Question

Exercise 13-22

Riverbed Machinery Co. manufactures equipment to a very high standard of quality; however, it must still provide a warranty for each unit sold, and there are instances where the machines do require repair after they have been put into use. Riverbed started in business in 2020, and as the controller, you are trying to determine whether to use the assurance-type or service-type warranty approach to measure the warranty obligation. You would like to show the company president how this choice would affect the financial statements for 2020, and advise him of the better choice, keeping in mind that the service-type approach is consistent with IFRS, and that there are plans to take Riverbed public in a few years.

You have determined that sales on account for the year were 1,000 units, with a selling price of $3,000 each. Ignore any cost of goods sold. The warranty is for two years, and the estimated warranty cost averages $190 per machine. Actual costs of servicing warranties for the year were $114,000. You have done some research and determined that if the service-type approach were to be used, the portion of revenue allocated to the warranty portion of the sale would be $360. Because the costs of servicing warranties are not incurred evenly, warranty revenues are recognized based on the proportion of costs incurred out of the total estimated costs

1.For the assurance-type approach, prepare the necessary journal entries to record all of the transactions described. Payments for completed warranty repairs are paid in cash. (Credit account titles are automatically indented when the amount is entered. Do not indent manually. If no entry is required, select "No Entry" for the account titles and enter 0 for the amounts.)
2.For the service-type approach, prepare the necessary journal entries to record all of the transactions described. (Credit account titles are automatically indented when the amount is entered. Do not indent manually. If no entry is required, select "No Entry" for the account titles and enter 0 for the amounts.)

Answer 1

Ans :

Warranties are classified in two categories: assurance- and service-type. An assurance-type warranty guarantees that the product will function as intended. This type of warranty promises to repair or replace a delivered good or service if it does not perform as expected. On the other hand, a service-type warranty provides a service in addition to the assurance. Service-type warranties can often be purchased separately.

Accounting For Assurance-Type Warranties

Since an assurance-type warranty guarantees the functionality of a product, the warranty is not accounted for as a separate performance obligation, and thus no transaction price is allocated to it. Rather, to account for an assurance-type warranty the vendor should estimate and accrue a warranty liability when the promised good or service is delivered to the customer (ASC 460)

Accounting For Service-Type Warranties

A service-type warranty provides additional benefit to the customer, and therefore represents a distinct performance obligation. An entity should allocate a portion of the contract transaction price to the service-type warranty and recognize revenue as the warranty obligation is satisfied.

The amount allocated to a service-type warranty should depict the amount that the vendor expects to receive for providing the service, which is usually based on its estimated standalone selling price (ASC 606 )

Revenue is recognized as the warranty obligation is fulfilled, which is likely over the term of the warranty.

If a warranty contains both assurance- and service-type warranties and the vendor cannot reasonably account for them separately, then the warranties should be grouped as a single performance obligation. A portion of the transaction price is allocated to the combined warranty and revenue is recognized as the performance obligation is fulfilled.

1) For the assurance-type approach , journal entries (Under IAS 37 )

Date	Account title and explanation	Debit($)	Credit($)
2020	Cash / Accounts Receivable Dr.	$3000000
	Sales Revenue ( 1000 * $ 3000)		$3000000
	( to record sale of equipment)
During 2020	Warranty expenses Dr.	$114000
	Cash		$114000
	(to record warranty expense)
Dec 31,2020	Warranty expense Dr.	$76000
	Accrued warranty liability		$76000
	( to record warranty liability)
[(1000 * 190 ) – 114000 ]

2) For the service-type approach, journal entries ( UNDER IFRS 15)

Date	Account title and explanation	Debit($)	Credit($)
2020	Cash / Accounts Receivable Dr.	$3000000
	Sales Revenue [ 1000 * ($ 3000 – 360 )]		$2640000
	Unearned warranty revenue ( 1000 * 360)		$ 360000
	( to record sale of equipment)
During 2020	Warranty expenses Dr.	$114000
	Cash		$114000
	(to record warranty expense)
Dec 31,2020	Unearned warranty revenue Dr.	$216000
	Warranty revenue (Note 1)		$216000
	( To remeasure unearned service revenue )
[(1000 * 190 ) – 114000 ]

Note 1

(Unearned warranty revenue * Warranty expenses) / Total estimated warranty cost

= (360000 * 114000 ) / (1000 * 190 ) = $ 216000