Whenever a person buys a product, there are a lot of thoughts going on in his mind; for instance product design, durability, specifications, etc. However, the biggest concerns of a consumer while buying a product are its durability, security, and longevity. The warranty gives the consumer an aspect of security.
A vendor or a manufacturing company uses a warranty as a marketing tool to promote and sell its product by providing its customers a sense of support and security. Typically, vendors or companies give different types of warranties to convey a message that their product meets the claimed specifications and they are so sure about it that they won’t mind giving a replacement.
What is a Warranty?
Warranty is usually defined as,
“A promise or assurance by one party to another party that a particular statement of fact is true and maybe relied upon by the other party, for a certain period of time “
Usually, one party is the seller, vendor, or manufacturer and the other party is the buyer. Seller gives an express or implied promise to the buyer, assuring him that the product’s given specification and facts are true and valid.
According to the US Generally Accepted Accounting Principles (GAAP),
“ A concept similar to performance obligation which is deliverable, only if it is a ‘separately priced extended warranty’ or ‘product maintenance contract’ is called warranty “
If a customer is given the choice to purchase a product with or without a warranty then the warranty is termed as ‘separately priced’. If it is not the case then according to the US GAAP, revenue is allocated to the warranty when the product is transferred to the customer and the entity recognizes a warranty obligation with a corresponding expense.
How to Account for Warranty?
According to the US GAAP, since a warranty is an assurance or promise of the seller to his buyer, it will be the expense of the seller if claimed by the buyer, which will be debited to the seller’s accounts at the time of sale in the warranty provision account. Further, if the warranty is claimed, it will be debited in the warranty provision account against the repairs.
The journal entry will be as follows,
|Cash/ Bank Account||Xxx|
|Unearned Warranty Provision Account||Xxx|
The accounting treatment varies depending upon the type of warranty. Usually, there are two types of warranties to be accounted for; according to US GAAP, ASC 606 as below:
- Assurance type warranties
- Service type warranties
According to the new revenue recognition guidance, sellers or companies must distinguish between assurance and service type warranties.
Assurance type warranties would continue to be accounted for under the cost model.
Service type warranties are those in which the buyer has the choice to purchase the warranty separately. It will be accounted for as a separate performance obligation.
In case the seller company promises both assurance and service type warranties but cannot record them separately, it will be considered as a single performance obligation.
In the later section below, we illustrate some of the examples showing how to account for warranty and passing journal entries to record warranty in the accounts of a selling company or a seller.
Example# 1: Assurance Type Warranties
Alexander a sports car manufacturer sells various models of sports cars to its customers. As a part of normal sales terms, Alexander offers a warranty option to its customers separately, which ensures that cars are free from defects and operate according to their given specifications.
A customer Wandy buys a sports car on 01/01/21 for $600,000, which includes the cost of the car $560,000 and the cost of the warranty $40,000. The warranty is for one year and at the end of the year on 31/12/21Wandy found a defect in one of the spare parts of the car which was covered in the warranty specifications and she filed a claim for that defect.
How should Alexander account for warranty to its customer Wandy?
The matching principle of accounting requires Alexander to record expenses related to sales at the time of recording sales. Under this principle, the assurance type warranties are treated as an expense related to the sales.
So, the warranty expenses will be debited at the time of sale and a provision for warranties is created which will be recorded in the liabilities in the balance sheet.
The warranty expense will be recorded as follows,
|Liability for Warranty Expense||$40,000|
At the end of the year when Wandy claims the warranty, liability for warranty expense will be debited and spare parts account will be credited.
The journal entry will be recorded as follows;
|Liability for Warranty Expense||$40,000|
Example# 2: Service Type Warranties
A company Delta is a manufacturer of consumer electronic appliances and includes product warranty as part of their standard sales term contract. The product warranty they provide is an agreement in which maintenance is provided by them for a specific period of time and this warranty is included in the price of their products.
A customer named John purchased a refrigerator on 01/01/21 for $250. On 31/12/21, there was a cooling defect and John claimed maintenance under the warranty which cost $25 to the Delta company.
How should Delta company record the maintenance expense incurred?
When John claims the maintenance of the refrigerator, the revenue is realized and the revenue earned has been made. The revenue earned account will be credited and the liability as the unearned warranty will be debited.
The journal entry will be recorded as,
|Unearned Warranty Revenue Account||25|
|Warranty Revenue Account||25|
Example# 3: Both Assurance and Service type Warranty
A company SmartUse manufactures and sells smartphones. The price of smartphones includes a 2-year warranty which is one year longer than the warranties provided by other smartphone manufacturers, in addition, the law only requires SmartUse to provide one year warranty.
A customer Monica purchased a smartphone from SmartUse on 01/01/21 for $550,000. This cost constitutes $500,000 for smartphone cost and $50,000 for warranty. Monica pays $550,000 on the same date. Based on past experience, SmartUse expects to incur a warranty expense of $25,000 in the first year and provide repairs evenly during the 2 years.
How should SmartUse record this sale of smartphone to Monica?
The two-year warranty is likely to contain both assurance and service type warranties. The first year warranty is an assurance type warranty as it is required by law and no revenue is allocated to this warranty. The second year’s warranty will be classified as a service type warranty as it is an additional service that SmartUse provides and revenue for this warranty will be recorded in the second year of warranty.
SmartUse will record this sale as follows;
|Warranty Expense(Assurance type)||$25,000|
|Liability for Warranty Expense (Assurance type)||$25,000|
|Unearned Warranty Revenue (Service type)||$50,000|
All the aspects of warranties, their types, accounting treatment, and nature have been discussed in detail. This elaborative article can help account for warranties to show the true profitability in the financial statements.