This is the third blog in a series on ASC 606 outlining how to implement and leverage these standards in your accounting. In the first blog in the series, we talked about the five-step ASC 606 revenue recognition process. The previous blog discusses revenue recognition examples and how to treat them under ASC 606. In this blog, we cover ASC 606 implications for warranties. In the final one, we cover practical expedients under ASC 606.
Consumers often weigh the pros and cons of purchasing product warranties. For the consumer, purchasing a warranty means that for an agreed-upon period, the seller will repair the product – like a new laptop or TV –if it stops working for a reason covered by the warranty.
For the seller, a warranty creates an added obligation to either repair or replace items. Warranties are paid for upfront and typically apply to a post-purchase period of one, three, or five years. Some sellers have terms in which customers can apply the value of unused warranties to a new purchase, while others follow the revenue recognition performance period.
Warranty revenue recognition: Types of Warranties
Assurance warranties provide customers’ confirmation that the product they’ve purchased will function as specified.
On the other hand, service warranties are separate performance obligations because the seller provides distinct services beyond guaranteeing that the product will function as specified. While service warranties may be priced separately, that’s not a requirement.
ASC 606 and Warranties
Per ASC 606 guidance, companies must apply the 5 steps of revenue recognition to first determine whether the warranty is considered a separate performance obligation.
Then, accounting teams need to allocate the transaction price to both the product and extended warranty to recognize revenue evenly over the period the warranty covers.
For example, if an extended warranty is for three years (36 months), the allocated transaction price is divided by 36 and recognized monthly for 36 months until the warranty expires.
Example: basic price allocation
Suppose a customer purchases a television for $3,000 with a 3-year warranty. As the law requires, other companies sell similar televisions with a one-year standard warranty.
The standalone price of the television is $2,500, and $500 for the two-year extended warranty. The company expects to incur $100 in expenses for the insurance-type warranty period and provide warranty service evenly over the life of the extended warranty.
The first year of the warranty is an insurance-type warranty. In contrast, the last two years are a service-type warranty considering the additional, separate seller service obligation r The seller will allocate the $500 standalone price of the service-type warranty evenly over the 24 months of the extended warranty period.
The following journal entry will be recorded for the sale of the television, warranty expense, and extended warranty liability:
| Account | DR | CR |
|---|---|---|
| Cash (or Accounts Receivable) | $3,000 | |
| Warranty Expense | $100 | |
| Revenue | $2,500 | |
| Accrued Warranty Liability | $100 | |
| Unearned Revenue – Warranty | $500 |
If the company incurs more warranty expense in the first year beyond historical trends, the additional expense will be added.
The company may then conduct a profitability analysis on warranty claims to determine if price adjustments are necessary to avoid incurring losses to repair and replace products.
Each month for 36 months, the company will record 1/36th of the warranty revenue by reclassing $13.89 ($500/36) from unearned revenue.
| Account | DR | CR |
|---|---|---|
| Unearned Revenue – Warranty | $14 | |
| Revenue – Warranty | $14 |
The key to proper revenue recognition for warranties is to first determine if the warranty provides a service to the customer beyond the required agreed-upon specifications. Next, the seller or company must allocate the price to both the product and separate warranty obligation based on standalone prices.
ASC 606 specifies the steps to follow (page 23 FASB ASC 606-10-55-30 through 55-35) to classify warranties as either assurance or service-type warranties. Following the new revenue recognition guidance ensures that companies properly recognize and account for warranty revenue, expenses, and associated obligations.
Recognizing revenue and tracking warranty recognition for a sale creates multiple layers of complexity, especially if revenue is recognized in different periods (incremental for a warranty and immediate for an item sale) and systems.
Mapping revenue against costs for different segments or individual warranties in a profitability analysis dauntingly requires either integration engineering or manual Excel manipulation.
Imagine the novel insights you’d uncover if you could evaluate warranty repair costs by customer segment, geography, and product line, rather than evaluating average warranty repair costs. Wouldn’t it be great to discover that (as is always the case with averages), some of your segments are more expensive to support than others? Therefore, you should charge them more for warranties, while other customers should be charged less to increase customer acquisition.
