Sales warranties – correct option IFRS 15 or IAS 37 complete explanation

Sales warranties

With the introduction of IFRS 15 Revenue from contracts with customers the treatment of sales warranties starts in IFRS 15, to end in certain circumstance in IAS 37 Provisions, Contingent liabilities and Contingent assets. So read this to learn on the decisions to be made! Sales warranties

Retails goods are frequently sold with a warranty (or guarantee) that they will operate satisfactorily for a specified period of time. The accounting treatment depends on: Sales warranties

  • Whether customers have an option to purchase the warranty separately, and
  • Whether the warranty is part of the overall package of goods sold to the customer, and if so, whether the warranty simply provides assurance that the goods are in compliance with the agreed upon specifications in the contract.

Agreed upon specifications often relate to an assurance that an item will function properly for a specified period, and may link to legal requirements in some jurisdictions. Sales warranties

If customers have an option to purchase a warranty separately from the goods themselves, this is accounted for separately. If the warranty is part of the overall package, if it simply provides an assurance of compliance with agreed upon specifications, it is not accounted for separately. If it goes beyond compliance with agreed upon specifications, then it is accounted for separately, regardless of whether it is identified as a separate component of the sales transaction.

Goods may also be sold with a warranty for a specified period (such as 12 months), with the customer being given the right to renew the warranty for a further 12 months at a discount from the standard selling price. In these cases, the consideration received for the first 12-month warranty may need to be split between the initial 12-month license and the renewal right, with revenue relating to that renewal right being deferred and recognised in a future period. Sales warranties

It is common practice to offer customers ‘free’ or extended warranties as an inducement to encourage purchase.

The key to determining whether this warranty is a separate performance obligation under IFRS 15 is to determine whether the warranties are ‘assurance-type’ warranties (which are usually required by law) or are warranties that can be sold separately.

There is no change to accounting for ‘assurance-type’ warranties (which are not a separate performance obligation as all they do is satisfy that the good sold is correctly functioning). However, extended warranties that can be sold separately are required to be accounted for separately which will result in delayed revenue. Sales warranties

Assurance-type warranties or 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, IFRS 15 B29 states that the entity is providing a service type warranty. Otherwise, it is an assurance-type warranty, which provides the customer with assurance that the product complies with agreed-upon specifications.

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In some cases, it may be difficult to determine whether a warranty provides a customer with a service in addition to the assurance that the delivered product is as specified in the contract. To help entities make that assessment, the standard provides the application guidance in IFRS 15 B31 and IFRS 15 B33. Sales warranties

Entities may need to exercise significant judgement when determining whether a warranty is an assurance-type or service-type warranty. An entity’s evaluation may be affected by several factors including common warranty practices within its industry and the entity’s business practices related to warranties. For example, consider an automotive manufacturer that provides a five-year warranty on a luxury vehicle and a three-year warranty on a standard vehicle. Sales warranties

The manufacturer may conclude that the longer warranty period is not an additional service because it believes the materials used to construct the luxury vehicle are of a higher quality and that latent defects would take longer to appear. In contrast, the manufacturer may also consider the length of the warranty period and the nature of the services provided under the warranty and conclude that the five-year warranty period, or some portion of it, is an additional service that needs to be accounted for as a service-type warranty. IFRS 15 excludes assurance-type warranties, which are accounted for in accordance with IAS 37.

The following decision tree could be used to determine whether a warranty is an ‘assurance warranty’ or a ‘service warranty’, as well as the appropriate accounting treatment: Sales warranties

Sales warranties

Example – Assurance type warranties

Question Sales warranties
Manufacturer A sells laptop computers with a 12-month warranty which assures that the laptops will work as intended for 12 months. The warranty is not sold separately. How should Manufacturer A account for the warranty?

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Answer Sales warranties
Because the warranty provides the customer with the assurance that the laptop will work as intended for one year, Manufacturer A will account for this ‘assurance-type’ warranty in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, i.e. a provision is raised for the expected cost of repairing the product in the next 12 months. Assurance-type warranties do not result in a change to current practice re the recognition of revenue, i.e. this does not represent a separate performance obligation.

Example – Providing a free extended warranty

Question Sales warranties
On 29 June 2018, Retailer C is running a special promotion on its washing machines. The selling price of the washing machine is $1,000. Customers will receive a free 24-month extended warranty, in addition to the 12-month standard warranty. The same 24-month extended warranty can be purchased from the manufacturer for $200. How should Retailer C account for the sale?  Assume that the standalone selling price of the washing machine is $1,000.

Answer Sales warranties
A portion of the selling price needs to be allocated to the extended warranty based on the relative standalone selling price.

free extended warranty

Retailer C will recognise $833 when the washing machine is sold. $167 is deferred until the warranty obligation is satisfied.

Before IFRS 15 was implemented, the common practice was to recognise $1,000 as revenue, and a provision under IAS 37.

Example on recognising and measuring provisions

A manufacturer gives warranties at the time of sale to purchasers of its product. Under the terms of the contract for sale, the manufacturer undertakes to make good, by repair or replacement, manufacturing defects that become apparent within three years from the date of sale. On the basis of experience, it is probable (ie more likely than not) that there will be some claims under the warranties. Sales warranties

Considerations Sales warranties

Present obligation as a result of a past obligating event—the obligating event is the sale of the product with a warranty, which gives rise to a legal obligation. Sales warranties

An outflow of resources embodying economic benefits in settlement—probable for the warranties as a whole.

Conclusion—the entity recognises a provision for the best estimate of the costs of making good under the warranty products sold before the reporting date. Sales warranties

Illustration of calculations

In 20X0, goods are sold for CU1,000,000. Experience indicates that 90 per cent of products sold require no warranty repairs; 6 per cent of products sold require minor repairs costing 30 per cent of the sale price; and 4 per cent of products sold require major repairs or replacement costing 70 per cent of sale price. Consequently, estimated warranty costs are: Sales warranties

Warranty expense

The expenditures for warranty repairs and replacements for products sold in 20X0 are expected to be made 60 per cent in 20X1, 30 per cent in 20X2, and 10 per cent in 20X3, in each case at the end of the period. Because the estimated cash flows already reflect the probabilities of the cash outflows, and assuming there are no other risks or uncertainties that must be reflected, to determine the present value of those cash flows the entity uses a ‘risk-free’ discount rate based on government bonds with the same term as the expected cash outflows (6 per cent for one-year bonds and 7 per cent for two-year and three-year bonds). Sales warranties

Calculation of the present value, at the end of 20X0, of the estimated cash flows related to the warranties for products sold in 20X0 is as follows: Sales warranties

Sales warranties

The entity will recognise a warranty obligation of CU41,846 at the end of 20X0 for products sold in 20X0. The provision has to be reassessed on a regular basis (at least each statutory reporting date but many times every reporting date).

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IAS 37 Provisions, Contingent Liabilities and Contingent Assets

Sales warranties

All of the entities in the examples have 31 December as their reporting date. In all cases, it is assumed that a reliable estimate can be made of any outflows expected. In some examples the circumstances described may have resulted in impairment of the assets; this aspect is not dealt with in the examples. References to ‘best estimate’ are to the present value amount, when the effect of the time value of money is material.

Also read: Sales warranties

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