CHAPTER 2

PREMIUM WARRANTY AND LIABILITY

PREMIUMS
Premiums are articles of value such as toys, dishes,
silverware and other goods, and in some cases cash
payments given to customers as result of past sales or
sales promotions activities.
In order to stimulate the sale of their products, entities
offer premiums to customers in returns for product
labels, box tops, wrappers and coupons.
Accordingly, when the merchandise is sold, an
accounting liability for the future distribution of the
premium arises and should be given accounting
recognition.
 Accounting procedure for the acquisition and
recognition of premium liability
When premiums are purchased :
Premiums xx
Cash xx

When premiums are distributed to customers”

Premium Expense xx
Premiums xx

At the end of the year, if premiums are still outstanding:

Premium Expense xx
Estimated Premium Liability xx
Illustration :
An entity manufactures a certain product and sells it at P300 per unit. A soup bowl
is offered to customers on the return of 5 wrappers plus a remittance of P10. The
bowl costs P50, and it is estimated that 60% of the wrappers will be redeemed.
The data for the first year concerning the premium plan are summarized below :
Sales, 10,000 units at P300@ 3,000,000
Soup bowls purchased, 2,000 units at P50@ 100,000
Wrappers redeemed 4,000

ENTRIES :
To record the sales :
Cash 3,000,000
Sales 3,000,000

To record the purchase of the premiums :

Premiums – soup bowls 100,000
Cash 100,000
To record the redemption of 4,000 wrappers :
Cash (800x10) 8,000
Premium Expense (800x40) 32,000
Premiums – soup bowls (800x50)40,000
(4,000 wrappers / 5 = 800 bowls distributed)

To record the liability for the premiums at the end of the first year :
Premium Expense 16,000
Estimated premium liability 16,000

COMPUTATION :

Wrappers to be redeemed (60% x 10,000 wrappers) 6,000

Less : Wrappers redeemed 4,000
Balance 2,000
=====
Premiums to be distributed 400 =====
Estimated warranty liability (400 x 40) 16,000
======
Financial Statement Classification :
Current Asset :
Premiums – soup bowls 60,000
Current Liability :
Estimated premium liability 16,000
Distribution Cost :
Premium Expense 48,000

CUSTOMER LOYALTY PROGRAM – IFRS 15

Many entities use a customer loyalty program to build brand loyalty, retain their valuable
customers and increase sales volume. It is designed to reward customers for past purchases
and provide incentives to make further purchases.

AWARD CREDITS - points granted to customers who buys goods and services, which has to be
accumulated to a specified minimum number before it can be redeemed.

MEASUREMENT :
An entity should account for the award credits as a separate component of the initial sale
transaction. The granting of the award credits is effectively accounted for as a “future
delivery of goods or services”

The entity shall allocate the transaction price to each performance obligation identified in a
contract on a relative stand-alone selling price basis.. The fair value of the consideration
received with respect to the initial sale shall be allocated between the award credits and the
sale based on relative stand-alone selling price.

Stand-alone selling price is the price at which an entity would sell a promised good or service
separately to customer.
RECOGNITION :
Deferred Revenue = initial recognition of the consideration allocated
to the awards credits.
Revenue = recognition of redeemed award credits.

The amount of revenue recognized shall be based on the number of

award credits that have been redeemed relative to the total number
expected to be redeemed.

The estimated redemption is assessed each period. Changes in the

total number expected to be redeemed do not affect the total
consideration for the award credits. Changes in the total number of
award credits expected to be redeemed shall be reflected in the
amount of revenue recognized in the current and future periods. The
calculation of the revenue to be recognized in any one period is made
on cumulative basis in order to reflect the changes in estimate.
Illustration – IFRS 15
An entity, a grocery retailer, operates a customer loyalty program.
The entity grants program members loyalty points when they
spend a specified amount on groceries. Program members can
redeem the points for further groceries since it has no expiry date.
The sales during 2016 amounted to P7,200,000 based on stand-
alone selling price. During 2016, the customers earned 10,000
points. But management expects that 80% or 8,000 or these
points will be redeemed. The stand-alone selling price of each
loyalty point is estimated at P100. On December 31, 2016, 4,000
points have been redeemed in exchange for groceries. In 2017,
the management revised its expectations to 90% or 9,000 points
will be redeemed altogether.
During 2017, the entity redeemed 4,100 points. In 2018, further
900 points are redeemed. Management continues to expect that
only 9,000 points will ever be redeemed, meaning, no more points
will be redeemed after 2018.
ALLOCATION OF TRANSACTION PRICE :

Product Sales 7,200,000

Points – stand-alone selling price (8,000x100) 800,000
Total 8,000,000

Product Sales (7,200,000/8,000,000x7,200,000) 6,480,000

Points (800,000/8,000,000x7,200,000) 720,000
Total Transaction price 7,200,000

JOURNAL ENTRIES :
Initial sale in 2016 is recorded as follows ;
Cash 7,200,000
Sales 6,480,000
Unearned revenue – points 720,000

The redemption of 4,000 points is record as :

Unearned revenue – points 360,000
Sales 360,000
In 2017, the redemption of 4,100 points is recorded as :
Unearned revenue-points 288,000
Sales 288,000
Points redeemed in 2016 4,000
Points redeemed in 2017 4,100
Total points redeemed to 12/31/2017 8,100

Cumulative revenue on Dec. 31, 2017

(8,100/9,000 x 720,000) 648,000
Revenue recognized in 2016 (360,000)
Revenue to be recognized in 2017 288,000

In 2018, the redemption of 900 points is recorded as:

Unearned revenue – points 72,000
Sales 72,000

Points redeemed in 2016 4000

Points redeemed in 2017 4100
Points redeemed in 2018 900
Total points redeemed to 12/31/2018 9,000

Cumulative Revenue – December 31, 2018

(9,000/9,000 x 720,000) 720,000
Cumulative Revenue – December 31, 2017 (648,000)
Revenue to be recognized in 2018 72,000
WARRANTY
Home appliances like television sets, stereo sets, radio sets, refrigerators and the
like are often sold under guarantee or warranty to provide free repair service or
replacement during a specified period if the products are defective. Such entity
policy may involve significant costs on the part of the entity if the products sold
prove to be defective in the future within the specified period of time.
Accordingly, at the point of sale, liability is incurred.

ACCRUAL APPROACH :
The accrual approach has the soundest theoretical support because it properly
matches cost with revenue. Following this approach, the estimated warranty cost
is recorded as follows :

Warranty expense xx
Estimated Warranty Liability xx

When actual warranty cost is subsequently incurred and paid, the entry is:
Estimated Warranty Liability xx
Cash xx
Any difference between estimate and actual cost is a
change in estimate and therefore treated currently or
prospectively, if necessary.
If the actual cost exceeds the estimate, the difference
is charged to warranty expense as follows :
Warranty Expense xx
Estimated warranty liability xx
If the actual cost is less than the estimate, the
difference is an adjustment to warranty expense as
follows :
Estimated warranty liability xx
Warranty Expense xx
ty sells 1,000 units of television sets at P9,000 each for cash. Each television set is under
ty for one year. The entity has estimated from past experience that warranty cost will
ly average P500 per unit and only 60% of the units sold will be returned for repair. The entity
P180,000 for repairs during the year

NTRIES:

e sales :
9,000,000
ales 9,000,000

e estimated liability on the warranty :

ty Expense 300,000
stimated warranty liability 300,000

ed sets to be returned (60% x 1000) 600 sets

y by estimated warranty cost per set 500
ed warranty cost 300,000

e payment of the actual cost :

ed warranty liability 180,000
ash 180,000

ment of financial position at the end of the year would report estimated warranty liability of
00 as a current liability
pproach
pensing warranty cost only when
his approach is justified on the basis of
arranty cost is not very substantial or
period is relatively short.

gerators that carry a 2-year warranty

e sales and warranty repairs are made
he year. Based on past experience, the
stimated warranty cost as a percentage

ranty 4%
warranty 10%
016 2017
0,000 6,000,000
airs 140,000 300,000
Journal Entries :
2016
To record the sales :
Cash 5,000,000
Sales5,000,000

To record the warranty expense

Warranty expense 700,000
Estimated warranty liability 700,000
(14% x 5,000,000)
Note that the total warranty expense each year is 14% to be incurred over a 2-year warranty period.

To record the actual warranty repairs:

Estimated warranty liability 140,000
Cash 140,000

2017
To record the sales :
Cash 6,000,000
Sales6,000,000

To record the warranty expense :

Warranty expense 840,000
Estimated warranty liability 840,000
(14% x 6,000,000)

To record the actual warranty repairs :

Estimated warranty liability 300,000
Cash 300,000
At this point, on December 31, 2017, the estimated warranty
liability is P1,100,000, determined as follows :

Warranty Expense :
2016 700,000
2017 840,0001,540,000
Actual Warranty Expense :
2016 140,000
2017 300,000 440,000
Estimated Warranty Liability, 12/31/17 1,100,000

Testing the accuracy of warranty liability

On December 31, 2017, the estimated warranty liability account
may be analyzed based on 4% and 10% estimate to determine
whether the actual warranty costs approximate the estimate
SALES MADE EVENLY :
To have an easier interpretation or understanding of sales accruing evenly during the year, it is fair to assume that half of the
sales were made on January 1 and the other half on July 1. Thus, the first contract year under a 2-year warranty of the sales
made on January 1, 2016 will be within January 1, 2016 to December 31, 2016 and the second contract year will be within
January 1, 2017 to December 31, 2017. The first contract year under a 2-year warranty of the sales made on July 1, 2016 will
be within July 1, 2016 to June 30, 2017 and the second contract year will be within July 1, 2017 to June 30, 2018.

Computations :
If sales and warranty repairs are made evenly during the year, the warranty expense for 2016-2017 and the estimated warranty
liability on December 31, 2017 are determined as follows :

Warranty Expense Related to 2016 sales :

2016
First contract year of January 1, 2016 sales
(2,500,000 x 4%)100,000
First contract year of July 1, 2016 sales
(2,500,000 x 4% x 6/12) 50,000

2017
First contract year of July 1, 2016 sales
(2,500,000 x 4% x 6/12) 50,000
Second contract year of July 1, 2016 sales
(2,500,000 x 10%) 250,000
Second contract year of July 1, 2016 sales
(2,500,000 x 10% x 6/12) 125,000

2018
Second year contract year of July 1, 2016 sales
(2,500,000 x 10% x 6/12) 125,000
Total Warranty Expense for 2016700,000
Warranty Expense related to 2017 sales :
2017
First contract year of January 1, 2017 sales 120,000
(3,000,000 x 4%)
First contract year of July 1, 2017 sales
(3,000,000 x 4% x 6/12) 60,000

2018
First contract year of July 1, 2017 sales
(3,000,000 x 5% x 6/12) 60,000
Second contract year of January 1, 2017 sales
(3,000,000 x 10%) 300,000
Second contract year of July 1, 2017 sales
(3,000,000 x 10% x 6/12) 150,000

2019
Second contract year of July 1, 2017 sales
(3,000,000 x 10% x 6/12) 150,000
Total Warranty Expense for 2017 840,000
The warranty costs after December 31, 2017 represent the estimated warranty
liability on December 31, 2017.
2016 sales under warranty after December 31, 2017
Second contract year of July 1, 2016 sales 125,000
2017 sales under warranty after December 31, 2017:
First contract year of July 1, 2017 sales 60,000
Second contract year of January 1, 2017 sales 300,000
Second contract year of July 1, 2017 sales 300,000

Estimated warranty liability – Dec. 31, 2017 785,000

Estimated warranty liability per book 1,100,000
Decrease in warranty liability (315,000)

The decrease in warranty liability is an adjustment of the warranty expense of

2017 as follows :

Estimated warranty liability 315,000

Warranty Expense 315,000
SALE OF WARRANTY :
A warranty is sometimes sold separately from the product. When the products are sold, the
customers are entitled to the usual manufacturer’s warranty during a certain period. However,
the seller may offer an extended warranty on the product sold but with additional cost.
The sale of the product with the usual warranty is recorded separately from the sale of the
extended warranty.
The amount received from the sale of the extended warranty is recognized initially as deferred
revenue and subsequently amortized using straight line over the life of the warranty contract.

Illustration :
An entity sold a product for P3,000,000. The regular warranty period for the product is two
years. The entity sold an additional warranty of two years at a cost of P60,000.
The sale is recorded as follows :
Cash3,060,000
Sales 3,000,000
Unearned warranty revenue 60,000
The extended warranty contract starts only after the expiration of the regular two-year warranty
period.
If the costs are incurred evenly, the unearned warranty revenue is amortized at the end of the
third year as follows :

Unearned warranty revenue 30,000

Warranty Revenue (60,000,2years) 30,000