10. Warranties and Upfront Fees

This note focuses on two key topics under ASC 606: warranties and upfront (nonrefundable) fees. These areas are common traps on the FAR exam, especially when it comes to determining when and how revenue should be recognized.

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🛠️ Warranties

🔎 Definition

A warranty is a promise by the seller to repair or replace a product if it fails to meet specified criteria.

🎯 ASC 606 Classification

Warranties are categorized as either:

1. Assurance-Type Warranty

   • Ensures that the product complies with agreed-upon specifications.
   • Not a separate performance obligation.
   • Accounted for as a cost accrual, not deferred revenue.

2. Service-Type Warranty

   • Provides a service beyond fixing product defects (e.g., extended warranty).
   • Considered a separate performance obligation.
   • Revenue is deferred and recognized over the warranty period.

Type	Description	Revenue Treatment
Assurance-type	Basic promise that product will function as intended	Not a separate performance obligation; expense is accrued
Service-type	Extended or additional warranty sold separately or implied	Treated as a separate performance obligation

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📌 Evaluation Criteria

Consider the following indicators to determine the warranty type:

• Whether the customer can purchase it separately
• Whether the warranty extends the coverage period
• The nature of the promised task

📘 Example – Assurance-Type

A company sells a product with a 1-year standard warranty included in the price:

Dr. Cash                $1,000  
    Cr. Sales Revenue            $1,000  

Dr. Warranty Expense    $50  
    Cr. Warranty Liability         $50

📌 Estimate is based on historical data, similar to accounting for contingencies.

📘 Example – Service-Type

Customer purchases a 3-year extended warranty for $150:

Dr. Cash                $150  
    Cr. Deferred Revenue        $150

(Over 3 years)
Dr. Deferred Revenue    $50  
    Cr. Warranty Revenue        $50

✅ CPA Tip:

• Watch for combined warranties (both types included). Allocate transaction price based on standalone selling prices.
• Ask whether the warranty can be bought separately — that’s usually a sign it’s service-type.
• If a warranty is required by law, it is almost always classified as an Assurance-Type Warranty.

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💵 Upfront (Nonrefundable) Fees

🔎 Definition

Upfront fees are nonrefundable amounts charged at the beginning of a contract — e.g., activation fees, membership initiation fees, setup charges.

❗ ASC 606 Treatment

Upfront fees do not represent a separate performance obligation unless they provide a distinct good or service.

• If no distinct good/service is transferred, defer the fee and recognize it over the contract period.
• Examples of non-distinct services: access rights, admin tasks, onboarding.

📘 Example – Health Club Membership

A customer pays:

• $100 initiation fee
• $400 annual membership fee

The initiation fee does not transfer a distinct good or service.

Dr. Cash                $500  
    Cr. Deferred Revenue        $500

(Monthly over 12 months)
Dr. Deferred Revenue    $41.67  
    Cr. Membership Revenue      $41.67

📘 Example – Setup Providing Distinct Service

If the setup involves significant customization of software before use, it may be a separate performance obligation.

✅ CPA Tip: Don’t be fooled by “nonrefundable” — revenue recognition is about performance, not payment timing.

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🧠 CPA Exam Focus

Topic	Key Issue	Recognition
Assurance Warranty	Included in sale price	Expense & liability
Service Warranty	Sold separately or adds value	Deferred revenue
Upfront Fees	Often administrative	Deferred over time unless distinct

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📝 Summary

• Warranties: Determine whether it's assurance-type (expense) or service-type (deferred revenue).
• Upfront Fees: Only recognize upfront if the service is distinct; otherwise, defer and amortize.

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