Atomby Entertainment Limited (AEL) sells multimedia presentation systems in Hong Kong. The company commenced business in 2018. Each product unit was sold for $5,000 cash representing a 25% markup over cost. The company provides a two-year parts and labor warranty on each product unit they sell. The estimated cost of providing the warranty coverage is $400 per unit. Apart from the assurance warranty, AEL also sells extended warranty services to customers. Such service warranty must be purchased at the same time as the related product is purchased, at a fee of $750 per unit. The service warranty will cover another 2 years after expiration of the assurance warranty provided by AEL.

 

Approximately 70% of customers purchased the service warranty in 2018, and 80% in 2019 and 2020. Accounting year end date of AEL is December 31.

 

At the end of 2020, AEL is considering changing its practice from selling service warranty separately to bundling it with the product sales. By this, customers will be automatically provided with a four-year warranty when they purchase the multimedia presentation systems. The new price of the bundled product would be the sum of the current sales prices of the product and service warranty purchased separately.

 

Required:

Advise AEL on the proposed change. Explain how the accounting treatments will be different and the effects on reported income and financial statements. What are the potential negative aspects of those changes, and what other issues should be considered? Journal entries are not required.

 

Answer

The proposed changes on the product warranties of Atomby Entertainment Limited (AEL) would change the 2 years service warranty into assurance warranty and hence eliminate the separate performance obligation since the customers can no longer buy the service warranty separately.

Assurance warranty is characterized by the following ;

a. The customer does not have the option to purchase the warranty separately.

b. The warranty is required by the law.

Accounting treatment.

• The accounting treatment of the 2 year extra warranty changes from that of a service warranty into that of assurance warranty
• This means that you should book a provision for warranty repairs in the amount of estimated cost of repairs over the next 4 years after the product has been purchased.
• this type of warranty is accounted for under IAS 37 and not as a separate performance obligation as in the case of service warranty which is accounted in line with IFRS 15.

Effects on reported income and financial statements.

• The estimated costs of repair for the next 4 years under warranty are expensed in the profit and loss account.
• A provision is created in the balance sheet and the same costs are credited in the provision account.

Potential negative aspects of these changes

• It extends the length of assurance warranty which increases the chances of economic losses due the repairs and maintenance of the products under the warranty.
• It increases the selling price of the products which may be disadvantageous to customers not requiring an extra warranty.
• Such long warranties may be extra expensive in the long run.

Other issues to consider.

• The set federal regulations in regards to issuance of warranty and the proper disclosure requirements for the customers such as if the warrant is full or limited
• Clarification of what the warranty does and does not cover.
• The expected useful life should be considered while issuing the warranty