Warranty revenue is the earnings that a company recognizes from offering warranties on its products. This revenue stream reflects a company’s assurance to its customers against defects or failures, and it serves as an indicator of the product’s reliability and the company’s commitment to quality. In financial reporting, warranty revenue impacts overall revenue figures and profitability. It also helps investors and analysts understand the after-sales monetisation strategies and any potential future liabilities.

Warranty revenue is important in the automotive and electronics industries, where products are complex and have a higher cost. Companies can gain a competitive advantage by effectively managing this revenue stream.

Below, we’ll explore how revenue recognition works with warranty revenue, in addition to the challenges and strategies for businesses recognising warranty revenue.

What’s in this article?

• Types of warranties and their impact on revenue recognition
  
• ASC 606 and warranty revenue recognition
  
• Examples of warranty revenue recognition
  
• Challenges in warranty revenue accounting
  
• Strategies for warranty revenue management
  

Types of warranties and their impact on revenue recognition

There are two main types of warranties that businesses deal with: assurance-type warranties and service-type warranties.

Assurance-type warranties are a basic guarantee that a product is free from defects and will work as promised. This is the standard warranty that comes with buying a new phone or car. For accounting purposes, these warranties aren’t treated as separate from the sale. The revenue from the sale is recorded immediately, and the costs associated with potential repairs are estimated and recorded as a warranty liability.

Service-type warranties are service contracts that promise extra protection or maintenance over a longer period. From an accounting perspective, these are considered separate from the original sale. The revenue from these warranties is recognised over the course of the contract to reflect the company’s ongoing obligation to provide service for a set time period.

ASC 606 and warranty revenue recognition

ASC 606, an accounting standard that governs revenue recognition, uses a five-step model to help companies properly recognise revenue. The way companies recognise warranty revenue depends on whether the warranties are considered distinct performance obligations in a contract. Here’s how the five-step model applies to warranties.

• Identify the contract with a customer: The company establishes whether there’s a contract in place, what it includes, and what the terms are.

• Identify the performance obligations in the contract: The company identifies all distinct performance obligations, or it promises in a contract to deliver a good or service. For warranties, the company must determine if the warranty is a separate service or just an assurance that the product works. If the warranty provides extra services beyond a basic fix, it’s likely a distinct performance obligation.

• Determine the transaction price: The company figures out how much it expects to receive from the customer. If there are separate warranties sold along with a product, the price must be broken down between the product and the additional service warranties.

• Allocate the transaction price to the performance obligations in the contract: If a warranty is identified as a separate performance obligation, the company must allocate part of the transaction price to it. This typically occurs with service-type contracts, not assurance-type warranties.

• Recognise revenue when (or as) the entity satisfies a performance obligation: The company recognises revenue when (or as) if fulfils each performance obligation. For assurance-type warranties that are bundled with the sale of the product, revenue is recognised at the point of sale. For service-type warranties that promise additional service over time, the revenue is recognised over the life of the warranty.

Examples of warranty revenue recognition

Here are two industry examples of how warranty revenue recognition can occur in practice. These scenarios show how auto manufacturers and tech companies would recognise revenue for their warranties.

An auto manufacturer sells cars with extended warranties

Automakers typically provide a standard warranty with every car sold. This warranty covers defects for a specific period or mileage (e.g., a three-year, 36,000-mile warranty). Manufacturers might also sell extended warranties with additional coverage beyond the standard warranty period (e.g., covering an additional two years of repair services).

Under ASC 606, the assurance-type warranty is not treated as a separate performance obligation, but the service-type warranty is. Here’s how revenue is recognised for each one.

• The contract includes the sale of the car with the included warranty and the optional extended warranty.

• Two obligations are identified: the sale of the car (including the standard assurance-type warranty) and the extended service-type warranty.

• If the car is sold for $30,000, and the extended warranty is sold for an additional $1,500, the transaction price is set at $31,500.

• $30,000 is allocated to the car sale (including the standard warranty) and $1,500 is allocated to the extended warranty.

• $30,000 of revenue is recognised immediately upon delivery of the car. The $1,500 of extended warranty revenue is recognised over the two-year period of the extended warranty as the manufacturer provides coverage and service.

A tech company sells laptops with optional protection plans

Tech companies often bundle assurance-type warranties with their products and sell extended service plans separately. For instance, when a laptop manufacturer sells its products, it might include a standard one-year warranty while also offering customers the option to buy a three-year protection plan. The assurance-type warranty guarantees the laptop is free from defects for one year, while the service-type warranty includes additional services such as accidental damage coverage and extended repair coverage.

Under ASC 606, the assurance-type warranty is not considered a separate performance obligation, but the service-type warranty is. Here’s how revenue would be recognised.

• The contract includes the sale of the laptop with the bundled one-year warranty and the additional three-year protection plan.

• Two distinct obligations are identified: the sale of the laptop (including the standard assurance-type warranty) and the extended protection plan.

• The laptop is sold for $1,000 and the protection plan is sold for $200. The total transaction price is $1,200.

• $1,000 is allocated to the laptop sale and $200 to the extended warranty.

• $1,000 of revenue is recognised at the time of sale. The $200 of revenue is recognised over the three-year length of the protection plan, during which services will be provided.

Challenges in warranty revenue accounting

Warranty revenue accounting under ASC 606 can present challenges, especially when dealing with bundled products and estimating warranty costs. These challenges can impact how companies report their financial health, manage their earnings, and comply with accounting standards. Here are some issues you might encounter.

• Classifying warranties: If a company sells a product with both a standard assurance-type warranty and an optional service-type warranty, the accounting team must carefully assess if the warranties are distinct from the product itself. Misclassifying a service-type warranty as an assurance-type warranty can result in incorrect revenue reporting and potential compliance issues.

• Allocating transaction prices: When products are sold with additional warranties, companies must allocate the transaction price between the different components. This allocation must reflect the stand-alone selling prices of each component. This can be difficult to determine, especially with bundled packages that don’t have a clear market value for each component or where the components are highly customised.

• Estimating warranty costs: Businesses must estimate the cost of fulfilling their warranty obligations. This can be difficult as it depends on several variables such as the rate of product defects and the cost of repairs, replacement parts, and labour. This is even more challenging for companies with products that are new to market or that have a limited performance data history. Higher-than-expected warranty costs could mean that a company’s liabilities have been underreported, resulting in financial surprises that could impact investor confidence and stock prices.

• Assessing changing business conditions: Economic, regulatory, and technological changes can also impact warranty costs. For example, if a new regulation increases the cost of repairs or requires additional safety checks under the warranty, the previously estimated costs could become outdated. Companies must continuously monitor these external factors and adjust their warranty cost estimates and recognised liabilities accordingly.

• Collecting and analysing data: To accurately estimate warranty costs, companies need to have systems in place to collect and analyse data on warranty claims, repair costs, product defect rates, and customer usage patterns. These systems can be time-consuming and costly to maintain, particularly for companies operating across multiple markets or with diverse product lines.

Strategies for warranty revenue management

Business owners should think strategically about warranty revenue management to ensure they’re recognising revenue correctly. Here are some best practices that can help.

• Set clear warranty terms: Establish in detail what’s covered, what’s not, and how long the warranty lasts. Doing so can avoid customer confusion and make it easier to distinguish between basic warranties that don’t require separate revenue recognition and those that do.

• Optimise your accounting process: Develop a straightforward system for warranty accounting. Make sure teams handling contracts, accounting, and finances work together, and that they conduct regular checks and audits to catch issues before they become big problems.

• Analyse warranty data: Look at past warranty claims to spot trends and better predict future costs. Identify any products that are likely to have issues, and adjust your estimates and reserves accordingly.

• Use strategic pricing: Use pricing strategies that reflect the real risk and value of the warranty, and offer different levels of coverage so customers can pick what works for them. This strategy might mean charging more for higher risk products or bundling warranties with other services to make them more attractive.