Official Definition
“Warranty is an implied or expressed promise of a manufacturer/vendor to a buyer, assuring that the product’s specifications, facts, and conditions are true and valid.”
A business’ warranty expense is the cost of repairing or replacing items it has sold or is expecting to incur in the future. A business’s warranty period determines how much warranty expense it can incur, and the company no longer incurs warranty liabilities after a product’s warranty period has expired.
It’s important to note that a warranty claim does not end with the product’s sale, but it’s a time when the business needs to recognize a provision for the Warranty.
Explanation
Whenever a product is sold with a warranty attached, the company needs to make the Warranty provision because warranty provisions give rise to the company’s liability when it needs to fulfill the warranty clause. After all, the company will need to support that liability.
The product’s Warranty is a promise given to the customer that there will be no problems with it, and those that are damaged will be repaired or replaced at no charge. As you may know, such promises usually last for a specific period, such as a year, three years, or five years.
A warranty provided by a company to its customers creates a contractual relationship that could result in the company having to incur future costs associated with the replacement or repair of defective units. The company needs to make provisions for this type of contingent liability by providing a product warranty.
Types of Warranty
There are two types of warranties such as
- Implied Warranty
- Extended Warranty
Implied Warranty
If the buyer purchases a specific product, they are entitled to the implied Warranty provided by the manufacturer. The buyer can exercise that type of Warranty irrespective of the express or implicit language used by the seller. It must be stated orally or in writing to be considered as a merchantable warranty.
Moreover, the Implied Warranty is further divided into two segments.
- Implied Warranty of merchantability
- Implied Warranty of fitness
Implied Warranty of merchantability
This type of Warranty ensures the product meets any reasonable expectations of the buyer. Therefore, the merchantability warranty implies that the product will meet the buyer’s expectations. if the product is new or used, the Implied Warranty of merchantability applies.
Implied Warranty of fitness
Assures that a product is suitable for the use it is intended for. For instance, knives have specific purposes, including cutting vegetables, fruits, thread, rope, etc. A buyer of a knife may claim the implied Warranty of fitness of the product is blunt or unfit for cutting.
Extended Warranty
Manufacturers’ warranties are generally 1 or 2 years long, as we discussed previously. However, vendors offer extended warranties to ensure the satisfaction of their customers.
Sellers also provide a service agreement that covers maintenance, repairs, and service for products. These additional warranties give the buyer further assurance about the service and maintenance of the product. As a result, an obligation clause is incorporated into the issuer’s contract.
Accounting Steps for the Warranty
The company can estimate the amount of the warranty expense. And with that, the warranty expense is recognized in the same period as the sales of the products. All sale-related costs and expenses are identified and recognized in the same period to satisfy the accounting concept called the matching principle.
For calculating and recording warranty expenses, businesses need to follow these steps:
- Identify the goods the Warranty is to be provided for.
- Estimate the historical warranty expense, can be determined with the sales ratio.
- Determine the warranty expense to be accrued.
- Use the same percentage for the sales of the current fiscal period.
- After adjusting this amount, it may be necessary to reflect unusual circumstances related to the goods sold.
- Observe if there is some unusually high failure rate, the recent batch of goods can be analyzed.
- The warranty expense account gets debited, and the warranty liability account gets credited.
- The cost of the replacement parts and products sent to customers is debited from the warranty liability account.
- And it is credited to the inventory account as actual warranty claims are received.
The sale of products will result in warranty expense even if no claims are made during that period, thereby affecting the income statement. The warranty liability and inventory account balances are both reduced as claims appear in later accounting periods.
In practice, warranty claims are unlikely to exactly match historical warranty percentages, which is why some adjustments to the warranty liability account will be made from time to time.
If warranty expenditures have been minimal, no warranty liability must be established until actual warranty costs are incurred. As soon as customers submit warranty claims, record the cost associated with them. However, the business must take account of the prudence concept but not to the extent which understates the profit.
Provision for Warranty Expense
For estimating the warranty expenses, companies use historical data that shows how much it costs to replace or repair defective or malfunctioning products. And the warranty contract’s estimated cost of honoring it should be recognized in the period when the sale occurs under the matching principle of accounting.
Although, taxation rules require to add up of the Warranty provided for calculating taxable income. However, these are allowed when a Warranty is exercised in reality.
Accounting entries for recording warranty expense
Here is what the business needs to pass the General Journal entry for the scenario mentioned above.
Assurance type warranty journal entries
| Particulars | Debit | Credit |
| Warranty expense | XXXX | |
| Provision for Warranty expense | XXXX |
The debit impact of the transaction is a recording of the warranty expense in the financial statement, which leads to a reduction in the accounting profit. However, it does not impact the taxable income as the provision is not taxed allowable expenses.
However, once the company has reimbursed or repaired the customer’s defective or damaged products under Warranty, the liability for a warranty expense will then be settled.
| Particulars | Debit | Credit |
| Provision for Warranty expense | XXXX | |
| Inventory / Cash / Repair Account | XXXX |
The debit impact of this journal entry is a reversal of the recorded provision as it has been utilized for the warranty claim. On the other hand, the credit impact of the transaction is the removal of resources that have been utilized in the exercise of Warranty.
Further, if there is a lapse of Warranty, the business can reverse the provision.
Service type warranty journal entries
This type of Warranty is when a business commits to perform a certain service. So, the following are the journal entries.
| Particulars | Debit | Credit |
| Cash/bank account | XXXX | |
| Unearned warranty account | XXXX |
The debit impact of the transaction is receipt of the cash; it’s received in the normal course of sales along with the total product price. On the other hand, the credit impact of the transaction is a recording of liability as the business may need to provide services in the future.
However, if the warranty lapses, the business can reverse the unearned Warranty by passing the following journal entry.
| Particulars | Debit | Credit |
| Unearned warranty accounts | XXXX | |
| Profit and loss account | XXXX |
The debit impact of the transaction is the removal of the deferred liability/unearned Warranty as the business no longer needs to meet the future commitment. Similarly, the credit impact increases the profit in the income statement as liability has been removed from the books of the account.
On the other side, if the customers exercise a Warranty, the following journal entries will be posted in the accounting system.
| Particulars | Debit | Credit |
| Unearned warranty accounts | XXXX | |
| Warranty revenue account | XXXX |
The debit impact of the transaction is the removal of the liability as the business has performed committed service for the customers. Similarly, the credit impact is a recording of the revenue in the income statement.
Example
Company A produces toy cars. Historically, the warranty cost has been 1% of revenue, and company A records warranty expenses based on that information. However, the company developed a plastic car that is less durable than metal toys. The toy can undergo more breakage or if it gets under a heavy load.
And due to this reason, the expected warranty claim rate is higher than that of other toy cars. Furthermore, no other companies in the industry sell plastic cars, so there is no information available for comparison. And for this plastic toy car, company A applies a high 3% warranty claim rate based on an accrual-based accounting system. Based on the initial product testing results.
The amount of the estimated entry is $60,000. And after some time, company A received claims of $23,000, and they all are covered under the company’s warranty claim policy.
The following journal entry will be passed at the time of sale.
| Particulars | Debit | Credit |
| Warranty expense | $60,000 | |
| Provision for warranty expense | $60,000 |
The following journal entry will be passed at the time of fulfilling the warranty claim.
| Particulars | Debit | Credit |
| Accrued warranty liability | $23,000 | |
| Cash / Inventory / Repair Account | $23,000 |
Conclusion
The business needs to record warranty estimates in the accounting record, and it’s done to ensure appropriate accounting and financial reporting is performed. From an accounting perspective, if the Warranty is of assurance type, the Warranty’s provision is credited at the time of product sales and debited at the time of warranty execution.
On the other hand, in the service warranty case, the deferred income (liability) is credited against receipt of the cash. And deferred income is recorded and released when service is performed under Warranty.
However, the business can reverse warranties if the time lapses.
Frequently asked questions
What’s the difference between assurance and a service-based Warranty?
The assurance warranty is when the business gives a general warranty of the product. For instance, the business promises that the product will perform as expected. On the other hand, a service-based Warranty is when a business promises to perform certain additional services.
Do we need to record deferred income to record the Warranty?
The Warranty can be recorded via deferred income if that’s a service-related Warranty, and it’s like a simple concept to record obligation and release when service is performed.
What’s the impact of warranty provision on tax expense?
The taxation authorities do not accept warranty provisions as a deductible expense, and hence, there is no impact on the taxable income of the profit. However, if the business needs to incur expenses under Warranty, it’s allowed and reduces taxable income.