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Product Guarantee and Warranty Obligations

A warranty liability arises when a business gaurantees to repair or replace goods that are defective within a period after their sale. When the guarantee or warranty is integral and inseperable from the sale of the underlying product or service, the liability is recorded at the time of the sale and is considered to be a contingent liability that is probable and should be estimated. 

For example, laptops often come with a one-year warranty. If the laptop gets a "bug" with in that one year period, it can be returned to the manufacturer. Manufacturers use these types of gaurantees to help promote sales

Embedded Warranty: An embedded warranty is provided along with the product or service being sold without an additional fee. A one-year warranty that comes with a new laptop is an example of an embedded warranty. If it is likely that a warranty cost will be incured in the future as a result of the sale of the product today, and the amount of the liability can be reasonably estimated it should be recognize on the financial statements today. When the embedded warranty is inseperable from the sale of the product, the expense warranty method is used. Under this method, estimated warranty costs should be recognized as an operating expense in the period in which the original sale occurs. 

Separate Product: A warranty can also be sold separately from the underlying product it relates to. For example, when you purchase a new laptop you are often able to purchase a seperate extended warranty that will insure your purchase from defects, or even damage, for several years. When the price of the warranty can be seperated from the the price of the underlying product or service, the sales warranty method is used. This method requires that the revenues associated with the sale of the warranty be deferred and recognized over the life of the contract on a straight-line basis. A current liability is not recognized, and the costs associated with honouring the warranties are recognized when they incur.