How to account for warranties and customer incentives

Warranties and customer incentives are common features of modern sales contracts. While they help drive customer engagement and sales volume, they also introduce additional performance obligations, variable consideration, or future cost liabilities depending on how they are structured. Both IFRS 15 and ASC 606 provide specific guidance on distinguishing between assurance-type warranties, service-type warranties, and sales incentives, each with different accounting implications. Accurately classifying and measuring these elements is critical to ensure compliant revenue recognition and financial reporting.

Warranties must be classified based on whether they provide assurance or services.

IFRS 15 and ASC 606 distinguish between two types of warranties:

1. Assurance-type warranty (standard product warranty):

   • Guarantees the product complies with agreed-upon specifications

   • Covers defects or malfunctions for a specified period

   • Does not provide additional goods or services

2. Service-type warranty (extended or optional warranty):

   • Provides a distinct service in addition to the product sale

   • May be purchased separately or included for a fee

   • Considered a separate performance obligation

Warranty Type	Accounting Treatment
Assurance-type	Accrue estimated cost as a liability
Service-type	Recognize as separate revenue component

Assurance-type warranties are treated as cost provisions.

When a warranty is provided as part of the sale, it is usually an assurance-type warranty. The company must:

• Estimate the expected cost of claims

• Recognize a warranty provision at the time of sale

• Record the offsetting warranty expense in the income statement

Example journal entry (warranty liability estimate at sale):

Dr. Warranty expense                   8,000  
    Cr. Warranty liability                       8,000

The liability is reviewed and adjusted at each reporting date based on:

• Historical claim rates

• Product defect rates

• Changes in coverage or usage

Service-type warranties are treated as deferred revenue.

If the warranty provides a separate service, such as an extended protection plan:

• A portion of the sale price is allocated to the warranty

• Revenue is deferred and recognized over the warranty period

• The allocation is based on standalone selling prices

Example journal entry (warranty is a separate obligation):

Dr. Cash or Accounts receivable      15,000  
    Cr. Revenue (product)                      13,000  
    Cr. Deferred revenue (warranty)            2,000

Revenue for the warranty is then recognized straight-line or based on usage patterns.

Customer incentives must be evaluated as variable consideration or separate obligations.

Incentives may take several forms:

• Cash rebates or loyalty points

• Volume discounts or price concessions

• Free or discounted goods or services

Accounting depends on the nature of the incentive:

1. If tied to the current contract:

   • Treated as variable consideration

   • Estimate the reduction in revenue at the time of sale

   • Apply a constraint to ensure only probable revenue is recognized

2. If the incentive provides a future right (e.g., points for future goods):

   • Treated as a separate performance obligation

   • Allocate part of the transaction price to the incentive

Loyalty programs and points are accounted for as deferred revenue.

If customers earn points redeemable for goods or services:

• A portion of the sale price is allocated to the points

• A contract liability is recognized

• Revenue is recognized when the points are redeemed or expire

Incentive Type	Treatment
Cash rebate (same sale)	Variable consideration
Future product discount	Separate performance obligation
Loyalty points	Deferred revenue
Volume-based discount	Variable consideration (estimate)

Example journal entry (loyalty points):

Dr. Cash or Accounts receivable     100,000  
    Cr. Revenue (product/service)     96,000  
    Cr. Contract liability (points)    4,000

Estimates for incentives and warranty costs must be reassessed continuously.

Estimates of:

• Warranty claims

• Incentive redemptions

• Points breakage (unused points)

…must be updated at each reporting period using:

• Historical data

• Current trends

• Forecasted usage patterns

Changes are accounted for prospectively unless there's an error in original estimates.

Disclosures improve transparency on warranties and incentives.

Entities must disclose:

• Types of warranties and incentives offered

• Judgments in classifying and recognizing obligations

• Amounts of deferred revenue and liabilities

• Movement in balances (e.g., redemptions, expirations)

These disclosures are typically found in the notes to the financial statements under revenue recognition or liabilities.

Warranties and customer incentives can significantly affect revenue recognition and future expense expectations. Correct classification between assurance and service-type warranties, and between variable consideration and performance obligations, ensures compliance with IFRS 15 and ASC 606, and enables transparent, faithful representation of the economic substance of customer arrangements.

____________

FOLLOW US FOR MORE.

DATA STUDIOS

datastudios.org