Accounting for standard and extended warranties

October 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 few
months 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 warranties
appropriately. 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 the
products defects, malfunction, etc. for a period 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 be
recorded when two conditions are met. The conditions are presented below:
Condition Comment
Information available before the financial
statements are issued or are available to be
issued indicates that it is probable that an asset
had been impaired or a liability had been
incurred at the date of the financial statements.
This condition is considered to be met if, based
on available information, it is probable that
customers will make claims under warranties
relating to goods or services that have been
sold.
The amount of loss can be reasonably
estimated.
This condition is considered met if
management of a company can reasonably
estimate warranty claims for products sold or
services provided based on historical
information, reference to other companies
within the industry, etc.
Note, for the second condition, a company may not necessarily have sufficient information to estimate the amount
of 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 company
doesnt have sufficient information; the company cant make use of reference to other companies in the industry). If
the potential warranty expenses may have a wide range, the company should question whether recognizing related
revenue 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 to
calculate 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 and
has sufficient information to estimate warranty expenses based on historical claims data. Standard warranties
cover 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
related to the sold gadgets. The gross margin on the products is $50% (so, $100,000 worth of gadgets has a cost
of goods sold of $50,000).
The company sells $100,000 of gadgets in May 20X3:
Account Titles Debit Credit
Accounts Receivable $100,000

Sales

$100,000
Cost of Goods Sold $50,000

Inventory

$50,000
The company establishes warranty reserve for sales in May 20X3:
Account Titles Debit Credit
Warranty Expense $5,000

Warranty 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 be
used 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 the
manufacturer's original warranty, if any, or to extend the period of coverage provided by the manufacturer's original
warranty.
Accounting for extended warranties differs from accounting for standard warranties described earlier. When a
company 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 which
sufficient historical evidence indicates that the costs of performing services under the contract are incurred on other
than a straight-line basis.
In this case, an extended warranty represents deferred revenue. It is still a liability, similar to standard warranty
reserves; however, extended warranties become earned revenues over the coverage effective period and are fully
recognized 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 the
acquisition of that contract (incremental direct acquisition costs) shall be deferred and charged to expense in
proportion 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 contract
that 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 the
example earlier also sells extended warranties on gadgets XYZ. Extended warranties go into effect after standard
warranties expire (on the first anniversary of the gadget sale date) and cover the products for additional two
years. 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
were no contract acquisition costs and that costs related to services under extended warranties are evenly
distributed over the coverage period. Each month during the coverage period, the company would recognize
extended 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 $4,800
Deferred Extended Warranties $4,800
The company starts recognizing extended warranties as revenues in May 20X4:
Account Titles Debit Credit
Deferred Extended Warranties $200
Extended Warranty Revenues $200
Each month for the next 23 months the company would recognize $200 of revenues related to the extended
warranties sold in May 20X3.