Sales incentives, future product returns and product warranties are classified as current liabilities. Unlike accounts payable where both payee and amount are known, three of them are not; payee is unknown and amount is estimated—therefore, they are accounted differently. So, what is the journal entry for each of them? You may ask. That is the topic I am going to discuss through this post.
What commonly known for current liabilities, in general, are obligations that due on demand or will be due on demand within one year—or the operating cycle (if it is longer.)
According to the FASB’s ASC 210-10-20, current liabilities are obligations whose liquidation is reasonably expected to require the use of existing resources classified as current assets OR the creation of other current liabilities. (Important note: the definition excludes from the current liability classification any currently maturing obligations that will be satisfied by using long-term assets and currently maturing obligations expected to be refinanced.) Current liabilities’ definition is surely important, but how to measure and how to account the current liabilities are even more important for those who actually conduct accounting works on daily basis.
You’re right; measurement of current liabilities is generally straightforward, but some liabilities are difficult to measure because of uncertainties—regarding whether an obligation exists, how much of an entity’s assets will be needed to settle the obligation, and when the settlement will take place can impact and for how much an obligation will be recognized in the financial statements.
Sales incentives, future product returns and product warranties have higher degree of uncertainties—compare to accounts payable incurred of purchases—for payees are unknown and the amounts are determined by estimations. Let’s discuss each of them—with case examples—to see what journal entries are required for each of them. Read on…
1. Sales Incentive
Many enterprises, today, offer sales incentive—in various ways—to increase their sales. It could be called “points” or “box tops” or “number of miles” (in the case of airlines) or “wrappers” (usually consumer goods) or any other proofs of purchase, but all of them are form of sales strategy that incentive customer keep purchasing. And they may or may not require the payment of a cash amount.
So, when and how do you record the sales incentives?
If the incentive offer terminates at the end of the current period but has not been completely accounted for, or if it extends into the next accounting period, a current liability for the estimated number of redemptions that are expected in the future period would be recorded.
If the incentive offer extends for more than one accounting period, the estimated liability must be divided into a current portion and a long-term portion. For easier understanding let’s construct a case example.
Air Asia, a specialty airline offering economical flights from and to Asia regular fliers—which I actually ever flied with Brisbane-Singapore, offers frequent flier miles to its passengers for example. Anyone remitting 15,000 mileage points earns a free flight on Air Asia, which costs the airline $120 per flight granted, or approximately $0.008 per mileage point remitted.
In March, the airline granted 23,000,000 mileage points, having a total value of $184,000 (23,000,000 miles flown × 0.008). Air Asia’s history of mileage claims remitted over the past 12 months has been that 40% of all mileage points are eventually remitted.
Thus, Air Asia records the following liability in March, based on recognition of 40% of the total value of mileage points granted:
[Debit]. Passenger transportation expense = $73,600
[Credit]. Un-remitted mileage points liability = $73,600
In the same period (April,) 8,475,000 mileage points are remitted by Air Asia’s passengers for free flights.
The cost of these remittances is as follows:
Mileage points remitted = 8,475,000
Cost per mileage point = × $ 0.008
Total liability reduction = $67,800
Air Asia records the liability reduction with the following entry:
[Debit]. Un-remitted mileage points liability = $67,800
[Credit]. Passenger transportation expense = $67,800
The actual cost of transportation of passengers paid or accrued by Air Asia at the time the flights occur is thus reduced by the amount accrued at the time the points currently being redeemed were awarded.
A year later, Air Asia finds that the mileage points remittance rate has risen from 40% to 42%. At this time, there are 163,000,000 mileage points outstanding. Air Asia records a liability for the incremental increase of 2% in the remittance level with the following entry:
[Debit]. Passenger transportation expense = $26,080
[Credit]. Un-remitted mileage points liability = $26,080
The entry is based on the following calculation:
Mileage points outstanding = 163,000,000
Net increase in percentage = × 2%
Cost per mileage point = × $ 0.008
Total liability = $26,080
Air Asia receives an offer to sell 20,000,000 mileage points to the HSBC branded credit card for example, which in turn sells the points to its card holders in exchange for purchases made with its credit card. The sale price is $0.005 per mile sold, resulting in the following entry:
[Debit]. Cash = $100,000
[Credit]. Revenue = $100,000
Air Asia must also record the related cost of this transaction. Based on its estimated 42% mileage points remittance rate and $0.008 cost per mileage point, Air Asia arrives at the following estimated cost of the transaction:
Mileage points sold = 20,000,000
Mileage remittance percentage = × 42%
Cost per mileage point = × $ 0.008
Total estimated cost = $67,200
Air Asia records the following entry to record the expense associated with the mileage point sale:
[Debit]. Passenger transportation expense = $67,200
[Credit]. Un-remitted mileage points liability = $67,200
As you can see from the case example, the company (Air Asia in this case) does not know yet who the payees and how much the exact amounts are—thus it records estimation-based amounts, until it is actually claimed by the payee (passengers in this case.)
2. Future Product Returns
Unless they are consumer goods, most products are sold with “product-return” right to customers, now days. Customers who purchase the product are given the right to return if the product does not function or does not meet specification stated on the product spec, during normal course of usage in within certain period (1 week or 1 month or six month for example, depend on how comfortable the management of the company with their products.)
With the return-right, means failure risks are taken over by the seller, so that customers feel safe in closing the deal (purchase the products.) And this is a form of current liability that company would need to record, but payees are unknown at certain estimated amount.
Future product returns are accrued if a buyer has a right to return the product purchased and the sale is recognized currently. Per FASB’s ASC 605-15, an accrual for returns must reduce both revenue and the associated cost of sales.
In the relatively rare situation where the reporting entity is unable to make a reasonable estimate of the amount of future returns, the sale cannot be recognized until the return privilege has expired or conditions permit the loss to be estimated—at which point it would become reportable.
Some examples of factors that might impair the ability to reasonably estimate a loss are:
- Absence of experience with returns on similar products sold to similar markets
- A lengthy period over which returns are permitted
- Susceptibility of the product to technological or other obsolescence
- Sales are few, significant, and have unique terms (rather than a large number of relatively homogeneous sales of small dollar amounts).
For better understanding, have a look at the next case example.
The BigTruck manufactures high-powered big trucks, for which it issues a six-month return policy to its distributors. It recently developed the KingTruck-050 model, which is an incremental enhancement of earlier models, with more horsepower and a tighter suspension. Given its similarity to earlier models, BigTruck’s management is comfortable in extending the historical product return rate of 10% to sales of the KingTruck-050 model.
In February, BigTruck sold $840,000 of KingTruck-050 big trucks which have an associated cost of $504,000 (a 60% cost of goods sold). At the same time, the company records $84,000 (10% of gross sales) in an allowance for sales returns, resulting in the following income statement presentation:
Sales = $840,000
Less: sales returns = $(84,000)
Net sales = $756,000
Note that, to fully comply with the requirements of ASC 605-15, a reserve for the cost of the estimated product should also be provided, with a corresponding reduction of cost of sales, as follows:
Cost of sales = $504,000
Less: cost of sales on estimated returns = $(50,400)
Net cost of sales = $453,600
In the following month, ten KingTruck-050 models are returned to BigTruck. The revenue originally recorded on their sale was $24,000, with associated cost of goods sold of $14,400. However, there is some damage to the models, which will require $3,000 to repair. BigTruck records the transaction with the following entry:
[Debit]. Allowance for sales returns = $24,000
[Debit]. Inventory—rework = $11,400
[Debit]. Loss—returned inventory damage = $3,000
[Credit]. Accounts receivable = $24,000
[Credit]. Allowance for cost of sales on product returns = $14,400
BigTruck develops an entirely new, high-powered big truck, called the KnightTruck-X, which requires the substantial redesign of its basic big truck platform. Also, it is to be sold strictly to high-power big truck with whom the company has minimal sales experience, with sale terms allowing returns only within the first two months.
In the first month, BigTruck has $150,000 of KnightTruck-X sales, for which the related cost of goods sold is $100,000. Given the sales return uncertainty associated with this model, BigTruck records no revenue during the first month, waiting until the second month for the product return policy to expire before recording any revenue.
In the first month, its entry to record KnightTruck-X sales is:
[Debit]. Accounts receivable = $150,000
[Credit]. Unearned revenue = $150,000
[Debit]. Inventory—customer location = $100,000
[Credit]. Finished goods inventory = $100,000
At the end of the second month, after the right of return has expired, BigTruck uses the following entry to record the sale and its related profit:
[Debit]. Unearned revenue = $150,000
[Credit]. Revenue = $150,000
[Debit]. Cost of goods sold = $100,000
[Credit]. Inventory—customer location = $100,000
“Is it okay to not record revenues?” You may ask. Well, the decision not to record revenues until after the risk of product returns has lapsed is relatively unusual in practice, and will be dependent on careful consideration of all the facts and circumstances.
3. Product Warranties
Along with the ‘return-right’, companies also often provide product warranties to make their customers feel comfortable with the purchase.
Product warranties providing for repair or replacement of defective products may be sold separately or may be included in the sale price of the product.
- If the warranty extends into the next accounting period, a current liability for the estimated amount of warranty expense expected in the next period must be recorded.
- If the warranty spans more than the next period, the estimated liability must be partitioned into a current and long-term portion.
FASB’s ASC-460 requires disclosure of product warranties in the notes to financial statements. Entities are required to disclose the following information:
1. The nature of the product warranty, including how the warranty arose and the events or circumstances in which the entity must perform under the warranty.
2. The entity’s accounting policy and methodology used to determine its liability for the product warranty, including any liability (such as deferred revenue) associated with an extended warranty.
3. A reconciliation of the changes in the aggregate product warranty liability for the reporting period. The reconciliation must include five components:
- The beginning aggregate balance of the liability;
- The reductions in the liability caused by payments under the warranty;
- The increase in the liability for new warranties issued during the period;
- The change in the liability for adjustments to estimated amounts to be paid under preexisting warranties, and
- The ending aggregate balance of the liability
4. The nature and extent of any recourse provisions or available collateral that would enable the entity to recover the amounts paid under the warranties, and an indication (if estimable) of the approximate extent to which the proceeds from recovery or liquidation would be expected to cover the maximum potential amount of future payments under the warranty.
5. The disclosures required by ASC-850 if the warranties are granted to benefit related parties.
Too see how product warranties are accounted, let’s have a look at the next case example.
The Sun International Corporation manufactures washing machines. It sells $900,000 of washing machines during its most recent month of operations. Based on its historical warranty claims experience, it reserves an estimated warranty expense of 2% of revenues with the following entry:
[Debit]. Warranty expense = $18,000
[Credit]. Reserve for warranty claims = $18,000
During the following month, Sun International incurs $10,000 of actual labor and $4,500 of actual materials expenses to repair warranty claims, which it charges to the warranty claims reserve with the following entry:
[Debit]. Reserve for warranty claims = $14,500
[Credit]. Labor expense = $10,000
[Credit]. Materials expense = $4,500
Sun International also sells three-year extended warranties on its washing machines that begin once the initial one-year manufacturer’s warranty is completed. During one month, it sells $54,000 of extended warranties, which it records with the following entry:
[Debit]. Cash = $54,000
[Credit]. Unearned warranty revenue = $54,000
This liability is unaltered for one year from the purchase date, after which the extended warranty servicing period begins. Sun International recognizes the warranty revenue on a straight-line basis over the 36 months of the warranty period, using the following entry each month:
[Debit]. Unearned warranty revenue = $1,500
[Credit]. Warranty revenue = $1,500
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