Accruals for Warranties and Other Guarantees

The last time you purchased an automobile, electronic device, or a major appliance – a new smart phone, refrigerator, or washing machine, for example – you were probably offered the option to buy an extended warranty or service contract. These cover the expenses of repairing, replacing, or refunding the purchase price of the product in the event of certain failures, damage, or other events.

An extended warranty is different from the warranty that may automatically come with a product. The extended warranty costs extra, may cover different issues than a manufacturer’s warranty, and is sold separately. If you decided to purchase the extended warranty, you paid a fee at the time of purchase (or shortly after) and were probably provided warranty protection for multiple years. The company underwriting the warranty or extended warranty usually records a liability on its books for the future expected costs of such promises in order to properly match costs with revenues and to comply with accounting standards.

Accrual accounting records revenues and expenses as they occur, as opposed to when money is actually received or paid. This amount registered on the books of a company is referred to as an accrual.

If your company posts accruals for its warranty obligations and/or product failures, you may have wondered if the amount and methodology used to estimate the accrual is reasonable. Warranty accruals can represent as much as 7% of sales on the company’s books.[1] For some manufacturers, that percentage exceeds their profit margin. How does your process for determining warranty accruals compare to those of your competitors?

We have seen a variety of methods for estimating warranty accruals, from rules of thumb to sophisticated analytics, and a variety of processes in-between. For example, some companies use:

1. A “rule of thumb” approach, which is usually based on reviewing multiple years of experience, a review of competitor accrual rates, or both. This approach is often the easiest to implement but may lack sufficient support for your auditors and regulators. While such metrics can help establish an accounting entry, a more rigorous approach is sometimes preferred or required. Sophisticated analytics can provide stronger support for your selected accrual but may be more time consuming to implement.
2. An accruals-to-sales ratio approach, which uses this specific metric from other similar entities applied to your company. However, differences in the quality of the product, time of coverage, claims reporting rates, jurisdiction of where goods or services are provided, geography, and other factors can make such comparisons inappropriate.
3. A frequency/severity approach, which estimates the likelihood of a claim (frequency), the average cost per claim (severity) and the number of units sold, and then multiplies these projections together to get an estimated outstanding liability. This approach tends to be more rigorous than the prior two approaches and requires estimates of the percentage of defective units and the average cost per unit to repair and replace. These estimates can be derived from a company’s own historical experience or from industry data.

Other estimation methods, ranging in complexity, can also be used. In some cases, a more analytical approach is used to develop the parameters of a simplified method that is used for the periodic booking of the accrual.

The accrual method used depends on the characteristics of the underlying product, the terms of the warranty and the data being collected. It also depends on the intended use of the accrual estimate and the regulatory and reporting requirements for the company.

Estimating accruals not only impacts a company’s liabilities, but it can also impact current pricing of warranty products: too high an accrual can result in uncompetitive pricing, while inadequate pricing can cause profits to suffer. Since many warranties cover multiple months or years, there can be a considerable delay between the date of the sale and finalization of the cost of the warranty.

Does your current warranty accrual estimate reasonably reflect your underlying liability? Now is a great time to take a closer look at this projection and the methodology you are using to derive it.

Grover Edie, MBA, FCAS, MAAA, CERA, CPCU, ARM, ARP, is a consulting actuary for Huggins Actuarial Services, Inc. He has extensive experience quantifying, evaluating, and monitoring warranty accruals and other loss reserves, and ensuring compliance with actuarial standards of practice. 

[1] Source: Warranty Week, 6/15/2023

https://www.warrantyweek.com/archive/ww20230615.html