Deferred Revenue and Extended Warranty

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 income.

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 repairs.

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

2. 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.)

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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?

You will find a good explanation of the tax accounting for service contracts and extended warranties for the retail trade in the IRS Internal Revenue Manual Part 4 Ch 43 Sec 1 (4.43.1).