When we buy different products, there is a whole back science going on in our minds. Product design, specifications, durability, reliability, color, utility, space management, and God knows what.
But, our biggest concern is longevity, durability, and security when choosing a product.
What aspect of a product gives you security?
We all know without a doubt that’s a warranty -Warranty of repair, replacement, discounted repairs, etc.
But, what does a warranty means for the vendor or a manufacturer?
For a vendor or manufacturer, the warranty has different purposes, being the most important one as the marketing tool to promote their product by providing support.
By giving different types of warranties, the brands and manufacturers convey a message that their products are up to the mark, and they are so confident about it that they won’t mind giving a replacement.
Every action of an entity has a process. Everything needs to be logged in records to view the profitability accurately. That means, when a company gives warranties, it will have to be recorded in one way or another.
Therefore, we will talk about the process of warranty, issuing warranties, and accounting for warranties by an entity.
Before that, we should look at what a warranty is, the different types of warranties, and when a company accounts for warranty expenses.
In the books of business law, you will find the definition of a warranty as something like,
Warranty is an implied or expressed promise of a manufacturer/vendor to a buyer, assuring that the product’s specifications, facts, and conditions are true and valid.
The warranty is implied by conditions or even implied by law. The buyers can go to the consumer court in case of any violation.
Since we are discussing the accounting treatment of the warranty, so we will look into that.
If we look into the GAAP standards, we will find a similar definition of warranty, saying,
A warranty is accounted for as a deliverable—a concept similar to a performance obligation— only if it is a “separately priced extended warranty” or a “product maintenance” contract.
We will further look into the nature of warranties, extended warranties, or product maintenance contract
Accounting Nature of Warranty
A warranty is the promise of the manufacturer or vendor to the buyer; therefore, it will be an expense for the company if a warranty is claimed.
So, the warranty’s accounting nature is an expense for the entity that will be debited to the company’s accounts at the time of sale against the warranty provision account.
The provision account will be debited against the repairs and replacement inventory account if the warranty is claimed.
Types of Warranty
A warranty issued by the manufacturer is generally for 1 year, 2 years, or it might be 5 years in some cases.
But, it is bound with different conditions like warranty can only be claimed if there has been no alteration, repair, changing of any parts with sub-standard substitutes, etc.
For instance, you will often find on the warranty card for a mobile warranty that the warranty cannot be claimed if the device has been exposed to water. So let’s have a look at some different types of warranties.
The most general types of warranties are two:
A buyer is entitled to the implied warranty for a specific product at the time of purchase. It is that type of warranty that is exercisable regardless of whether the seller or manufacturer has explicitly expressed the assurance.
However, one type of implied warranty requires oral or written assurance, which is the merchantable warranty.
In terms of accounting, such a warranty is called an assurance kind of warranty regulated under the IFRS 15 and IAS 37. such warranties do not give rise to a special obligatory clause, and these are considered as a provision for expense in books of accounts.
In the implied warranty, there are two types of warranties: merchantable warranty and fitness warranty.
Implied warranty of merchantability confirms that the products meet the reasonable buyer’s expectations and are merchantable.
In other words, the warranty of merchantability means that the product will fulfill the buyer’s intended purpose. The implied warranty of merchantability applies to new as well as used products.
Implied warranty of fitness assures that the product is fit for the specific purpose it is made for. For instance, the purpose of a knife can be cutting a vegetable, fruit, thread, rope, etc., but cutting is the specific purpose.
If a buyer of a knife finds that the knife is blunt and not fit for cutting, the implied warranty of fitness is applicable for replacing such a product.
We already discussed that the manufacturers’ warranty is mostly a standard of 1 year or 2 years. Many vendors go for an extended warranty to ensure that their customers are satisfied.
The extended warranty is a service agreement for the products’ repairs, maintenance, and service.
The extended warranties are called service-type warranties and are regulated under IFRS 15. These give the buyer additional assurance of the product’s service and maintenance. Hence, giving rise to a separate obligation clause for the issuer.
Such service-type warranties are revenue for the seller and will be recorded at the time of sale. We will talk about the accounting treatment in detail in the following sections.
How Does An Entity Accounts For Different Kinds Of Warranties?
Depending on the type of warranty, the accounting treatment also varies. We will look into each in detail.
To undergo an accounting treatment for a warranty, the first thing to question is what kind of warranty your customers have.
To understand this, you can answer 2 questions to make the picture clear.
- Do the local state laws require the warranty? It is a general practice that local state laws regulate the warranties, and laws vary across the globe. If the answer to this question is yes, it is most likely that the type of warranty is assurance-type, and you will not be obligated for separate services.
- Is the warranty period longer than what state laws have prescribed? If the answer is yes, it is most probable that the warranty is more likely to be a service-type warranty.
Accounting Treatment For Warranties
Now let’s look at the accounting treatment for assurance-type and service-type warranties.
The matching principle of accounting requires the business entities to record the expenses related to the revenue at the time of revenue generation.
Under this principle, assurance-type warranties are treated as an expense related to the sale of goods.
At the time of the sale, the warranty expenses are debited. A provision for the warranties is credited, which goes under the liabilities in the balance sheet.
The journal entry for the recording of warranty expenses is as under:
Later on, if a certain warranty is claimed, the liability for warranty expense will be debited, and cash, inventory, or spare parts account will be credited depending on the scenario. The entry for the exercise of warranty is as follows:
The buyer purchases the service-type warranties along with the price of the product. As a result, the unearned warranty revenue is credited while cash is debited. The journal entry for the service-type warranty will be:
|Unearned Warranty Revenue Account||Xxx|
When the customer comes for repair or maintenance of the product, the revenue is realized, and the revenue earned is made.
The revenue earned account is credited, and the liability as unearned warranty revenue is decreased, therefore, debited.
The journal entry is as follows:
|Unearned Warranty Revenue Account||Xxx|
|Warranty Revenue Account||Xxx|
Is Warranty Expense Or An Asset?
For the business entities purchasing the products with warranties, one of the most staggering questions is whether to treat the warranty as an operating expense or add it to the asset’s value.
So here is the answer to this question.
According to the International Accounting Standards, IAS 16 Property, Plant and Equipment regulate the costs to be incurred as the asset costs and capitalized. It states that:
Any cost can be added to the asset value that:
- Cost adjusted for duties, taxes, and discounts
- The cost incurred for the first-time installation
- The cost incurred for dismantling and removing the asset
Besides, no cost should be capitalized and treated as an operating cost.
The answer is that,
The extended warranties purchased separately do not relate to the functionality or intended use of the asset.
The asset can work well regardless of the warranty. Besides, the extended warranties do not fit under the criteria of capitalization of asset cost under IAS.
Therefore, for the entities purchasing extended warranties, it will be recorded as a normal operating cost.
We have discussed all the aspects of warranties, types, nature, accounting treatment, and the perspective of buyer and seller.
We hope this comprehensive effort will help you understand accounting for the warranty to show the true profitability in the financial statements.