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Accounting for standard and extended warrantiesOctober 31, 2013

Companies often provide warranties to their customers. There may be standard warranties and extended

warranties. Standard warranties are provided when a product is sold and may cover periods from a fewmonths to multiple years. Extended warranties usually require a separate payment and cover periods in

addition or after standard warranties. Companies need to account for standard and extended warrantiesappropriately. We will discuss such accounting in this article. 1. Accounting for standard warranties by product seller or manufacturer Standard warranties are provided when a product is sold (or service is provided). Such warranties may cover theproducts defects, malfunction, etc. for a peri od of time from a few months to multiple years.

Warranties represent an uncertainty because one doesnt know for sure when customers will submit warranty

claims. As such, warranties fall within the definition of uncertainty and warranty reserves (accrual) should berecorded when two conditions are met. The conditions are presented below:

Condition Comment

Information available before the financialstatements are issued or are available to beissued indicates that it is probable that an assethad been impaired or a liability had beenincurred at the date of the financial statements.

This condition is considered to be met if, basedon available information, it is probable thatcustomers will make claims under warrantiesrelating to goods or services that have beensold.

The amount of loss can be reasonablyestimated.

This condition is considered met ifmanagement of a company can reasonablyestimate warranty claims for products sold orservices provided based on historicalinformation, reference to other companies

within the industry, etc.

Note, for the second condition, a company may not necessarily have sufficient information to estimate the amountof warranty claims. In such cases, the company may refer to experience of other entities in the same industry.

In certain situations, a company may not be able to reasonably estimate future warranty claims (e.g., the companydoesnt have sufficient information; the company cant make use of reference to other companies in the industry). Ifthe potential warranty expenses may have a wide range, the company should question whether recognizing relatedrevenue before the warranty loss can be reasonably estimated or the warranty period expires, is appropriate.

There may be a number of ways to estimate future warranty claims. Companies need to use the methodology tocalculate warranty reserves considering the companys warranty policies, available information and so forth.

Lets look at an example of accounting for standard warranties. Company ABC has been selling gadget XYZ andhas sufficient information to estimate warranty expenses based on historical claims data. Standard warrantiescover defects in gadgets for one year after gadgets are sold. The company knows that, on average, for every$100,000 of gadgets XYZ sold (at selling price), there will eventually be approximately $5,000 of warranty claims

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related to the sold gadgets. The gross margin on the products is $50% (so, $100,000 worth of gadgets has a costof goods sold of $50,000).The company sells $100,000 of gadgets in May 20X3:Account Titles Debit Credit

Accounts Receivable $100,000Sales $100,000

Cost of Goods Sold $50,000Inventory $50,000

The company establishes warranty reserve for sales in May 20X3:Account Titles Debit Credit

Warranty Expense $5,000Warranty Reserve $5,000

Customers submit $250 warranty claims in June 20X3:Account Titles Debit Credit

Warranty Reserve $250 Accounts Payable / Cash $250

When customers submit warranty claims, the company settles them by fixing defects in the gadgets. The cost of

fixing the gadgets is recorded as a credit to accounts payable (e.g., vendor invoices for fixing the defects) or cash(e.g., company reimburses customers for repairs). The established warranty reserve of $5,000 will eventually beused for warranty claims as long as the companys methodology for estimating such claims is accurate.

2. Accounting for extended warranties by product seller or manufacturer Extended warranties are agreements to provide warranty protection in addition to the scope of coverage of themanufacturer's original warranty, if any, or to extend the period of coverage provided by the manufacturer's originalwarranty.

Accounting for extended warranties differs from accounting for standard warranties described earlier. When acompany sells extended warranties, it is required that the sales amount of extended warranties be deferred and

recognized in income on a straight-line basis over the contract period except in those circumstances in whichsufficient historical evidence indicates that the costs of performing services under the contract are incurred on otherthan a straight- line basis. In this case, an extended warranty represents deferred revenue . It is still a liability , similar to standard warrantyreserves; however, extended warranties become earned revenues over the coverage effective period and are fullyrecognized into revenue at the time extended warranty contracts expire.Costs that are directly related to the acquisition of a contract and that would have not been incurred but for theacquisition of that contract (incremental direct acquisition costs) shall be deferred and charged to expense inproportion to the revenue recognized. All other costs, such as costs of services performed under the contract ,general and administrative expenses, advertising expenses, and costs associated with the negotiation of a contractthat is not consummated, shall be charged to expense as incurred .Let us look at an example of accounting for extended warranty revenues. Assume that Company ABC from theexample earlier also sells extended warranties on gadgets XYZ. Extended warranties go into effect after standardwarranties expire (on the first anniversary of the gadget sale date) and cover the products for additional twoyears. In our example, for the gadgets sold in May 20X3, extended warranties sold by the company amounted to$4,800. The coverage period for the extended warranties is May 20X4 to April 20X5. We will assume that there

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were no contract acquisition costs and that costs related to services under extended warranties are evenlydistributed over the coverage period. Each month during the coverage period, the company would recognizeextended warranty revenues in the amount of 1/24 th of $4,800 or $200.The company sold $4,800 of extended warranties in May 20X3:Account Titles Debit Credit

Cash $4,800Deferred Extended Warranties $4,800

The company starts recognizing extended warranties as revenues in May 20X4:

Account Titles Debit Credit

Deferred Extended Warranties $200Extended Warranty Revenues $200

Each month for the next 23 months the company would recognize $200 of revenues related to the extendedwarranties sold in May 20X3.