How to Account for Extended Warranty Contracts
There is a disagreement among retail accountants as to how to account for extended warranty contracts. The reason for the disagreement is that while the revenue for the warranty is received at the time of the sale of whichever item the warranty is being sold with, the warranty represents a liability on the part of the company for a later date. There are three alternatives to claim this revenue. There is full recognition, full deferral and partial recognition.
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Instructions
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Three Different Methods
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Record the full profit of the sale including the warranty. Recording the total of the sale creates a profit that would not be there otherwise in the accounting period that the sale is made. Those who support this method use FASB Statement no. 5 as support. FASB sets forth the rules which accountants should use in accounting for different transactions. Statement 5 is entitled "Accounting for Contingencies." This statement requires a loss contingency to be accrued if it's probable that a liability will be incurred. According to an article in Business Week on this subject, warranties are seldom used and if they are it's at a rate of 1 out of 10 sales. Recognize an adjustment in the books when the warranty is used.
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Use the "Full Deferral" method. Those who support this method view the sale of the item and the warranty as two different transactions. This would involve recording the profit on the item at the time of the sale, and the revenue of the warranty contract over the period of time the contract covers. For example, a $4,000 flat screen television may have a 2-year service warranty price of $400. The profit on the flat screen is recorded immediately. The $400 profit from the warranty would be deferred until the 2-year period is completed.
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Use the partial recognition method. A partial recognition means that the sale of a portion of the warranty would be recorded at the time of the sale and the remaining would be reported at the end of the 2 year period. This portion would be calculated based on the estimated costs of providing services as per the warranty terms. This depends highly on what type of item is sold and the typical repair needs of the item.
Using the flat screen television as the model, the typical cost of a flat screen repair in its first two years will be deducted from the $400 profit. If this cost equals $200, this expense is recorded as a potential liability for the two year period. If the warranty is not used, an adjustment is made adding the $200 to the revenue of the company at the end of the second year.
Why It Matters
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Examine the profit margin on the warranties versus the margin on goods for sale. According to the 2004 Business Week article, the profits from warranties accounted for all of Circuit City's operating income and almost half of Best Buy's. With a 50 to 60 percent profit margin on contracts, less revenue was made in the actual sales of the goods.
As long as the prices for these goods remains high, these warranties seem like a good investment. Unfortunately, as the prices fall, according to the same article, at a rate of 45% every 18 months, fewer consumers see the advantage of an overpriced warranty plan.
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Locate the last balance sheets for Circuit City stores. While Circuit City accountants argued for the full recognition at the time of the sale, after the first two years of separating the revenue into sales of goods and then sales of warranty plans, you will see that they stopped doing so and began counting warranty sales as "Other Income". As the prices fell on the items being warrantied and fewer consumers bought them it meant the ratio of those needing repairs on the items increased.
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Avoid artificially inflating the revenues. Circuit City's policy of accounting for warranties at the time of the sale was just one of the factors that led to their financial demise in January of 2009. Financial experts including Bloomberg's Business Week, and others had been warning investors about for more than three years. Technically, the best way to account for the revenue from an extended warranty plan is the partial recognition method to record the revenue in equal shares using the number of years for the warranty. A $400, two year warranty plan purchased in 2008 would mean recording $200 in revenue in 2009 and another $200 in 2010. Expenses from consumers using the warranty plan would be recorded in the year they were incurred.
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