Accounting for Extended Warranty Contracts

Article excerpt

ISSUE NO. 89-17

Say you're buying a camcorder at Hazy Freddie for $500. As the clerk rings up the sale, he offers you the option to buy a two-year service contract for $50. He says this is a special offer only for those who buy a camcorder from Hazy Freddie and it extends the original manufacturer's warranty on the camcorder. He promises Hazy Freddie will clean and inspect the camcorder once a year. And if repair is needed, he says the cost of parts and labor will be covered by the retailer during the two-year period.

The salesperson's offer appeals to you. You decide to purchase the extended warranty contract although it's noncancelable unless you return the camcorder. Exhibit 1 on page 102 summarizes the transaction.

Accounting issue. How does Hazy Freddie account for the revenue and cost of the warranty contract? Is immediate revenue recognition appropriate or should all or part of the income and related cost be deferred?

The task force considered three alternatives:

* Full recognition.

* Full deferral.

* Partial recognition.

Under the full recognition method, Hazy Freddie would recognize at the date of sale total revenue of $550 and a total cost of $460, yielding a profit of $90. If his actual cost under the service contract either exceeds or falls short of the $10 estimate, an adjustment will be made on his books.

Those who favor this approach point to FASB Statement no. 5, Accounting for Contingencies, for support of their position. Statement no. 5 requires a loss contingency to be accrued if it's probable a liability was incurred and the amount is reasonably estimable. They believe a liability under the service contract is both probable and reasonably estimable at the point of sale and should be accrued at that time. To properly match revenue and expense, contract revenue also should be recognized at the time of sale.

Others disagree that contract revenue and cost should be recognized at point of sale. They think none of the contract services has been rendered at that time. In their view, Hazy Freddie should recognize profit of only $50 for the sale; the $50 contract revenue is earned over the contract period and should be recognized over that period (full deferral method). Costs under the contract, however, should be recognized immediately.

Proponents of the full deferral approach view the sale of the camcorder and the sale of the extended warranty contract as two distinct transactions because customers have the option to buy the camcorder without the service contract. Therefore, while profit on the camcorder may be booked immediately, in their view, revenue on the service contract should be recognized over the service period.

Supporters of the third approach (partial recognition method) would recognize a portion of the combined revenue at the time of sale, based on the relative costs of the product and service contracts. Employing this method would result in booking revenue of $538 at the time of sale; the remaining $12 would be deferred and recognized over the contract period. (See exhibit 2 at right for the calculation.)

Under this method, profit of $88 ($538 revenue less $450 cost) would be recognized at the time of sale. Costs under the contract would be recognized as incurred during the contract period.

Opponents of the partial recognition method argue it would permit retailers to recognize almost as much profit at the time of sale as the full revenue recognition method. …