delivers the equipment to the customer? Construction warranties

Manufacturer should generally accrue the estimated warranty costs over the construction period, consistent with the transfer of control of the equipment to the customer. Construction warranties

Construction warranties

Warranties are commonly included in contracts to sell goods or services, whether explicitly stated or implied based on the entity’s customary business practices. IFRS 15 identifies two types of warranties: Construction warranties

  • Warranties that promise the customer that the delivered product is as specified in the contract are called ’assurance-type warranties’. The Boards concluded that assurance-type warranties do not provide an additional good or service to the customer (i.e., they are not separate performance obligations). By providing this type of warranty, the selling entity has effectively provided a quality guarantee. Construction warranties Construction warranties Construction warranties

    For example, E&C entities often provide various warranties against construction defects and the failure of certain operating systems for a period of time. Under the standard, the estimated cost of satisfying these warranties is accrued in accordance with the current requirements in IAS 37. Construction warranties

  • Warranties that provide a service to the customer in addition to assurance that the delivered product is as specified in the contract are called ’service-type warranties’. If the customer has the option to purchase the warranty separately or if the warranty provides a service to the customer beyond fixing defects that existed at the time of sale, the entity is providing a service-type warranty. The Boards determined that this type of warranty represents a distinct service and is a separate performance obligation. Construction warranties

    Therefore, the entity will allocate a portion of the transaction price to the warranty based on the estimated stand-alone selling price of the warranty. The entity will recognise revenue allocated to the warranty over the period the warranty service is provided. Service-type warranties may be infrequent in the E&C industry. Construction warranties

What is the source of warranties?

Accrual accounting

The fundamental idea of accrual accounting is that revenues are recognized when the earnings process is complete and not necessarily when the goods or services are paid for. In many cases determining when the earnings process is complete is very easy.  A bar that lets patrons run a tab has a completed earnings process every time a customer is poured a drink. However in many businesses the completion of the earnings process is not so clear cut. Take the case of product sellers who offer warranties to purchasers.

Some kind of product warranty

Many if not most consumer goods are sold subject to some kind of product warranty. This includes everything from microwaves and computers to automobiles and trucks. Sales of products subject to warranties present yet another challenge to accrual accounting.

Construction warranties

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