Embedded Product Warranty

1. Explain the difference between an embedded and an extended product warranty.

2. Account for the liability and expense incurred by a company that provides its customers with an embedded warranty on a purchased product.

3. Account for the amount received on the sale of an extended warranty and any subsequent cost incurred as a result of this warranty.

4. Compute the average age of accounts payable.

Question: FASB Statement Number 5 includes an embedded product warranty as an example of a contingency. A

company sells merchandise such as a car or a microwave and agrees to fix certain problems if they arise within

a specified period of time. If the car’s transmission breaks, for example, the seller promises to replace it. Making

the sale with a warranty attached is the past event that creates this contingency. However, the item acquired by

the customer must break before the company has an actual loss. That outcome is uncertain.

In accounting for contingencies, several estimates are required:

• The approximate number of claims

• The likelihood that claims will result from the warranty

• The eventual cost

As an example, General Electric reported on its December 31, 2008, balance sheet a liability for product

warranties totaling over $1.68 billion. That is certainly not a minor obligation. In the notes to the financial

statements, the company explains, “We provide for estimated product warranty expenses when we sell the related

products. Because warranty estimates are forecasts that are based on the best available information—mostly

historical claims experience—claims costs may differ from amounts provided.” How does a company record and

report contingencies such as product warranties?

Answer: In accounting for warranties, cash rebates, the collectability of receivables and other similar

contingencies, the likelihood of loss is not an issue. These losses are almost always probable. For the accountant,

the challenge is in arriving at a reasonable estimate of that loss. How many microwaves will break and have to be

repaired? What percentage of cash rebate coupons will be presented by customers in the allotted time? How often

will a transmission need to be replaced?

Many companies utilize such programs on an ongoing basis so that data from previous offers will be available to

help determine the amount of the expected loss. However, historical trends cannot be followed blindly. Officials

still have to be alert for any changes that could impact previous patterns. For example, in bad economic periods,

customers are more likely to take the time to complete the paperwork required to receive a cash rebate. Or the

terms may vary from one warranty program to the next. Even small changes in the wording of an offer can alter

the expected number of claims.