Question - A conceptual framework
A newly established gas heating manufacturer has asked you for advice concerning the most appropriate accounting policy for service warranties. Unfortunately an early model heater has developed a fault which requires to be rectified. It is a small problem that is soon put right but it may impact on the otherwise successful launch of the company's product range.
The company accountant has investigated how service warranties are accounted for in other entities in the industry and found that companies either:
Establish a provision based on past experience or, expense warranty costs as they are incurred.
The accountant is also concerned that the new company did not have any experience in warranty claims. These concerns related to the need for financial statements to be reliable as well as relevant in order to be useful to users. The accountant proceeded to outline an accounting policy that appeared more suitable for a new appliance manufacturing company.
The policy is stated as follows:
As a new entrant into gas heating appliance manufacture, there is no appropriate warranty experience on which to base a provision for warranties. Accordingly, the costs of meeting claims arising under warranty service agreements are charged against revenue, as an expense, as they are incurred.
Required - Advice the company whether you consider the above policy covering service warranty costs is appropriate. In your response refer to any relevant accounting pronouncements.