Change – Some people say that’s what our country wants, and the accounting standard setters have delivered!
The change is related to accounting for warranties. The good news is that the differences between accounting for warranties under current generally accepted accounting principles and the new revenue standard are minimal. Warranty accounting itself remains unchanged, but warranties will need to be accounted for as separate performance obligations under the new standard, if they provide the customer with additional services. (A performance obligation is defined as a promise to transfer a good or service.)
The difference in accounting for warranties under the new standard depends on whether the warranty is considered an assurance-type warranty or a service-type warranty.
Assurance-type warranties are often provided with products to assure customers that the product is free of defects at the time of sale and to comply with certain agreed-upon specifications. These assurance-type warranties are not treated any differently under the new revenue standard and will continue to follow the cost-accrual guidance in Accounting Standards Codification 460. Since the warranty is not separately priced or a product maintenance contract, no revenue is allocated to the warranty, and upon transfer to the customer, the entity recognizes a warranty expense and corresponding warranty obligation.
Service-type warranties, which are often sold separately, give customers the ability to fix defects other than those that existed at the time of sale. With the new standards, service-type warranties need to be accounted for as separate performance obligations. The price paid for a service warranty is recorded as a contract liability and only recognized into revenue as time expires or as service is provided.
How do you know if you have a service-type warranty? The new standard does not contain a specific definition of a service-type warranty, but there are three factors that should be considered when evaluating your warranties:
- Is the warranty required by law? If so, then the promised warranty is not accounted for as a separate performance obligation.
- What is the length of the warranty coverage period? The longer the term, the more likely it is that the warranty is a performance obligation, because it is more likely to provide a service in addition to the assurance that the product compiles with agreed-upon specifications.
- What is the nature of the tasks that the company promises to perform? If the company has to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (such as a return shipping service for a defective product), then those tasks likely would not give rise to a performance obligation.
For example: A manufacturer is selling a commercial saw for $5,000. They are including a one-year assurance-type warranty, which costs the manufacturer $250. The customer also has an option to buy a 5-year service-type warranty that covers items other than commercial defects, for $1,000. A customer buys the saw at a different negotiated sales price, including the five-year warranty, for $5,500.
This contract contains two purchase obligations: the saw and the five-year warranty. The manufacturer has to allocate the total sale price of $5,500 between the two performance obligations.
When booking the transaction, the following entries are recorded once ownership of the saw is transferred to the customer:
To record the sale of the saw and service-type warranty
Accounts receivable $5,500
Contract liability ($917)
To record the liability for the assurance-type warranty
Warranty expense $250
Accrued warranty ($250)
Recognition of the contract liability (deferred service-type warranty revenue) occurs at the end of year one and run through the end of year five. Expenses to the service-type warranty are expected to be recognized as incurred.
Changes to warranty revenue recognition is the only area that will be affected when the new revenue standards are adopted. To learn more and to better understand how and if your business could be affected, please contact our manufacturing accounting expert, Barbara Walker, at 301-662-2400.