Obligations for product warranties and product liability
The Boards considered two matters arising from the comment letters on the Discussion Paper (DP) Preliminary Views on Revenue Recognition in Contracts with Customers. These matters related to whether:
- all product warranties give rise to separate performance obligations; and
- product liability laws give rise to performance obligations.
While the DP proposed that all product warranties give rise to a separate performance obligation, most respondents to the DP disagreed. In deliberating the comments received, the Boards considered whether a distinction can be made between a warranty in which the objective is to provide the customer with cover for manufacturing defects (quality assurance warranty) and a warranty that provides cover for faults that arises after the product is transferred to the customer (insurance warranty).
Several Board members agreed that there is a difference between the warranties. One Board member noted that the discussion is similar to what was considered in the IAS 37 project on what constitutes an obligation.
The Boards agreed that:
- an insurance warranty constitutes a performance obligation
- some portion of the transaction price should be allocated to the separate performance obligation based on the standalone selling price of the warranty, and
- revenue should be recognised over time as the warranty coverage is provided.
The Boards then turned the discussion to whether a quality assurance warranty gives rise to a performance obligation. In their deliberations, the Boards considered several practical examples across various industries and agreed that a warranty provided against defects at the time of the transaction does not give rise to a separate performance obligation. An entity would therefore have to determine at the end of each reporting period the likelihood and extent of defects in assets sold and account for the unsatisfied performance obligation as follows:
- if the entity is required to replace the defective assets, no revenue is recognised for the sale of those assets until the warranty expires;
- if the entity is required to repair the defective assets, a portion of the revenue that can be attributed to the components that need to be replaced should not be recognised until the warranty expires.
One Board member questioned what would happen if an entity sold a product with both types of warranties in place. After a short discussion, it was decided that such a situation should be treated similar to an insurance warranty.
Another Board member questioned what the other side of the entry would be and whether inventory should be released when revenue is not recognised. It was agreed that to the extent that full revenue from a sale has not been recognised, inventory should not be released. The Boards agreed that the exposure draft should provide guidance on how inventory should be accounted for in such situations.
The Board considered a related issue on whether product liability laws give rise to performance obligations. As an example, staff presented an example of an entity that would be liable for damages if one of their products caused damage to property or harm to people (for example, a television set that were to explode). The Boards unanimously agreed that the past event that gives rise to the liability is not the sale of the product but the default that occurred and that such obligations should be accounted for in accordance with IAS 37.
Sale of goods with the right to return
In considering the comments received on the DP in relation to the sale of goods with the right to return, the Boards were presented with a revised analysis of the recommended accounting treatment for a right to return. The revised approach presented by the FASB staff is summarised as follows:
- revenue should not be recognised for the goods that are expected to be returned; instead, a refund liability should be recognised for the expected amount of refunds;
- the refund liability should subsequently be updated for changes in expectations about the amount of refunds;
- an asset should be recognised for the right to recover goods from customers on settling the refund liability; and
- the promised return service meets the definition of a performance obligation, and a portion of the transaction price should be allocated to the performance obligation when it is material.
The Boards deliberated the revised approach. Several Board members expressed concerns that a return service should be regarded as a performance obligation if it is material. The staff responded by explaining the as not all transactions are accompanied by a right to return; the return service is separable from the sale of the goods and should be recognised as a separate performance obligation.
Board members still did not think that it would be useful to allocate a portion of the transaction price to a performance obligation and questioned what the entry would be on the asset side.
When put to a vote, the Boards agreed in principle with the staff's revised approach; however, the majority of Board members disagreed with the proposal to treat the return service as a separate performance obligation if material. One Board member explained that in certain legal environments there is no difference between a right to return and a quality assurance warranty and questioned why there should be a difference in accounting. The Boards agreed that there should be consistency between the treatment of quality assurance warranties and the right to return.
Estimates of uncertain consideration
The Boards were reminded of their previous decisions with regards to the determination of the transaction price and the recognition of revenue when a customer promises an uncertain amount of consideration, being:
- at contract inception, the transaction price is the probability-weighted estimate of consideration to be received;
- after inception, changes in transaction prices should be allocated to all performance obligations and recognised as revenue in the period of change; and
- recognition of revenue should be constrained if the entity cannot reliably estimate the consideration amount.
The staff explained that although the DP did not consider the effects of uncertain consideration, the Boards reached tentative decisions before the end of the comment period and, hence, some respondents also commented on those decisions. A majority of the respondents supported the Boards' tentative decisions.
To provide guidance on what a 'reliable' estimate is in the context of revenue recognition, the Boards considered to the following two criteria:
- an estimate can only be reliable if an entity has previous experience with identical or similar transactions or can reference to the experience of other entities in the same business; and
- the previous experience is only relevant if circumstances surrounding the contract are not likely to change significantly.
One Board member questioned what the difference is between uncertain consideration and unrecoverability of receivables. The Boards deliberated the matter for some time and considered whether the same principles should apply to both situations. It was agreed, however, to remove recoverability from the discussion as it stems from a violation of contractual terms and only to focus on situations where there is uncertainty about the total amount of consideration to be received as a result of the contractual terms.
When asked to vote on the matter, a majority of Board members agreed with the proposed approach and criteria for reliable estimates and reiterated that any situation involving uncertain consideration would involve judgement based on all facts and circumstances.