Accounting for Extended Warranty

Companies take care of their customers in various ways. Previously, companies only sold products and services without any other services. While this process was still profitable, it did not ensure they could retain their customers. However, customers have become more loyal now due to the added-on services and products that companies offer.

For companies that offer physical products, the working condition and longevity of items matter a lot. Most customers value these items on how much they can get their money’s worth in exchange. However, products may not function properly or break down due to several reasons. Companies usually counter these problems by offering customers a warranty.

What is a Warranty?

A warranty is a promise from a company or seller regarding their products. Usually, it involves ensuring customers about the quality of the underlying product. It also includes an obligation to fix or replace a product that does not function properly or breaks down. However, companies do not offer warranties for an unlimited period. Usually, warranties last for a year.

A warranty involves a contract or agreement between a seller and a buyer. With this contract, the seller becomes obligated to replace defective products or repair them when needed. Usually, companies first seek to bring the existing item into a working condition. This process involves repairing the underlying product. When repair and maintenance are not an option, companies will replace the item.

Warranties usually come in written form. It legally obligates the seller to provide a working product to a buyer for a specific period of time. It entitles the seller to damages if the underlying item does not function properly. Similarly, a warranty does not constitute a guarantee. Instead, it represents a promise enforceable if it is breached.

Warranties are a term of the contract that a seller and buyer sign. In some cases, the warranty may also be implicit rather than explicit. An implied warranty comes from an action that the seller takes. It may also stem from the particular contract law in the jurisdiction. Either way, it enforces the buyer’s right to the product and the obligation of the seller to replace it.

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What is an Extended Warranty?

Most standard products come with a warranty period of a year or less. Extended warranties provide sellers with a prolonged period to a working product. In other words, it is longer than the standard warranty offered to customers on products. Usually, extended warranties get an offer in addition to the standard warranty. Most of these warranties come on new items rather than used ones.

Extended warranties may come from many parties. These may include the manufacturer, the retailer, or the warranty administrator. Usually, these warranties come at an extra cost compared to standard warranties. For the manufacturer, the prolonged coverage period can result in more expenses. Therefore, they charge more to cover a longer period in exchange for those costs.

Extended warranties do not extend the original warranty. Instead, they may have terms and conditions that do not match those of the original one. Similarly, some extended warranties that come for multiple years state that the first year is still the original warranty. Therefore, these warranties only act as an extended guarantee for the remaining period of the contract.

Extended warranties exist for various products. However, they are more common in the automobile and electronics industries. Like original warranties, extended ones also limit the coverage of the items. When intermediaries offer these warranties, they will also charge extra on them. Some of them also include commissions on extended warranties provided by manufacturers.

What is the Accounting for Extended Warranty?

The accounting for extended warranty poses a challenge to the revenue recognition of manufacturers. In essence, a warranty is an income that can incur costs in the future. At the time of the sale, the seller is unsure whether these costs will materialize. Therefore, recognizing these revenues in the same year as the sale is not possible under accounting standards.

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The accounting standard that deals with revenue recognition for contracts are IFRS 15 – Revenue from contracts with customers. This standard provides a five-step process for recognizing revenues. These are as below.

  1. Identify the contract.
  2. Identify the separate performance obligations within that contract.
  3. Determine the transaction price.
  4. Allocate the transaction price to the performance obligations in the contract.
  5. Recognize revenue when (or as) a performance obligation gets satisfied.

As per the above process, the contract is usually straightforward to recognize. However, the separate performance obligations include the product itself and the warranty. Therefore, companies must separate these from each other. They must then identify the transaction price and allocate them to the product and the warranty. Lastly, they must recognize the product at the time of sale and the warranty when the performance obligation is satisfied.

Lastly, extended warranties also come with a chance of higher expenses in the future. Usually, companies recognize a provision for these items each year. This requirement comes under IAS 37 – Provisions, contingent liabilities, and contingent assets. However, companies recognize the increase or decrease in the provisions each year from the previous period.

What are the Journal Entries for Extended Warranty?

When a company sells a product with an extended warranty, it must recognize the transaction. This process involves accounting for the product and the additional proceeds from the addition of the warranty. However, this warranty does not count toward the company’s revenues. Instead, it goes into deferred revenues or unearned revenues account.

After a sale, companies must separate the product from the warranty component. Usually, they use the following journal entries to recognize revenues.

AccountDebitCredit
Cash / Bank / ReceivablesXXXX 
Revenues XXXX

However, for extended warranties, the credit side will change. The journal entries for extended warranty are as below.

AccountDebitCredit
Cash / Bank / ReceivablesXXXX 
Deferred revenues XXXX

After the end of each accounting period, companies must convert these unearned revenues. The accounting entries will be as below.

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AccountDebitCredit
Deferred revenuesXXXX 
Revenues XXXX

Similarly, companies must increase their expenses. However, this process does not occur for the sale of every item with an extended warranty. Companies usually use a percentage of their sale proceed to account for warranties. The accounting entries will be as follows.

AccountDebitCredit
Warranty expenseXXXX 
Provision for warranties XXXX

Example

A company, ABC Co., sells products with a warranty of a year. However, it also provides extended warranties for three years. ABC Co.’s single product costs $10,000. With the extended warranty, the price becomes $10,900. When the company sells a single product for cash, it makes the following journal entries.

AccountDebitCredit
Cash$10,900 
Revenues$10,000
Deferred Revenues $900

At each year-end, ABC Co. recognizes a part of these deferred revenues as revenues. Every year, one-third of the amount converts. Therefore, the amount for each entry will be $300 ($900 / 3 years). The journal entries for the process are as follows.

AccountDebitCredit
Deferred revenues$900 
Revenues $900

Lastly, the company estimates a total of 5% of its revenues to incur warranty costs. Assuming ABC Co. has no prior provision for the amount and total revenue of $10 million, the amount will be $500,000. Therefore, the accounting treatment will be as follows.

AccountDebitCredit
Warranty expense$50,000 
Provision for warranties $50,000

In practice, however, companies only record an increase or decrease in the provision amount. In this case, there was no prior provision for warranties. Some companies may also have an existing balance in the account. Therefore, they will only account for the difference in the previous and newly calculated amount. In some cases, it can also result in an income for the company.

Conclusion

A warranty is a promise from a seller to replace a product in case of damages or breakdowns. Some companies also offer extended warranties for a longer period. However, these warranties do not entail an extension to the original terms and conditions. The accounting for extended warranties includes recognizing the additional revenues and creating a provision.

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