Chapter 5 — Step 2: Identify the Performance Obligations

5.5 Warranties

5.5.1 In General

Early in the drafting of the revenue standard, the FASB and IASB thought to treat all warranties similarly because generally, all warranties represent an entity’s promise to stand ready to repair or replace the good or service that the entity has provided to a customer in accordance with the terms of the parties’ contract. However, stakeholders informed the boards that some warranties are different from others and that entities should account for such warranties differently. The boards agreed with the stakeholders’ feedback.

5.5.2 Types of Warranties

ASC 606-10

55-30 It is common for an entity to provide (in accordance with the contract, the law, or the entity’s customary business practices) a warranty in connection with the sale of a product (whether a good or service). The nature of a warranty can vary significantly across industries and contracts. Some warranties provide a customer with assurance that the related product will function as the parties intended because it complies with agreed-upon specifications. Other warranties provide the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.

It is important to determine what type of warranty an entity offers to a customer because the way in which revenue is recognized will vary depending on that determination. An entity should determine whether it offers the customer an assurance-type warranty or a service-type warranty. An assurance-type warranty provides the customer with the peace of mind that the entity will fix or possibly replace a good or service if the original good or service was faulty. It is the type of warranty with which most customers are familiar. In contrast, a service-type warranty provides the customer with a service that is incremental to the assurance that the good or service will meet the expectations agreed to in the contract.

5.5.3 Determining Whether a Warranty Is a Performance Obligation (Service-Type Warranties)

ASC 606-10

55-31 If a customer has the option to purchase a warranty separately (for example, because the warranty is priced or negotiated separately), the warranty is a distinct service because the entity promises to provide the service to the customer in addition to the product that has the functionality described in the contract. In those circumstances, an entity should account for the promised warranty as a performance obligation in accordance with paragraphs 606-10-25-14 through 25-22 and allocate a portion of the transaction price to that performance obligation in accordance with paragraphs 606-10-32-28 through 32-41.

55-34 If a warranty, or a part of a warranty, provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, the promised service is a performance obligation. Therefore, an entity should allocate the transaction price to the product and the service. If an entity promises both an assurance-type warranty and a service-type warranty but cannot reasonably account for them separately, the entity should account for both of the warranties together as a single performance obligation.

55-35 A law that requires an entity to pay compensation if its products cause harm or damage does not give rise to a performance obligation. For example, a manufacturer might sell products in a jurisdiction in which the law holds the manufacturer liable for any damages (for example, to personal property) that might be caused by a consumer using a product for its intended purpose. Similarly, an entity’s promise to indemnify the customer for liabilities and damages arising from claims of patent, copyright, trademark, or other infringement by the entity’s products does not give rise to a performance obligation. The entity should account for such obligations in accordance with the guidance on loss contingencies in Subtopic 450-20 on contingencies.

The decision tree below illustrates the revenue standard’s process for determining whether a warranty represents a separate performance obligation.

An entity may need to use judgment to determine whether a warranty is a service-type warranty (i.e., performance obligation). This is important because, depending on the outcome of the entity’s assessment, consideration could be allocated to the performance obligation and consequently change the pattern of revenue recognition.

To assess the nature of a warranty, an entity should consider whether the warranty provides an additional service. An easy way to determine this is if a warranty is sold separately. A contract is considered separately priced if the customer has the option of purchasing the contract for an expressly stated amount separate from the price of the product. As discussed in paragraph BC371 of ASU 2014-09, an entity could also separately negotiate a warranty with a customer and determine that a performance obligation exists.

However, a warranty does not necessarily have to be separately sold or separately negotiated to be considered a performance obligation. To determine whether a warranty is a performance obligation, an entity should consider various indicators in accordance with ASC 606-10-55-33.

ASC 606-10

55-33 In assessing whether a warranty provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, an entity should consider factors such as:

Whether the warranty is required by law — If the entity is required by law to provide a warranty, the existence of that law indicates that the promised warranty is not a performance obligation because such requirements typically exist to protect customers from the risk of purchasing defective products.
The length of the warranty coverage period — The longer the coverage period, the more likely it is that the promised warranty is a performance obligation because it is more likely to provide a service in addition to the assurance that the product complies with agreed-upon specifications.
The nature of the tasks that the entity promises to perform — If it is necessary for an entity to perform specified tasks to provide the assurance that a product complies with agreed-upon specifications (for example, a return shipping service for a defective product), then those tasks likely do not give rise to a performance obligation.

A warranty that provides a service in addition to the entity’s assurance that the goods or services transferred to a customer will function as intended or meet agreed-upon specifications would represent a separate performance obligation. Accordingly, the entity would need to allocate a portion of the transaction price to the separate service and recognize the related revenue when (or as) performance is completed even when this warranty is neither separately priced nor separately negotiated.

If the warranty merely provides what ASC 606-10-55-30 describes as “assurance that the related product will function as the parties intended because it complies with agreed-upon specifications,” the assurance is not a service and therefore not a separate performance obligation. For an assurance-type warranty obligation incurred in connection with the sale of a product (i.e., an obligation that is not separately priced or sold or otherwise a separate performance obligation), the costs associated with providing the warranty would be accrued in accordance with ASC 460-10 (see ASC 606-10-55-32).

Assessing the substance of the promise in a warranty arrangement that is neither separately priced nor separately negotiated often will require judgment. To aid in such an assessment, ASC 606-10-55-33 lists three factors that an entity should consider in determining whether a warranty provides the customer with a service in addition to the entity’s assurance that the good or service complies with agreed-upon specifications: (1) whether the warranty is required by law, (2) the length of the coverage period, and (3) the nature of the tasks that are promised.

Questions continually arise about how an entity would determine whether a product warranty that is not separately priced is a performance obligation (i.e., whether the warranty represents a service rather than a guarantee of the product’s intended functionality). For illustrative purposes, TRG members in March 2015 discussed an example in which a luggage company provides a lifetime warranty to repair any damage to the luggage free of charge and noted that such a warranty would be a separate performance obligation because the company agreed to repair any damage (i.e., repairs that extend beyond those that fix defects preventing the luggage from functioning as intended).

TRG members generally agreed with the conclusion that the warranty in the luggage example would represent a separate performance obligation but that it “illustrates a relatively [straightforward] set of facts and circumstances that demonstrate an instance of when a warranty provides a service.”13 However, the conclusion for other warranty arrangements may be less clear. Accordingly, an entity will need to assess the substance of the promises in a warranty arrangement and exercise judgment on the basis of the entity’s specific facts and circumstances.

In addition, while the duration of the warranty (e.g., the lifetime warranty in the luggage company example discussed) may be an indicator of whether a warranty is a separate performance obligation, it is not determinative.

Example 5-12

In accordance with customary business practices, a luggage manufacturer provides all customers with a one-year warranty that covers only manufacturing defects.

This warranty does not represent a separate performance obligation because it only provides assurance that the luggage will function as intended over a short (and customary) period. This is an “assurance-type” warranty, which should be accounted for under ASC 460. As a result, there is no revenue deferral for the warranty.

Example 5-13

A luggage manufacturer provides all customers with a lifetime warranty that covers all defects and damages, including those arising from normal wear and tear.

This warranty represents a separate performance obligation because the manufacturer has agreed to provide repairs for all damage (i.e., it has agreed to provide a service of repairing the luggage for all damage, which extends beyond rectifying manufacturing defects) and over a longer period than is customary (i.e., the life of the luggage). The luggage manufacturer should (1) determine the stand-alone selling price of the repair service and allocate an appropriate portion of the transaction price to it and (2) recognize that portion as revenue over the period in which the service is delivered.

The above issue is addressed in Implementation Q&A 17 (compiled from previously issued TRG Agenda Papers 29 and 34). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

5.5.4 Warranties Within the Scope of Other Guidance (Assurance-Type Warranties)

Warranties could be within the scope of guidance outside the revenue standard under certain circumstances. For example, warranties that are determined to be separate performance obligations in accordance with the guidance in ASC 606-10-55-30 through 55-35 might appear to be insurance contracts. However, such warranties would only be considered insurance contracts within the scope of applicable guidance in ASC 944 if they are directly issued by a third-party insurance entity. Further, a warranty could be within the scope of the guidance on product warranties in ASC 460-10 if it only provides assurance that a product complies with agreed-upon specifications, as explained in ASC 606-10-55-32.

ASC 606-10

55-32 If a customer does not have the option to purchase a warranty separately, an entity should account for the warranty in accordance with the guidance on product warranties in Subtopic 460-10 on guarantees, unless the promised warranty, or a part of the promised warranty, provides the customer with a service in addition to the assurance that the product complies with agreed-upon specifications.

Example 44 in ASC 606 illustrates how to account for an assurance-type warranty.

ASC 606-10

Example 44 — Warranties

55-309 An entity, a manufacturer, provides its customer with a warranty with the purchase of a product. The warranty provides assurance that the product complies with agreed-upon specifications and will operate as promised for one year from the date of purchase. The contract also provides the customer with the right to receive up to 20 hours of training services on how to operate the product at no additional cost. The training services will help the customer optimize its use of the product in a short time frame. Therefore, although the training services are only for 20 hours and are not essential to the customer’s ability to use the product, the entity determines that the training services are material in the context of the contract on the basis of the facts and circumstances of the arrangement.

55-310 The entity assesses the goods and services in the contract to determine whether they are distinct and therefore give rise to separate performance obligations.

55-311 The product and training services are each capable of being distinct in accordance with paragraphs 606-10-25-19(a) and 606-10-25-20 because the customer can benefit from the product on its own without the training services and can benefit from the training services together with the product that already has been transferred by the entity. The entity regularly sells the product separately without the training services.

55-312 The entity next assesses whether its promises to transfer the product and to provide the training services are separately identifiable in accordance with paragraphs 606-10-25-19(b) and 606-10-25-21. The entity does not provide a significant service of integrating the training services with the product (see paragraph 606-10-25-21(a)). The training services and product do not significantly modify or customize each other (see paragraph 606-10-25-21(b)). The product and the training services are not highly interdependent or highly interrelated as described in paragraph 606-10-25-21(c). The entity would be able to fulfill its promise to transfer the product independent of its efforts to subsequently provide the training services and would be able to provide training services to any customer that previously acquired its product. Consequently, the entity concludes that its promise to transfer the product and its promise to provide training services are not inputs to a combined item and, therefore, are each separately identifiable.

55-313 The product and training services are each distinct in accordance with paragraph 606-10-25-19 and therefore give rise to two separate performance obligations.

55-314 Finally, the entity assesses the promise to provide a warranty and observes that the warranty provides the customer with the assurance that the product will function as intended for one year. The entity concludes, in accordance with paragraphs 606-10-55-30 through 55-35, that the warranty does not provide the customer with a good or service in addition to that assurance and, therefore, the entity does not account for it as a performance obligation. The entity accounts for the assurance-type warranty in accordance with the requirements on product warranties in Subtopic 460-10.

55-315 As a result, the entity allocates the transaction price to the two performance obligations (the product and the training services) and recognizes revenue when (or as) those performance obligations are satisfied.

5.5.5 Implicit Warranty Beyond the Contractual Period

In addition to providing a warranty that guarantees that an entity’s product or service complies with agreed-upon specifications for a specified period, entities in many industries may continue to provide warranty-type services (e.g., repairs) beyond the original specified period as part of their customary business practices. In accordance with ASC 606-10-55-34, if an entity’s warranty, or part of its warranty, provides a customer with a service in addition to the assurance that the product complies with agreed-upon specifications, the promised service represents a performance obligation.

Regardless of whether the warranty services are explicitly promised in the contract for a specified period or are implied by customary business practices, the entity must assess whether the services to be provided represent an assurance-type warranty (which should be accounted for in accordance with ASC 460-10) or a promised service (in addition to the assurance that the product complies with agreed-upon specifications) in the contract. This assessment requires an analysis of the nature of (1) the products or services that are subject to the specific warranty and (2) any other products or services that are provided as part of the entity’s customary business practice.

Example 5-14

Entity X sells long-life LED lightbulbs to customers with a two-year contractual warranty period. Entity X also has a customary business practice of providing its customers with a replacement lightbulb free of charge if a defective lightbulb is returned within three years of the date of purchase.

In accordance with ASC 606-10-55-32 and ASC 606-10-55-34, the practice of replacement in the third year is not considered an additional service (i.e., it is not a separate performance obligation) and therefore should not be accounted for as a service-type warranty. Entity X concludes that the practice of replacement in the third year should be accounted for as an assurance-type warranty, and is not a separate performance obligation, because X is only guaranteeing that the lightbulb will function as intended. Therefore, X accounts for the warranty in accordance with ASC 460-10.

Footnotes

Quoted from Implementation Q&A 17.

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