Service warranty approach

The accounting for a service-type warranty is as follows:

Definitions

Service-type warranty

A warranty sold as a separate performance obligation, recognized as revenue over the warranty period rather than at the time of sale.

Assurance-type warranty

A warranty that only assures the product meets specifications at the time of sale; the full sale price is recognized as revenue immediately, and the seller accrues an estimated warranty expense and liability instead. (Covered in the next chapter, assurance warranty approach.)

Journal entry at the time of sale

Under a service type warranty, since the warranty is a separate performance obligation, the total transaction price from the sale should be split between the main product or service and the warranty. The warranty is typically initially recorded as a liability and is transferred to the revenue account as the performance obligation is satisfied.

Account	Debit	Credit	Financial statement element
Cash or accounts receivable	XXX		Assets
Revenue - product or service		XXX	Revenue
Unearned revenue - warranty		XXX	Liability
To record a sale with warranty as a separate performance obligation

The process of allocating the transaction price among the performance obligations is also discussed in the chapter about revenue recognition.

Example: Selling a product with a service-type warranty

Crane Co. sells a machine for $10,000 cash, allocating $9,200 to the machine and $800 to a two-year service-type warranty.

At sale: debit cash $10,000, credit revenue - product $9,200, credit unearned revenue - warranty $800.

Each year: debit unearned revenue - warranty $400, credit revenue - warranty $400 ($\$800÷2=\$400$ straight-line).

Answer: $9,200 of product revenue is recognized at the time of sale; $400 of warranty revenue is recognized in each of the two years.

Journal entry as the performance obligation is satisfied

Since we initially recorded the allocated transaction price of the service type warranty as a liability, we need to periodically transfer amounts from this liability account to the revenue account as the performance obligation is satisfied.

For warranty obligations, the most typical way of recognizing the revenue is recognition over time. In this case, as time passes, we transfer warranty revenue from the liability account on a straight-line basis throughout the warranty period with the following journal entry.

Account	Debit	Credit	Financial statement element
Unearned revenue - warranty	XXX		Liability
Revenue - warranty		XXX	Revenue
To record the satisfaction of performance obligations on the warranty

Note that if the service type warranty (i.e., extended warranty) picks up after an assurance type warranty (i.e., standard manufacturer’s warranty), the recognition of revenue under the service type warranty does not commence until after the expiration of the assurance type warranty period.

Why there is no separate estimated warranty expense entry

Service-type vs. assurance-type warranty: service-type warranties defer the allocated revenue and expense fulfillment costs as incurred, with no estimated-expense accrual. Assurance-type warranties recognize the full sale price as revenue immediately and accrue an estimated warranty expense and liability upfront (covered in the next chapter).

Journal entry for the actual costs of the providing warranty

When the company performs services to fulfill their obligations under the service type warranty agreement, the expenses are recorded as follows:

Account	Debit	Credit	Financial statement element
Warranty expense - service type	XXX		Expense
Cash		XXX	Asset
To record costs incurred related to fulfilling the service type warranty