We have all been there, and for me, it happened just last week. After an incident at my house where a ball mysteriously hit the television, I made a trip over to the electronics store. As I’m getting ready pay, the clerk asks, “Would you like to purchase the 3-year extended warranty?” Questions quickly flew through my head… How risky am I feeling today? What warranty automatically comes with the TV? What are the chances my kids will break another TV within 3 years? Then the accounting nerd in me took over. How should I account for the additional warranty purchase under ASC 606?
First, a determination must be made on the type of warranty. Generally, assurance-type warranties are not considered a separate performance obligation. These types of warranties do not provide an additional good or service to the customer, because the selling entity has effectively provided a guarantee of quality and that the product will meet its agreed-upon specifications. Televisions typically come with a 1-year warranty that covers defects in the material, design, and workmanship. These types of warranties are accounted for as warranty obligations and are accrued in accordance with ASC 460-10, which details the accounting for guarantees. Once the liability is recorded, it should be adjusted as changes in estimates occur, with the offset recorded as an adjustment to costs of sales.
However, the extra extended warranty is different! It is an example of a service-type warranty. These warranties provide a service to the customer beyond fixing defects that existed at the time of sale. Think a tennis ball to the screen! Sales-type warranties are considered distinct and are a separate performance obligation. This is because there is an additional promise to provide services to the customer. Therefore, the entity must allocate a portion of the total transaction price to the warranty based on the relative stand-alone selling prices of all performance obligations, including the extended warranty. The transaction price allocated to the extended warranty revenue is recognized over the period the warranty is provided.
The entity needs to think about the appropriate pattern of revenue recognition for service-type warranties. If they provide warranty services ratably over a three-year period, the revenue would likely be recognized evenly over the period. However, if historical data indicates that warranty services are typically provided in the second and third year of the warranty period, the entity might recognize little or no revenue in that first year.
How do I know what type of warranty I have?
ASC 606-10-55-33 outlines factors to consider when determining if a warranty in question provides a customer with a service in addition to the agreed-upon specifications:
- Whether the warranty is required by law.
- The existence of a law would indicate that the promised warranty is an assurance-type warranty and not a separate performance obligation.
- The length of the warranty coverage period.
- The longer the coverage period, the more likely the promised warranty is a service-type warranty and, therefore, a separate performance obligation.
- The nature of the task that the entity promises to perform.
- If it is necessary for an entity to perform tasks to provide assurance that the product is functional as described in the contract, then the tasks probably would not constitute a separate performance obligation.
Although the above television example is fairly straightforward, certain arrangements can be more complex. Sometimes warranties may include both assurance-type and service-type components. For instance, what if there was a promotion that included the extended service-type warranty with the purchase of the television? If an entity cannot reasonably account for them separately, the warranties are accounted for together as a single performance obligation. That means that the value of the warranty would need to be carved out of the total transaction price and recognized over the period the warranty services are provided. In this case, the entity must do two things: accrue the expected costs associated with the assurance-type warranty and defer revenue for the service-type warranty. Assessment of these arrangements are crucial, because assurance-type costs would have been accrued for previously while service-type costs are a period expense!
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