Entities often include warranties in their sale of goods or services to give assurance to the customer that the purchased good or service meets the promised specification. Accounting Standards Codification (ASC) 606 requires that in order for the warranty to be accounted for as a separate performance obligation, it must also include an additional service to the customer. Warranties can be explicitly stated in contract terms or implied based on a company’s customary practices.
Distinguishing Between Assurance- and Service-Type Warranties
Warranties are classified in two categories: assurance- and service-type. An assurance-type warranty guarantees that the product will function as intended. This type of warranty promises to repair or replace a delivered good or service if it does not perform as expected. On the other hand, a service-type warranty provides a service in addition to the assurance. Service-type warranties can often be purchased separately. However, sometimes the differences between the two types of warranty can be difficult to distinguish.
ASC 606-10-55-33 provides factors to consider when determining if the warranty qualifies as an additional service and would therefore be accounted for as a service-type warranty:
- Whether the warranty is required by law. A warranty that is required by law exists to protect customers from defective products and does not provide supplementary services to customers.
- The length of the warranty. The longer the warranty period, the more likely that it 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. If it is necessary for the entity to provide a warranty to ensure the product meets agreed-upon specifications, then it likely does not include an additional service. For example, if the entity is required to provide return shipping services for defective products, this would not be an additional service.
Accounting for Assurance-type warranties
Since an assurance-type warranty guarantees the functionality of a product, the warranty is not accounted for as a separate performance obligation, and thus no transaction price is allocated to it. Rather, 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 ASC 460).
Ra Medical Systems sells laser systems as treatment for certain vascular or dermatological diseases. Customers can also purchase catheters for use with the laser systems. Although Ra Medical does not provide the customer with a right to return, the company will replace defective catheters. In correspondence with the SEC, Ra Medical Systems explained how they value and record their warranty liabilities for defective catheters under ASC 460.
The product warranty liability is determined based on historical information such as past experience, product failure rates or number of units repaired, estimated cost of material and labor, and in certain instances, estimated property damage.
The warranty accrual is included in accrued expenses in the balance sheets. Warranty expenses are included in cost of sales in the statements of operations. Changes in estimates to previously established warranty accruals result from current period updates to assumptions regarding repair and replacement costs and are included in current period warranty expense. (October 2019 Letter)
Accounting for Service-type Warranties
A service-type warranty provides additional benefit to the customer, and therefore represents a distinct performance obligation. An entity should allocate a portion of the contract transaction price to the service-type warranty and recognize revenue as the warranty obligation is satisfied.
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).
Revenue is recognized as the warranty obligation is fulfilled, which is likely over the term of the warranty.
Axon Enterprise is a company that develops technology and sells weapons. Axon offers extended warranties for some hardware accessories and, in a letter to the SEC, the company explained when they recognize revenue for their extended warranties.
The revenue allocated to the extended warranty is recognized as the customer receives and consumes the benefits, which is ratably over the period of coverage for the warranty. (October 2019 Letter).
In correspondence with the SEC, CONMED Corporation, a medical technology company, explains the difference between their assurance- and service-type warranties for equipment and how they recognize the revenue related to the service-type warranties.
The standard warranty period on sales of our capital equipment is generally one year. These standard warranties are assurance-type warranties under ASC 606-10-55-30. In addition, we sell extended warranty (stand ready) service contracts for a period of one to three years. These separately priced extended warranty contracts are service-type warranties under ASC 606-10-55-30. We receive payment for the extended warranty in advance and record a contract liability with revenue recognized over the life of the contract on a straight-line basis, which is reflective of our obligation to stand ready to provide repair services. (October 2018)
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.
It is important to note that a law requiring an entity 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: Accounting for both an Assurance- and Service-Type Warranty
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 because it is an additional service that Vendor A provides. 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:
|January 1, 20X1||Cash||$200,000|
|Warranty Expense (Assurance-type warranty)||$25,000|
|Accrued Warranty Liability (Assurance-type warranty)||$25,000|
|Un-earned Warranty Revenue (Service-type warranty)||$20,000|
ASC 606 distinguishes two types of warranties which depends on whether the warranty provides a service. An assurance-type warranty guarantees the product will perform as promised and is not a performance obligation. A service-type warranty provides an additional service to the customer and is a separate performance obligation. The revenue associated with a service-type warranty should be recognized as that obligation is fulfilled.
- ASC 450-10
- ASC 460-10-25-5 to 25-7
- ASC 605-20-25-1
- ASC 606-10-55-81 to 55-84
- EY, Financial Reporting Developments: “Revenue from contracts with customers.” October 2018. Section 9.1.
- KPMG, Handbook: “Revenue Recognition.” November 2018. Section 4.5.
- PWC, “Revenue from contracts with customers.” September 2018. Section 8.3.