Let us discuss the definitions and see the key differences between a warranty and a guarantee.
Warranty – Definition
A warranty is an assurance to a customer for the quality of a product or service. Companies can adopt different warranty policies depending on their nature of business, industry, or product sold.
A warranty is offered in the form of repair of damages or replacement of goods by a company. Usually, there is no cash refund against a warranty.
Companies can estimate their warranty expenses using historic data and forecasts. They should also accrue a warranty expense for the estimates for a specific accounting period.
If a company offers a warranty that can be sold separately from the product/service, it should be accounted for as a separate performance warranty. Warranties that assure a customer that a product/service will perform as described do not account for a separate performance warranty.
Accounting for Warranty
The first thing a company should determine is whether the warranty is offered as a separate performance warranty or not. The accounting treatment for both types differs.
Warranties offered with the sale of a product or service for repairs or damage recovery do not act as a separate performance warranty.
Additional costs incurred to cover these warranties are accounted for under ASC 460. The company should record a liability when the product is sold or a service is rendered to a customer.
A company can use the following conditions to determine whether a warranty expense should be recorded or not.
- If it is probable that an obligation arises due to a transaction on or before the date of the financial statement. And
- If the amount can be estimated reasonably.
The company can set these conditions when making the warranty policy. The customer(s) or the counter-party may not be identified at that time though.
The warranty expense or liability may extend to the next accounting period as well. The company can record the estimated expense for the next accounting period as well.
When a warranty expense is estimated to span across several accounting periods, it should be spread over those accounting periods. The company should divide the warranty expense into current and long-term portions.
Warranties come with specified periods. The customer can claim for the damages within these periods only. Often companies render additional services such as for repairs or maintenance of a product within these periods.
Companies would need professional judgment to decide whether the additional service offered to settle warranty claims can be accounted for as a separate performance obligation.
Warranty as a Separate Performance Obligation
When a warranty can be sold separately from the product, it should be accounted for under ASC 606. Similarly, the revenue generated or costs incurred to provide separate and additional services should be accounted for here.
Companies should evaluate different scenarios to determine whether the costs incurred are attached with the original product sale.
A company can consider the following key points to estimate whether the services rendered are additional and separate as an assurance of the product performance.
- If a warranty exists to comply for a law, it should not be accounted for as a performance liability. These warranties are offered to protect customers from damaged goods or poor-quality products.
- If the length of the warranty period is longer, it indicates that it is a performance obligation. Companies usually offer prolonged warranty claims as a separate performance obligation.
- If it is necessary for a company to offer certain warranties. For instance, most companies offer free returns or shipping to customers for damaged goods delivered.
If a company cannot determine the service and assurance elements separately, it can account for both the elements together as a single performance obligation.
Warranty Accounting Example
Suppose a company ABC sells electronic items such as washing machines. It offers warranties on the sale of washing machines to its customers for one year from the date of sale.
It sold $ 800,000 worth of washing machines in recent months. It estimates an increased sale of up to $ 1 million. The company allocates a generous 3% of the total revenue as warranty obligation expense.
ABC Company will record an initial accounting entry as below:
|Warranty Expense||$ 30,000|
|Accrued Warranty Liability||$ 30,000|
Suppose during the next quarter ABC company received warranty claims worth $ 12,000. The company also had to incur labor charges to provide additional repairs. The labor costs amounted to $ 6,000 for the quarter.
The subsequent entries for these transactions would be:
|Accrued Warranty Liability||$ 18,000|
|Labor Costs||$ 6,000|
|Material Costs (Spare Parts)||$ 12,000|
Any extended warranty expenses can be spread over several accounting periods. The company can divide the total estimated costs into several accounting periods.
Guarantee – Definition
A guarantee is a promise or commitment by one party for another that a certain obligation will be met.
A guarantee can come in several forms including product performance, project performance, financial liability payment, and contractual obligation fulfillment.
A guarantee is often a pledge undertaken by one party for another in case of non-performance of a certain obligation. It can be in the form of a standby obligation during the period of guarantee.
A guarantor can offer the standby obligation guarantee for the past or future performance obligation of another party. However, it cannot provide the same for its own future performance obligations.
Accounting for Guarantee
Guarantees are accounted for under ASC 460 that requires:
- The fair value of the liability should be recorded, and
- A company should establish that a guarantee consists of two separate elements.
Initially, the company can record the contingent and non-contingent elements of a guarantee at their fair value.
A company can use the following guidelines under ASC 460 to determine whether a contract should be recorded as a guarantee liability or not.
- Contracts that contingently require a guarantor to pay the guaranteed party on the basis of any changes in the underlying asset, liability, or equity instrument of the guaranteed party.
- Contracts that contingently require a guarantor to pay the guaranteed party based on another party’s failure to perform certain duties under contractual agreements.
- Any changes in underlying that relate to assets, liabilities, or equity of an indemnified party that obligate the guarantor to make a payment to the indemnified party contingently.
- Even if the changes to underlying that relate to an asset, liability, or equity of the guaranteed party, the guarantor may need to make a payment for the indirect indebtedness of the guaranteed party.
Types of Guarantees
Companies use several types of guarantees in the business. The accounting treatment for these guarantees depends on the recognition criteria under ASC 460. The company needs to determine if the obligation can be established under ASC 460 or not.
Some commonly used forms of guarantees are mentioned below.
Commercial Letter of Credit
These are documents issued by a financial institute on behalf of its customer or a third party for the payment up to a certain limit. It acts as a conditional form of guarantee.
Direct Guarantee of Indebtedness
In such guarantees, the guarantor becomes directly liable for the default of the guaranteed party.
Indirect Guarantee of Indebtedness
These are conditional guarantees where a guarantor becomes liable for the obligation only when certain events happen or certain conditions are fulfilled.
Minimum Revenue Guarantee
It is often offered to the business owners that the revenue of the business will reach certain levels for a specified accounting period.
Performance Standby Letter of Credit
Performance LCs are issued by a guarantor that is irrevocable in nature. If the guaranteed party fails to perform the obligation, the guarantor is held liable for the losses.
Warranty vs Guarantee – Key Differences
Bothe a warranty and a guarantee are assurances to another party by the guarantors. However, the nature and the working mechanism differ for both types of assurances.
A warranty is specifically used directly between the two parties. Whereas, a guarantee often involves a third party that acts as a guarantor on behalf of the guaranteed party.
Let us briefly discuss the key differences between a warranty and a guarantee.
- A warranty acts as an assurance between two parties offered by the seller to the buyer of a product or service. A guarantee often involves a third party that acts as a guarantor.
- A warranty is offered for a specified period with certain conditions. A guarantee is often linked with certain performance or financial conditions that must be met to put a claim.
- For accounting purposes, a warranty should not be offered as a separate performance obligation. A guarantee can take several forms that may be offered as a separate performance obligation as well.
- A major difference is the liability or obligation of losses for both items. In case of losses with a warranty, the liability lies only with the first party that offered it. Contrarily, the liable party for losses in a guarantee can be the first party or the guarantor depending on the type of guarantee used.