Question

Pleasant Co. manufactures specialty bike accessories. The company is known for product quality, and it has offered one of the best warranties in the industry on its higher-priced products—a lifetime guarantee, performing all the warranty work in its own shops. The warranty on these products is included in the sales price. Due to the recent introduction and growth in sales of some products targeted to the low-price market, Pleasant is considering partnering with another company to do the warranty work on this line of products, if customers purchase a service contract at the time of original product purchase. Pleasant has called you to advise the company on the accounting for this new warranty arrangement.

Instructions

If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses.

1. Identify the accounting literature that addresses the accounting for the type of separately priced warranty that Pleasant is considering.
2. When are warranty contracts considered separately priced?
3. What are incremental direct acquisition costs and how should they be treated?

Short answer

1. An item maintenance contract or an enhanced guarantee offered separately is handled in terms of income and costs.
2. The contracts are considered separately priced when buyers can purchase an additional extended warranty.
3. The contract is immediately allocated the incremental direct cost, which is the additional direct cost.

Step-by-step solution

Meaning of FASB

FASB is autonomous for the non-profit, private association that develops financial accounting and reporting standards for for-profit and public businesses that follow GAAP.

(a) Identifying account literature

In understanding FASB ASC 605-20-25, revenue and expenses related to an item upkeep contract or an amplified guarantee sold separately are addressed.

(b) Explaining when warranty contracts are considered separately priced

An Extended Warranty is a contract that promises to extend the original manufacturer's warranty's coverage duration or to give warranty protection beyond the original warranty's sphere of application if any.

Maintenance of Products Contracts are agreements to carry out specific agreed-upon services to maintain a product for a predetermined time. The conditions of the contract may express in various ways, such as an agreement to carry out a certain service regularly or an agreement to carry out a specific service as needed during the duration of the contract.

Separately Priced Contracts are agreements that provide the buyer the choice to add an extended warranty or a maintenance contract to their purchase for a clearly stated sum in addition to the product's purchase price.

(c) Explaining the incremental direct acquisition costs and how they should be treated

Incremental direct acquisition costs are expenses that are delayed and charged in proportion to revenue realized that are directly associated with the acquisition of a contract but would not have been incurred absent that contract. All other expenditures, including those for services rendered by the contract, general and administrative costs, marketing costs, and expenses related to contract negotiations that do not result in a consummated agreement, must be charged to expenses as they are incurred.