What are rules regarding deferring revenue recognition when an extended
warranty is included with the tangible product being sold? If the product
has one price and the warranty has a separate itemized price, I assume that
the product revenue is recognized when the product is received and accepted
by customer. The extended warranty becomes a liability and revenue is
recognized over the lifetime of the warranty. What if the warranty is
not itemized and is just included into the price of the product? Assume
a three year warranty for example.
I'm going to assume you are asking a tax question (this being a tax
board) and not inquiring about financial reporting.
Income from the sale of an extended warranty (advance payment) is
recognized when the retailer makes the sale. This is true for a retailer
on the cash basis or accrual basis. There is a revenue procedure
floating around that allows for some deferral to the next tax year based
on the retailer's accounting method for financial reporting. There is
also a revenue procedure that allows deferral when the retailer buys an
insurance contract to cover the warranty.
If the warranty is not priced separately, then income is recognized when
the retailer makes the product sale.
If the warranty is insured (say Best Buy sells a warranty insured by New
Hampshire Insurance Group), then Best Buy will recognize the commission as
If Best Buy is liable for performing the repairs, then they would have to carry
a reserve for repairs that would be reduced over the life of the warranty.
I can't say how it is treated for GAAP purposes, but I can say that under
insurance accounting rules the reserve must be the greatest of:
a) The liability for refunds if the warranty can be cancelled.
b) The discounted present value of expected future repairs
c) The premium times the ratio of expected future repairs to expected total
Let's say you had a $360 three-year warranty where repairs occurred at an equal
pace throughout the the life of the warranty and refunds were also pro-rata, and
that the cost of repairs was expected to be $360 (no profit) and the discount
rate was zero. Now all three methods would produce the same reserve, of $10 per
month of term left.
Let's now ignore refunds and use a discount rate of zero (for simplification)
and assume repairs occur 1/6 in the first year, 1/3 in the second year, and 1/2
in the third year.
If total expected repairs are $180, then the second method would give a reserve
after 12 months of $150 (remaing cost of repairs) and the third method would be
$300 (5/6 of repairs not yet done times premium of $360).
If total expected repairs are $540, the second method would give a reserve of
$450 and the second method a reserve of $300.
Method 2 requires the company to have enough in reserve to pay future claims,
thus requiring it to immediately recognize losses on contract sold at a loss.
Method 3 prevents an insurance company from immediately booking all the profit
in a contract sold at a profit. If it weren't for that limitation, then in the
first example the company would book $180 of profit in the first year ($360
revenue less $30 spent on repairs and $150 reserve) and no profit in years 2 and
The "earnings" or "loss" curve vary by type of product. For new automobiles, it
is almost always back-loaded because the first 3 years or 36,000 miles are
covered by the manufacturer's warranty. For used cars, it is usually somewhat
front-loaded. Although cars deteriorate over time, used cars can be sold,
retired, or exceed the milage cap.
For electronics, the curves tend to approximate pro-rata. Products initially
defective are covered by the manufacturer's warranty. As they get older they
may deteriorate, but most warranties are shorter than a product's physical life.
Again, these three methods are specified for use by insurance companies by the
accounting rules of the National Association of Insurance Commissioners. I
don't know what the GAAP treatment is.
(Yes, I was an actuary setting reserves for warranty companies for a few years.)
========================================= MODERATOR'S COMMENT:
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Good point. Yes, this is exclusively a tax question not a financial
reporting question. If financial reporting method determines the tax
answer then of course you need to talk about both. It is the tax treatment
I ultimately want to understand.
So the first two sentences seems to contradict the last one. The first two
sentences seem to say "always recognize income upon sale" (i.e., customer's
receipt and acceptance). The last sentence seems to say that you do not
need to always recognize all income at time of sale, based on some revenue
procedure that is not detailed.
This seems odd since an insurance contract partly relieves the reseller of
financial responsibility for the warranty claim. You would think that
would accelerate recognition of income not delay it?