Warranties are a normal part of business for most product selling companies but the accounting for standard warranty costs continues to confuse people.
Before I delve into this any further however, I must define what I mean by a “standard warranty”? A standard warranty is normally built into the sales price of a product and cannot be bought separately by the purchaser e.g. a fridge sold with a standard 12 month warranty. In this scenario, companies will recognise the full amount of revenue for these types of transactions (as it is typically deemed the IAS 18: Revenue criteria have been met) and a separate warranty provision will be recognised as an expense (typically in Cost of Sales) under IAS 37: Provisions.
So let’s consider a very simple example where a company sells a product with a standard warranty but where there exists a number of different warranty terms:
Alpha Ltd. sells a product for €600 that cost €400 to manufacture. Calculate the warranty provision required and the profit that will be recognised from the transaction on the basis that:
- Alpha expects the product will returned and Alpha will provide a full refund. Alpha can resell the returned product.
- Alpha expects the product will returned and Alpha will provide a full refund. Alpha must scrap the returned product (assume nil scrapping costs).
- Alpha expects the product will returned for repairs and Alpha will have to incur costs of €100 before giving the product back to the customer.
- Alpha expects the product will returned and Alpha will provide a replacement product. Alpha must scrap the returned product (assume nil scrapping costs).
- Scenario 1: The warranty provision required is the profit on the sale. Alpha must provide a full refund but will get a working product back, no profit or loss is recognised as Alpha, when the item is returned, will be in the exact same position it was before the sale occurred i.e. it has a product costing €400 that it wants to sell.
- Scenario 2: The warranty provision required is the entire amount of the sale. Alpha must provide a full refund and will have to scrap the product. Therefore it’s net loss will be the cost of the product i.e. €400.
- Scenario 3: The warranty provision required is the amount of the repair costs. The total product cost, once the repairs are made, will be €500 (400 + 100) and this must be reflected in the accounts when the sale occurs.
- Scenario 4: The warranty provision required is the cost of the product. In effect, Alpha has made a sale for €600 but will have to provide the customer with two products in order to keep the consideration received.
Another scenario typically encountered is where the customer purchases an extended warranty as part of the overall transaction. In this case the extended warranty is a separate service component of the overall transaction and the revenue relating to the warranty component is recognised over the warranty period (any payments relating to the warranty that are received upfront are deferred).
Finally , when IFRS 15, the new standard on accounting for revenue, is eventually endorsed by the EU and is applied by IFRS account preparers, the accounting for warranty provisions will be slightly different from what I’ve outlined above. I don’t think it’s worth saying anything further about this accounting standard for now, the standard has been issued but is not yet effective and I expect further changes/amendments to the standard before EU endorsement takes place.