Warranty Obligations

By July 14, 2015Other Issues

Warranties are commonly provided in contracts to sell goods or services. They can be explicitly stated in contract terms or implied based on a company’s customary practices. A warranty may assure the customer that the purchased good or service meets the promised specification or, alternatively, a warranty may provide additional service to the customer. The new standard requires companies to distinguish between these two types of warranties and to account for them separately.


 

How To

Warranties are classified into two categories in the new standard:

Assurance-type Warranties. An assurance-type warranty promises to repair or replace a delivered good or service if it does not perform as expected. This type of warranty is not a separate performance obligation, and thus no transaction price is allocated to it. To account for an assurance-type warranty, the vendor should estimate and accrue a warranty liability when the promised good or service is delivered to the customer (see Accounting Standards Codification (ASC) 460).

Service-type Warranties. This type of warranty arises when (1) a customer has the option to purchase it separately or (2) it provides service beyond assuring that the product complies with promised specifications. A service-type warranty represents a distinct performance obligation, thus a portion of the transaction price is allocated to it. Revenue is recognized as the warranty obligation is fulfilled, which is likely over the term of the warranty. For more information, refer to Revenue Recognition Over Time and Input versus Output Methods.

A vendor should use the following factors to determine whether a warranty provides additional service (ASC 606-10-55-33):

  • Whether the warranty is required by law. A warranty that is required by law exists to protect customers from defective products; therefore, it does not provide supplementary services to customers.
  • The length of the coverage period. The longer the coverage period, the more likely that a warranty provides extra service to the customer. A vendor should consider the industry norm when making this assessment. For example, if a manufacturer provides a seven-year warranty when most participants in the industry provide five-year warranties, then the extra two-year warranty likely provides additional service.
  • The nature of the performance obligations. For example, if a software warranty provides more than fixing bugs or basic trouble shooting, such as training and customization, then that warranty is likely to provide additional service.

A vendor should allocate a portion of the contract transaction price to the service-type warranty and recognize revenue as the warranty obligation is satisfied. If a warranty contains both assurance- and service-type warranties and the vendor cannot reasonably account for them separately, then the warranties should be grouped as a single performance obligation. A portion of the transaction price is allocated to the combined warranty and revenue is recognized as the performance obligation is fulfilled.

The amount allocated to a service-type warranty should depict the amount that the vendor expects to receive for providing the service, which is usually based on its estimated standalone selling price (ASC 606-10-32-28). For more information, see Standalone Selling Prices.

It is important to note that a law requiring a vendor to compensate for damages caused by its products is not a performance obligation. For example, a software developer sells a software to a customer and the customer suffers from identity theft due to their use of the product for its intended purpose. The law may require the software developer to compensate for damages to the customer. In this case, the obligation should be accounted for as a loss contingency (ASC 450-20).

Example

Vendor A manufactures and sells a model of luxury sports cars. Included in the car’s price is a five-year warranty that is two years longer than warranties provided by other car manufacturers; in addition, the law only requires Vendor A to provide a three-year warranty.

On January 1, 20X1, Vendor A sells a car to a customer for $200,000. The car’s estimated standalone selling price is $180,000, and the extra two years of warranty is $20,000. Vendor A delivers the car on January 1, 20X1 and the customer pays $200,000 on that same date. Based on past experience, Vendor A expects to incur $25,000 of warranty expense during the first three years of the car’s life and provide repairs evenly during the last extra two-year warranty period. How should Vendor A recognize revenue from this contract?

The five-year warranty is likely to contain both assurance- and service-type warranties. The first three years of the warranty is an assurance-type warranty because it is required by law. No revenue is allocated to this warranty. The two-year additional warranty should be classified as a service-type warranty for the following reasons: (1) the law only requires Vendor A to provide a three-year warranty; and (2) this warranty is longer than other warranties provided in the same industry. Vendor A should allocate $20,000 of the transaction price to the extended warranty. It should recognize revenue ratably over the two-year warranty period because on average, repair service is provided evenly over the two-year period for all customers. Vendor A would make the following entry on January 1, 20X1:

1

The table below illustrates the timing of revenue transaction for this contract:

2

Comparison to 605

Under current practice, a warranty is a deliverable if it is separately priced and negotiated (ASC 605-20-25-1). Separately priced and negotiated means that the customer can purchase the product without the warranty. If a warranty is not separately priced and negotiated, then no revenue is allocated to it; a warranty obligation and a related expense are recorded when the product is transferred to the customer (ASC 460-10-25-5 to 7).

Under the new standard, a warranty that provides service beyond assuring that the product meets the agreed-upon specification is a performance obligation, even if the warranty is not separately priced and negotiated. In most instances, the new standard won’t affect how warranties are currently treated. However, for warranties that are not separately priced and negotiated but provide additional services, some revenue will likely be deferred under 606 that would otherwise be recognized up-front under 605.

Another difference is the fact that the new standard allows companies to combine assurance- and service-type elements in a warranty as a single performance obligation if the elements cannot be reasonably separated. The combined warranty does not require the vendor to record an estimated warranty liability, thus the vendor would not have to record an expense until actual warranty costs are incurred.

Summary

The new guidance distinguishes two types of warranties depending on the service that a warranty provides. An assurance-type warranty guarantees the product will perform as promised and is not a performance obligation. A service-type warranty provides service in addition to assuring that the product will perform as promised and is a performance obligation. A vendor should use the three factors in the standard (i.e., legal requirement, length of the warranty, and nature of the warranty service) to determine whether a warranty provides additional service to the customer. Overall, some service-type warranties that are not recognized as deliverables under current practice may be recognized as performance obligations under the new standard. A portion of the transaction price would need to be allocated to the warranty.


 

Resources Consulted

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Author Haoran Jiang

Haoran grew up in Salt Lake City, UT. When he is not reading the Codification, he can be found climbing rocks in the wilderness. He will be joining the FASB as a PTA in January 2017.

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