CHAPTER 5 Revenue Recognition and Profitability Analysis 243 is an advance payment by the customer for future products or services and should be included in the transaction price, allocated to the various performance obligations in the contract, initially recorded as deferred revenue, and recognized as revenue when (or as) each performance obligation is satisfied. WARRANTIES. Most products are sold with a warranty that obligates the seller to make repairs or replace products that later are found to be defective or unsatisfactory. These warranties are not sold separately, and either can be stated explicitly or be implicit based on normal business practice. We call these q uality-assurance warranties. A qualityassurance warranty (sometimes called an “assurance-type warranty”) is not a performance obligation. Rather, it is a cost of satisfying the performance obligation to deliver products of acceptable quality. The seller recognizes this cost in the period of sale as a warranty expense and related contingent liability. Because the exact amount of the cost usually is not known at the time of the sale, it must be estimated. For example, Lenovo, which manufactures personal computers and other technology products, reported a quality-assurance warranty liability of $279 million at the end of its 2013 fiscal year. E xtended warranties , on the other hand, are offered as an additional service that covers new problems arising after the customer takes control of the product. It’s unusual these days to buy a phone, digital tablet, car, or almost any durable consumer product without being asked to buy an extended warranty. An extended warranty (sometimes called a “service-type warranty”) provides protection beyond the manufacturer’s quality-assurance warranty. Because an extended warranty usually is priced and sold separately from the product, it constitutes a performance obligation and can be viewed as a separate sales transaction. The price is recorded as a deferred revenue liability and then recognized as revenue over the extended warranty period. However, if an extended warranty is included along with the related product as part of a single contract, the extended warranty still is treated as a separate performance obligation, allocated a portion of the transaction price, and that portion of the transaction price is recorded as deferred revenue. Lenovo reported a liability for deferred extended warranty revenue of $404 million at the end of its 2013 fiscal year. How can you tell if a warranty should be treated as a quality-assurance warranty or an extended warranty? A warranty should be treated as an extended warranty if either (a) the customer has the option to purchase the warranty separately from the seller or (b) the warranty provides a service to the customer beyond only assuring that the seller delivered a product or service that was free from defects. The specifics of the warranty have to be considered when making this determination. For example, if the warranty period is very long, it’s likely the warranty is covering more than just the quality of the product at the date of delivery, so it likely would represent an extended warranty. We discuss accounting for warranties more in Chapter 13. CUSTOMER OPTIONS FOR ADDITIONAL GOODS OR SERVICES. In some contracts the seller grants to the customer an option to receive additional goods or services at no cost or at a discount. Examples include software upgrades, customer loyalty programs (frequent flier miles, credit card points), discounts on future goods or services, and contract renewal options. Options for additional goods or services are considered performance obligations if they provide a material right to the customer that the customer would not receive otherwise. 16 For example, if a shoe seller normally discounts its products by 5%, but customers who purchase a pair of shoes receive a 20% discount off the next pair of shoes purchased at the same store, the extra discount of 15% (20% 2 5%) is a material right, as it is a discount customers would not receive otherwise. When a contract includes an option that provides a material right, the seller must allocate part of the contract’s transaction price to the option. Just like for other performance obligations, that allocation process requires the seller to estimate the stand-alone selling price of the option, taking into account the likelihood that the customer will actually exercise the A quality-assurance warranty is not a performance obligation. An extended warranty is a separate performance obligation. An option for additional goods or services is a performance obligation if it confers a material right to the customer. 16 Be careful not to confuse these types of options with stock options, which are financial instruments that allow purchase of shares of stock at a specific price at a future date.
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