US GAAP - Issues and Solutions for Pharmaceutical and Life Sciences: Chapter 7

Chapter 7: Warranty

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7-1 Accounting for new product warranty

Background

Company A offers a standard warranty on a newly-launched medical device. Customers do not have the option to purchase the warranty separately. Company A has determined the standard warranty does not provide the customer a service in addition to the assurance that the product complies with agreed-upon specifications. Company A has no historical experience selling a similar medical device and has not offered a similar warranty on a different product in the past.

Question: How should Company A account for the standard warranty?

Solution

Company A would account for the warranty in accordance with ASC 460 by considering the two conditions in ASC 450-20-25-2. Company A would first assess whether it is probable that a liability was incurred in connection with the warranty. If it is probably that a liability has been incurred, satisfaction of the second condition in ASC 450-20-25-2 (the amount can be reasonably estimated) will normally depend on the experience of the company or other available information. Because Company A has no experience of its own, reference to the experience of other companies in a comparable business may be appropriate.

If a customer has the option to purchase the warranty separately, or the warranty provides the customer with a service (e.g., repairing or replacing the device following damage caused by the customer) in addition to the assurance that the product complies with agreed-upon specifications, the warranty should be accounted for as a distinct performance obligation and a portion of the transaction price would be allocated to the warranty related performance obligation under ASC 606. If Company A cannot reasonably separate the service component from a standard warranty, it should be accounted for together as one performance obligation under ASC 606.

Relevant guidance

ASC 606-10-55-31: If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is a distinct service because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract. In those circumstances, an entity should account for the promised warranty as a performance obligation in accordance with paragraphs 606-10-25-14 through 25-22 and allocate a portion of the transaction price to that performance obligation in accordance with paragraphs 606-10-32-28 through 32-41.

ASC 606-10-55-32: If a customer does not have the option to purchase a warranty separately, an entity should account for the warranty in accordance with the guidance on product warranties in Subtopic 460-10 on guarantees, unless the promised warranty, or a part of the promised warranty, provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.

ASC 606-10-55-33: In assessing whether a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, an entity should consider factors such as:

a. Whether the warranty is required by law—If the entity is required by law to provide a warranty, the existence of that law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products.

b. The length of the warranty coverage period—The longer the coverage period, the more likely it is that the promised warranty is a performance obligation because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.

c. The nature of the tasks that the entity promises to perform—If it is necessary for an entity to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), then those tasks likely do not give rise to a performance obligation.

ASC 460-10-25-5: Because of the uncertainty surrounding claims that may be made under warranties, warranty obligations fall within the definition of a contingency. Losses from warranty obligations shall be accrued when the conditions in paragraph 450-20-25-2 are met.

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

a. Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...

b. The amount of loss can be reasonably estimated...

7-2 Recognition of warranty-related costs absorbed by manufacturer

Background

Company A purchases components from various manufacturers and integrates them into a single medical equipment solution that is sold to end users. Company A accounts for the sale of equipment in accordance with ASC 606. Company A has concluded that it is the principal in the transactions with its customers. As part of its normal sales terms, Company A offers its customers a standard warranty that ensures the product will be free from defects and will operate in accordance with its published specifications. The warranty is not sold separately and is not considered to provide a distinct service.

The sale of equipment includes a manufacturer’s standard warranty, such that in the event there is a defect with the equipment, Company A will submit a warranty claim to the manufacturer, which will either replace or repair the defective product. Company A has concluded that it is contractually responsible for the warranty to all of its customers who purchase the equipment.

Question: How should Company A account for the standard warranty to its customers?

Solution

Company A should accrue warranty costs in accordance with ASC 450–20-25-2. Although the manufacturer is expected to ultimately fulfil the standard warranty claims, Company A is liable to its customers based on its contractual sales terms. A corresponding asset may be recorded for the portion covered by the manufacturer’s warranty. Company A is not permitted to offset the recorded liability with the asset. The warranty accrual and asset would be reversed in the period in which the manufacturer completes the repair, replaces the product or when the warranty expires. This accounting would be different for resellers that do not provide a warranty to the customer. In this situation, the customer would be required to file any warranty claims to repair or replace the product directly with the manufacturer. No warranty expense would be recorded because the reseller is not offering a warranty to the customer.

Relevant guidance

ASC 606-10-55-32: If a customer does not have the option to purchase a warranty separately, an entity should account for the warranty in accordance with the guidance on product warranties in Subtopic 460-10 on guarantees, unless the promised warranty, or a part of the promised warranty, provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.

ASC 460-10-25-5: Because of the uncertainty surrounding claims that may be made under warranties, warranty obligations fall within the definition of a contingency. Losses from warranty obligations shall be accrued when the conditions in paragraph 450-20-25-2 are met.

ASC 450-20-25-2: An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

a. Information available before the financial statements are issued or are available to be issued... indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements...

b. The amount of loss can be reasonably estimated.

ASC 410-30-35-8: … An asset relating to the recovery shall be recognized only when realization of the claim for recovery is deemed probable… 

7-3 Standard product warranty vs. an extended product warranty

Background

Company A, a manufacturer of medical devices, includes a standard product warranty as part of its standard sales contract terms. The standard product warranty is an agreement to provide warranty protection by the manufacturer for a specific period of time and is included in the price of the product.

Company A offers customers the option to purchase an extended warranty in addition to the scope of coverage of the original standard warranty. Customers also have the option of purchasing a product maintenance contract, under which Company A will perform certain agreed-upon services to maintain its product for a specific period of time.

Question: Does the existence of an extended warranty or a product maintenance contract constitute a performance obligation in the arrangement?

Solution

Yes. Extended product warranties and product maintenance contracts that are sold separately provide customers with a service and would represent a distinct performance obligation under ASC 606. Company A should allocate the transaction price to the product and the services following the guidance in ASC 606-10-32-28 through 32-41. If Company A cannot reasonably account for the standard and extended warranty separately and/or the extended warranty and the product maintenance contract separately, the warranty/extended warranty and/or the extended warranty/product maintenance contract should be accounted for together as a single performance obligation under ASC 606.

Relevant guidance

ASC 606-10-55-31: If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is a distinct service because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract. In those circumstances, an entity should account for the promised warranty as a performance obligation in accordance with paragraphs 606-10-25-14 through 25-22 and allocate a portion of the transaction price to that performance obligation in accordance with paragraphs 606-10-32-28 through 32-41.

ASC 606-10-55-34: If a warranty, or a part of a warranty, provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, the promised service is a performance obligation. Therefore, an entity should allocate the transaction price to the product and the service. If an entity promises both an assurance-type warranty and a service-type warranty but cannot reasonably account for them separately, the entity should account for both of the warranties together as a single performance obligation.

7-4 Allocating consideration for an extended warranty

Background

Company A, a manufacturer of medical devices, includes a standard product warranty as part of its standard sales contract terms. The standard product warranty is an agreement to provide warranty protection by the manufacturer for one-year and is included in the price of the product.

Company A runs a promotion by selling a medical device for $1,800 (its regular price) with a “free” extended three-year warranty (which is regularly sold for a separate price of $300). Customers must take the extended warranty. Company A has concluded the extended warranty provides a service to the customer beyond the assurance that the product complies with agreed-upon specifications and, therefore, the service represents a separate performance obligation.

Question: How should Company A allocate the consideration to the performance obligations in this arrangement?

Solution

Under ASC 606, Company A should allocate the transaction price to each performance obligation identified in the contract on a relative standalone selling price basis in accordance with ASC 606-10-32-28 through 32-41. This applies whether or not the extended warranty is priced separately as part of the transaction.

While the extended warranty is not being sold separately and is not optional to the customer under the promotion, Company A has concluded it provides the customer with a service. In accordance with ASC 606-10-32-36, Company A would likely allocate a discount proportionately to all performance obligations in the contract. As such, the $1,800 total consideration would be allocated to each performance obligations based on its relative selling prices, resulting in an allocation of $257 to the warranty ($1,800 x ($300/$2,100)) and an allocation of $1,543 to the medical equipment ($1,800 x ($1,800/$2,100)).

Relevant guidance

ASC 606-10-32-28 through 32-41 provides guidance on the allocation of the transaction price to each performance obligation.

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Josh Herron

US Pharmaceutical & Life Sciences Assurance Leader, PwC US

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