Our tutorial on warranty costs discussed the situation where a business makes a sale to a customer and includes in the product purchase price a standard warranty, which allows the customer to have the product repaired or replaced if it is found to be defective within a certain period of time.
In addition to the standard warranty, businesses often sell a separate extended warranty for an additional fee allowing the customer to have the product repaired or replaced if for example, it is found to be damaged or defective after the original standard warranty has expired. In essence, the customer has purchased a separate insurance policy for the product.
As the extended warranty is for a period of time in the future, revenue from the sale is initially unearned and is therefore deferred and recognized over the period covered by the extended warranty.
In accordance with the matching principle as the revenue is deferred no costs are accrued at the inception of the extended warranty agreement. (This is in contrast to the standard warranty given as part of the purchase price of the product where the revenue is not deferred and the contingent liability for warranty costs is immediately recognized and matched to the revenue).
Extended Warranty Accounting Treatment
Suppose a business sells an extended warranty with a term of four years for an additional fee of 80. In this example, the extended warranty does not become active until the standard warranty has expired in a years time. The fee is not yet earned as the services are to be provided over the four year period which starts in one years time, and the extended warranty fee is entered into the accounting records of the business with the following accounting journal.
The balance on the unearned revenue account is a liability of the business, as it has an obligation to provide services to a customer at some future date over the term of the extended warranty agreement.
Extended Warranty Revenue Recognition
When the standard warranty expires (one year after the product sale), the extended warranty becomes active for a term of four years. At the end of each of those years one quarter of the fee revenue (20) can be treated as earned, and the following double entry bookkeeping journal is entered:
|Extended warranty fees||20|
Extended Warranty Costs
Each year warranty costs to repair and replace defective and damaged products will be incurred and, as the revenue has now been recognized, the warranty costs need to be matched to the revenue earned and shown as expenses in the income statement.
Suppose in the above example warranty costs of 16 has been incurred during the first year of the extended warranty term, then the bookkeeping journal to record this entry is as follows:
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a BSc from Loughborough University.