5.6 Product Warranties

ASC 460 includes guidance on warranty obligations incurred in connection with the sale of goods or services (i.e., product warranties). The ASC master glossary defines a warranty as follows:

ASC Master Glossary

Warranty

A guarantee for which the underlying is related to the performance (regarding function, not price) of nonfinancial assets that are owned by the guaranteed party. The obligation may be incurred in connection with the sale of goods or services; if so, it may require further performance by the seller after the sale has taken place.

5.6.1 Scope of Guidance on Product Warranties

Section 5.2 discusses the application of the scope guidance in ASC 460 that is relevant to all guarantees other than product warranties. All product warranties are within the scope of the disclosure requirements of ASC 460; however, certain product warranties may be outside the scope of ASC 460’s recognition and measurement guidance and may instead be accounted for in accordance with ASC 606.

ASC 460-10

15-9 The guidance in the Product Warranties Subsections applies only to product warranties, which include all of the following:

Product warranties issued by the guarantor, regardless of whether the guarantor is required to make payment in services or cash
Separately priced extended warranty or product maintenance contracts and warranties that provide a customer with a service in addition to the assurance that the product complies with agreed-upon specifications (see paragraphs 606-10-55-30 through 55-35 for guidance on determining whether a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications)
Warranty obligations that are incurred in connection with the sale of the product, that is, obligations in which the customer does not have the option to purchase the warranty separately and that do not provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.

Connecting the Dots

Because the general recognition and measurement requirements that apply to guarantees in ASC 460-10 differ significantly from the recognition and measurement requirements for product warranties, it is important for entities to appropriately determine whether an arrangement is subject to the guidance that applies to product warranties. On the basis of informal discussions, we understand that the SEC’s Office of the Chief Accountant recently objected to a transaction in which a registrant accounted for an arrangement as a product warranty that involved the guarantee of the functionality of a security service provided to the entity’s customer by another customer of the entity. While this guarantee was part of a multiple-element revenue arrangement, the SEC staff objected to the registrant’s conclusion that this arrangement was a product warranty. We understand that the SEC staff believed that a guarantee of a service provided to a customer by another entity cannot be a product warranty because the guarantor was not the entity that provided the service. The SEC staff believed that the arrangement should be accounted for in accordance with the general recognition and measurement guidance that applies to guarantee obligations.

As noted in ASC 460-10-15-9(b), certain warranties may be accounted for as separate performance obligations under ASC 606. Section 5.5 of Deloitte’s Roadmap Revenue Recognition discusses the determination of whether a warranty is an assurance-type warranty (and therefore outside the scope of ASC 606) or a service-type warranty (and is therefore accounted for as a performance obligation in accordance with ASC 606). The following decision tree illustrates this determination:

See Section 5.5 of Deloitte’s Roadmap Revenue Recognition for additional guidance on each step in the determination of whether a warranty is within the scope of ASC 606 or is instead within the scope of ASC 460.

5.6.2 Recognition and Measurement of Warranty Obligations

Once an entity determines that its warranty is an assurance-type warranty that is within the scope of ASC 460’s recognition and measurement guidance, it should account for its warranty obligation in a manner consistent with its accounting for other loss contingencies.

ASC 460-10

25-5 Because of the uncertainty surrounding claims that may be made under warranties, warranty obligations fall within the definition of a contingency. Losses from warranty obligations shall be accrued when the conditions in paragraph 450-20-25-2 are met.

25-6 The condition in paragraph 450-20-25-2(a) is met at the date of an entity’s financial statements if, based on available information, it is probable that customers will make claims under warranties relating to goods or services that have been sold. Satisfaction of the condition in paragraph 450-20-25-2(b) will normally depend on the experience of an entity or other information. In the case of an entity that has no experience of its own, reference to the experience of other entities in the same business may be appropriate. Inability to make a reasonable estimate of the amount of a warranty obligation at the time of sale because of significant uncertainty about possible claims (that is, failure to satisfy condition [b] in that paragraph) precludes accrual and, if the range of possible loss is wide, may raise a question about whether a sale should be recorded before expiration of the warranty period or until sufficient experience has been gained to permit a reasonable estimate of the obligation.

25-7 The conditions in paragraph 450-20-25-2 may be considered in relation to individual sales made with warranties or in relation to groups of similar types of sales made with warranties. If those conditions are met, accrual shall be made even though the particular parties that will make claims under warranties may not be identifiable.

The recognition requirements of ASC 450 apply to warranty obligations, which meet the definition of a contingency given the uncertainty associated with the volume, amount, and timing of any future claims that may be made. Because the recognition requirements of ASC 450 apply to the warranty obligations, there is no initial fair value guarantee to record in accordance with ASC 460. Therefore, estimates are required for accruals related to warranty claims; such accruals should be recorded when the loss is both probable and reasonably estimable in accordance with ASC 450-20-25-2. (See Chapter 2 for further discussion of the application of the recognition guidance in ASC 450.)

ASC 450-20

25-2 An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met:

Information available before the financial statements are issued or are available to be issued (as discussed in Section 855-10-25) indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. Date of the financial statements means the end of the most recent accounting period for which financial statements are being presented. It is implicit in this condition that it must be probable that one or more future events will occur confirming the fact of the loss.
The amount of loss can be reasonably estimated.

The purpose of those conditions is to require accrual of losses when they are reasonably estimable and relate to the current or a prior period. Paragraphs 450-20-55-1 through 55-17 and Examples 1–2 (see paragraphs 450-20-55-18 through 55-35) illustrate the application of the conditions. As discussed in paragraph 450-20-50-5, disclosure is preferable to accrual when a reasonable estimate of loss cannot be made. Further, even losses that are reasonably estimable shall not be accrued if it is not probable that an asset has been impaired or a liability has been incurred at the date of an entity’s financial statements because those losses relate to a future period rather than the current or a prior period. Attribution of a loss to events or activities of the current or prior periods is an element of asset impairment or liability incurrence.

The criteria in ASC 450-20-25-2 are met if (1) it is probable, as of the date of an entity’s financial statements, that customers will make claims under warranties related to goods or services that have been sold and (2) the amount of such claims is reasonably estimable. Generally, an entity may use its own historical information and experiences to assess the probability of warranty claims related to sales in the current period. If an entity has no prior experience, it may be appropriate to consider the experiences of similar entities in the same industry if such information is known. If an entity cannot reasonably estimate possible claims (and therefore does not meet the criterion in ASC 450-20-25-2(b)), ASC 450 precludes that entity from recording a loss accrual.

An assurance-type warranty guarantees to the customer that the goods or services are free from defects and function in accordance with the entity’s performance obligation. Therefore, ASC 460-10-25-6 notes that if an entity concludes that it is unable to estimate its warranty obligation in accordance with ASC 450-20-25-2(b), or “if the range of possible loss is wide,” questions may arise about whether the associated sale should be recognized before either (1) the warranty period expires or (2) the entity has enough experience to reasonably estimate the obligation. Because assurance-type warranties guarantee the performance of an underlying good or service, if a customer is dissatisfied with the good’s or service’s ability to function in accordance with the revenue contract, the guarantee provides for remediation to the customer in the form of further vendor performance. If an entity is unable to estimate its warranty obligation at the time of delivery, or the range of loss is wide, the entity should consider whether it is appropriate to recognize revenue for the sale of the product. For example, ASC 606-10-55-85 through 55-88 discuss whether a customer’s acceptance of a product indicates that the customer has obtained control of the product. ASC 606-10-55-87 states:

[I]f an entity cannot objectively determine that the good or service provided to the customer is in accordance with the agreed-upon specifications in the contract, then the entity would not be able to conclude that the customer has obtained control until the entity receives the customer’s acceptance. That is because, in that circumstance the entity cannot determine that the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the good or service.

See Chapter 8 of Deloitte’s Roadmap Revenue Recognition for a discussion of customer acceptance clauses.

An entity does not need to identify the particular customer who will make a warranty claim in determining whether it is probable that a claim will be made and the amount is reasonably estimable. A warranty accrual may be recognized for either (1) an individual sale with a warranty or (2) groups of similar types of sales with warranties. Using a group of similar types of sales with warranties as the basis for the reasonable estimate differs from a general reserve, which an entity would be prohibited from recognizing. (See Section 2.3.1.5 for more information about general reserves.) Recognition of general reserves is prohibited because it is not probable that the uncertain future event or events will confirm that a loss occurred on or before the date of the financial statements. In contrast, a recognized product warranty reserve is akin to unasserted claims (as discussed in Section 2.3.2.1) related to a loss that, as of the date of the financial statements, is both probable and reasonably estimable. An entity may need to draw upon historical experience with similar types of sales with warranties to conclude that the loss is both probable and reasonably estimable.

5.6.3 Constructive Product Warranties

Even in the absence of a written contractual arrangement with a customer, a constructive obligation may arise from a historical practice or a stated intention to perform repairs even if there is no legal requirement to do so. Section 5.5.3 of Deloitte’s Roadmap Revenue Recognition gives an example of a constructive obligation that is within the scope of ASC 460.

5.6.4 Product Warranty Disclosures

As discussed in Section 5.6.2, if the condition in ASC 450-20-25-2(b) is not met, ASC 450 precludes accrual of a warranty obligation. In those instances, an entity must apply the disclosure requirements for loss contingencies in ASC 450-20-50-3 through 50-6. When a warranty obligation is accrued, in addition to applying the disclosure guidance in Section 5.5 on guarantees and in Section 2.8 on loss contingencies, an entity should consider the disclosure requirements below for product warranties. In addition, product warranties to which the recognition and measurement guidance in ASC 606 applies are subject to the disclosure requirements in ASC 460-10-50-1 through 50-8.

ASC 460-10

50-8 A guarantor shall disclose all of the following information for product warranties and other guarantee contracts described in paragraph 460-10-15-9:

The information required to be disclosed by paragraph 460-10-50-4 except that a guarantor is not required to disclose the maximum potential amount of future payments specified in paragraph 460-10-50-4(b)
The guarantor’s accounting policy and methodology used in determining its liability for product warranties
A tabular reconciliation of the changes in the guarantor’s aggregate product warranty liability for the reporting period. That reconciliation shall include all of the following amounts:
1. The beginning balance of the aggregate product warranty liability
2. The aggregate reductions in that liability for payments made (in cash or in kind) under the warranty
3. The aggregate changes in the liability for accruals related to product warranties issued during the reporting period
4. The aggregate changes in the liability for accruals related to preexisting warranties (including adjustments related to changes in estimates)
5. The ending balance of the aggregate product warranty liability.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.