Warranty expense definition
/What is Warranty Expense?
Warranty expense is the cost that a business expects to or has already incurred for the repair or replacement of goods that it has sold. The total amount of warranty expense is limited by the warranty period that a business typically allows. After the warranty period for a product has expired, a business no longer incurs a warranty liability.
What is a Warranty?
A warranty is a contract between a seller and its customer, specifying the situations under which the seller will repair or replace a defective item, free of charge, that it has sold to the customer. In rare cases, the contract may also specify that the seller will compensate the customer for any damage caused by its product; however, this can represent quite a large liability, and so is rarely provided to a customer.
How to Account for Warranty Expense
Warranty expense is recognized in the same period as the sales for the products that were sold, if it is probable that an expense will be incurred and the company can estimate the amount of the expense. This is called the matching principle, where all expenses related to a sale are recognized in the same reporting period as the revenue from the sale transaction.
Follow these steps to calculate and record warranty expense:
Determine the historical percentage of warranty expense to sales for the same types of goods for which the warranty is currently being determined.
Apply the same percentage to the sales for the current accounting period to derive the warranty expense to be accrued. This amount may be adjusted to account for unusual factors related to the goods that were sold, such as initial indications that a recent batch of goods had an unusually high failure rate.
Accrue the warranty expense with a debit to the warranty expense account and a credit to the warranty liability account.
As actual warranty claims are received, debit the warranty liability account and credit the inventory account for the cost of the replacement parts and products sent to customers.
Thus, the income statement is impacted by the full amount of warranty expense when a sale is recorded, even if there are no warranty claims in that period. As claims appear in later accounting periods, the only subsequent impact is on the balance sheet, as the warranty liability and inventory accounts are both reduced.
It is very unlikely that actual warranty claims will exactly match the historical warranty percentage, so some adjustment of the warranty liability account to actual results will be justified from time to time.
If there is a history of minimal warranty expenditures, there is no need to record a warranty liability in advance of actual warranty expenses. Instead, just record the cost associated with the few warranty claims as they are submitted by customers.
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Example of Warranty Expense
ABC International sells $1,000,000 in widgets in September. It has historically experienced a warranty expense of 0.5 percent, so ABC records the warranty expense with a debit to the warranty expense account of $5,000 and a credit to the warranty liability account of $5,000. This journal entry appears in the following exhibit.
In October, ABC receives a warranty claim, which it fulfills with a $250 replacement part. The entry for this claim is a debit of $250 to the warranty liability account and a credit of $250 to the spare parts inventory account.