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Dear Sir, I have a question as follows:
A COMPANY SELLS 100 MACHINES FOR $500 EACH DURING THE FIRST WEEK OF THE YEAR. EACH DEAL INCLUDES ONE YEAR’S FREE CREDIT, VALUED AT $25 PER MACHINE AND A 3-YEAR FREE PARTS WARRANTY VALUED AT $10 PER MACHINE PER YEAR. DESCRIBE HOW REVENUE WOULD BE RECOGNISED IN THE YEAR OF SALE.
My answer is as follows:
Revenue = 100* 500 = $ 50,000
Cost of giving one year credit = $ 100 * 25 = $2500
Cost of providing free parts warranty ( for 1 year) = 100 * 10 = $1000Net Revenue = (50,000 -2500 – 1000) = $46,500
Answer from KAPLAN BOOK reads the following
Machine Revenue = 100 * (500-30-25) = $44,500
Warranty Revenue = 100 * 10 = $1000
Interest Income = 100 * 25 = $2,500Total = $48,000
The issue is why on earth would a warranty be a revenue, the question clearly says the parts are FREE, so this should be a cost to the company
Also, i do not understand why 30 and 25 are subtracted from 500 for the revenue, if they are subtracted why are they added back as revenue?
For the interest income, why is it an interest charged to the customer rather than a loss of interest due to a given credit ( like paper F9 )
Thank you
“The issue is why on earth would a warranty be a revenue, the question clearly says the parts are FREE, so this should be a cost to the company” – imagine that the company has made a provision for this potential warranty out-going
So, instead of crediting revenue, the company has credited the warranty value to a provision account
After the warranty period has elapsed there in now no longer a potential outflow so the provision is no longer needed
Dr Warranty Provision Account, Cr Warranty Revenue Account
“i do not understand why 30 and 25 are subtracted from 500 for the revenue” – IFRS 15 says that revenue should be recognised when it is earned. If it isn’t eared immediately, it shall be deferred to a period when it IS earned
The 30 and the 25 are not earned at the point of sale – there are continuing obligations related to warranties (for three years) and the credit period of a year will not be complete for ….. a year. So only then will the cost of allowing that credit period be earned
Therefore, of the total revenue from the sale, the amount to be recognised at the end of the first full year (note, the machines were sold in the first week of the accounting year!)
100 machines x value less warranty and interest free credit period
100 machines x the first year’s warranty
100 machines x value of interest free credit periodIn the first year’s statement of profit or loss will be
100 x (500 – 30 – 25) = 44,500
100 x 10
100 x 25Is that better?
Dear Sir, thank you very much for your response. I’m really grateful the way you have replied point by point. Two issues: WARRANTY and MACHINE revenue (deferral) are crystal clear, although here we have made a vital assumption that NO CUSTOMER has complained. Do you think this would have been an important point to include in the question?
Regarding the interest free credit period, I understand that the company has given an incentive to its customers by selling the machines on credit WITHOUT interest. I mean i understand we have removed from the $500 at the point of sale and then re added as a deferred revenue at the year end, my concern is on the wording “free credit period” (it’s like this in paper F9, when the company gives a discount or waive an interest, it’s a cost to the company, not a revenue.
If any customer HAD complained, that would have been included within the information given
Giving discounts and waiving interest are both actual costs to the company. They represent income that is being foregone.
Allowing an interest free credit period is merely deferring income – it’s not losing revenue, merely deferring it (unlike discounts and foregone interest which was receivable but has now been given up)
Is that ok?
That is much better, i thank you very much Sir. Really Tutors like you and Sir John are getting thousands of blessings throughout the world. Thank u so much.
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