Option to purchase additional goods at discounted price in case the product fails

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Anuradha13
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Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

Hi Guys,

Company provides an option to purchase an additional good at a discounted price if the product fails to function, if it fails in 1st month, at 80% discount, if its in 2nd month, 70% discount and so on, if it fails in 12th month, no discount and customer has to pay full to purchase the product.

Company does not considers this as warranty as the company's warranty policy is to only provide service visits and repairs and not replacing or selling at discounted price.


Should this be considered under option to purchase additional goods and a separate performance obligation.


Thanks,
Anuradha
JRSB
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by JRSB »

As well as refunding the faulty product, or instead?
Anuradha13
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

no refund, customer can buy the new one at discounted price
pub_acco
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by pub_acco »

Is it not just one form of warranties (for the purpose of accounting only).
Leo
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Leo »

I would try the decision tree :

https://annualreporting.info/additional ... r_services

and concludes either the option is a material right or not, if yes, then it gives rise to a performance obligation.

If it's not a material right, so I guess you just recognise the revenue in full at a point in time for the first good delivered and the discounted one when the time comes.

If it's a material right, I guess you'll have to estimate the material right of the option, allocate the price accordingly and recognise it in liability along with the sale of the first good.

This is only what I would do in that case but what's your thought guys ?
Anuradha13
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

Thanks Leo.

if this offer is unlimited ie the customer can purchase the third one fails at discounted price if the second one fails and if the third one fails, they can buy fourth at discounted price and so on.

Does it still fall under 'Option to purchase additional goods' section.


Thanks,
Anuradha
Leo
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Leo »

Is the third one's discount based on the second one or the first one ? For example you sell product A for 100 LC and the product fails within the first month, so you sell a second one for 80 LC and the second one fails within the first month, so you sell a third one for 80 LC or 80 LC * 80% which is 64 LC ?
Anuradha13
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

It is not based on the price of first and second. third one will be sold at 80 again.
JRSB
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by JRSB »

Presumably the historic record is that the products do fail with a % probability?
Anuradha13
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

Yes, based on the historic record product has failed in 6 or 7 month.
JRSB
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by JRSB »

So over time every product is expected to come with a 30-40% off voucher for another product.
Anuradha13
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

Yes, our estimation is that the product fails in 6th or 7th and the client gets 30% to 40% discount on the following product.
since this is unlimited, how do we consider it as a separate performance ? it would be difficult to estimate how many products.
Leo
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Leo »

Hi,

Here is what I would do :

1. Evaluate the nature of the entity's promise : either it is a custom option or a variable consideration because depending on the conclusion, the accounting treatments are different. If it's a variable consideration, an entity will have to estimate at inception the variable consideration expected over the life of the contract and update the estimates at each reporting period.

One of the characteristics distinguishing if it's an option or not is that the entity is not obligated to provide additional goods and services until the customer exercises the option. By looking at the terms of your post, I think it's the case because the customer can choose whether to take the option or not, and the obligation is not fulfilled unless the customer choose the option. This makes me think that it's an option and I would move to step 2.

2. If it's an option, the entity need to determine if there is a material right. If not, no accounting until the subsequent purchase occurs. If yes, then, assess the value of the option and allocate a portion of the transaction price to the material right at contract inception and recognise the revenue when the option is exercised.

So, for me, I would first see whether there is a material right in the contract. And I think it's not that straight forward, there are certain criteria's, you can see this article :

https://revgurus.com/knowledge-center-i ... component/

Based on the criteria's listed in this article, I would focus on point 2 and 3 :
2) : (...) that it would not receive without entering into that contract (for example, a discount that is incremental to the range of discounts typically given for those goods or services to that class of customer in that geographical area or market).
3) : (...) would reflect the stand-alone selling price for that good or service, that option does not provide the customer with a material right

You asked about what if the option applies only to the next product, also, if the option is unlimited.

For me, I think, if it only applies once, to the next product, it's a material right. Because it seems to me that all the criteria's of the material right are satisfied. And I would, based on the probability of failure which is around the 6th month, calculate the value of the option. For example, product A is sold at 100 LC, discount applicable at the 6th month failure of the product A is 40%, and you expect a 50% of chance that the customer would exercise the option, the calculation could be :

100 * 40% * 50% = 20 LC

And then you allocate it to the option (20/120 * 100 = 16.7 LC) recognised in liability at inception and in revenue when the option will be exercised.

Now, if the option is unlimited, I do think that the material right reflect the stand-alone selling price for that good (criteria 3 of the article) and that option does not provide the customer with a material right. Thus, accounting only when the subsequent purchase occurs.

The reason, for me, is that the customer who's contracted this contract, will buy the next good at 40% in perpetuity. It's neither a one off nor something that happens only a few times. It's become normality. (In fact, selling at 60 LC occurs more often then selling at 100 LC)

"The best evidence of standalone selling price is the price a reporting entity charges for that good or service when the reporting entity sells it separately in similar circumstances to similar customers. However, goods or services are not always sold separately. The standalone selling price needs to be estimated or derived by other means if the good or service is not sold separately. This estimate often requires judgment, such as when specialized goods or services are sold only as part of a bundled arrangement. "

https://viewpoint.pwc.com/dt/us/en/pwc/ ... da_US.html

Does this applies to your entity ? And what's your thoughts ?
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Marek Muc
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Marek Muc »

Some pretty solid analysis by Leo!
Anuradha13
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

Thank you so much for the detailed explanation Leo.

This unlimited offer applies when this particular product is sold with a machinery (a significant component) and also when the product is sold separately at 100 (the unlimited offer is included to buy at discounted price when it fails ) to the customer who has already bought the machinery in the earlier periods.


since the offer is included even when the product is separately and buying at 60 is more than at 100.

does this mean the offer reflects the standalone selling price ?


Thanks,
Anuradha
Leo
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Leo »

Hi,

For me, I think so, because 100 LC only happens once, and 60 will happen at perpetuity.

In this article, there is the methods used to determine the standalone selling price :

https://www.bakertilly.com/insights/con ... ling-price

If you take the expected cost plus margin method for example, what you can do is ask your cost controlling team, what's the cost and the margin they've forecasted for this product.

I think there might be possible that they'll tell you their targeted selling price isn't 100 LC but 60 LC (cost + margin).
Anuradha13
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Joined: 28 Apr 2022, 11:47

Re: Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

Thank you Leo.

I did speak internally today. unfortunately the margin at 60 is less than the expected/estimated margin.
Leo
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Leo »

So, what's the expected margin or cost + margin and how many times did they expect the product to be renewed by the customer ?
Anuradha13
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

I am still trying to collect this information. I will get back to you with these details.
Leo
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Leo »

Thanks.

You said earlier that the product is sold with the machinery, so how long do you expect the machinery to function ?

For example, if the machinery has a economic life of 3 years, that means, for me, that the customer will buy the first product at inception for 100 LC, and after every six months for 60 LC. That would be 100 LC + 60 LC * 5 = 400 LC in total. The average selling price is 66.67 LC which is not 60 LC but isn't far from it. Hence, I would conclude that the price reflect the standalone selling price and that option doesn't provide the customer with a material right.

So maybe ask them, in reality, how many times did the customer renew, even that in the contract, it says that it's unlimited. And then, Assess the material rights based on the average selling price.
Anuradha13
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Anuradha13 »

the estimated useful life of the machinery is considered to be 7 years. our sales department is still working on this, as this is something new that we are planning to offer.

Yesterday, i received this discount model.
Discount model
Discount model
Leo
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Re: Option to purchase additional goods at discounted price in case the product fails

Post by Leo »

I would argue in the way that the option doesn't provide a material right, hence, no accounting.
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