When a business makes a sale to a customer it normally does so on the understanding that if the product is found to be defective it will undertake to repair or replace the product free of charge, this is known as providing a product warranty.
If the product does need to be repaired or replaced then the business will incur warranty costs in doing so. The potential for warranty costs to be incurred at some future date gives rise to a contingent liability for the business.
To be recorded in the accounting records and included in the financial statements of the business, a contingent liability must be both probable and subject to reasonable estimation.
In the case of warranty costs, there is little doubt that some products will be defective and result in a warranty claim and therefore the contingent liability is probable, and the first condition is satisfied, the next condition, that the business must be able to estimate the extent of the potential liability is discussed below.
Warranty Costs Estimation
For most businesses the estimation of warranty costs involves the following steps:
- Find the number of products sold in an accounting period e.g. 200,000 units
- Use historical or industry data to establish the percentage of products which are likely to be subject to a warranty claim. e.g. 2%
- Use historical or industry data to calculate the average cost of a repair or replacement product (warranty cost) e.g. 2.00
Based on this information an estimate of the likely warranty costs for the accounting period can be calculated using the following formula:
Based on the example values above the estimated warranty costs for year 1 are calculated as follows:
Warranty costs = Units sold x % subject to a claim x average cost per claim Warranty costs = 200,000 x 2% x 2.00 Warranty costs = 8,000
Based on historical or industry data the business has estimated that the warranty costs for the products sold during the accounting period (year 1) are likely to be 8,000.
As the cost is both probable and can be estimated, the 8,000 contingent liability must be recorded in the financial statements of the business. To comply with the matching principle, the estimated costs of repairing and replacing the products under the warranty should be recorded in the same period as the revenues from those product sales.
It should be noted this is the estimated warranty costs for products sold during this accounting period, and is not the actual warrant costs incurred.
Accounting for Warranties
The double entry bookkeeping journal required to record the estimated warranty costs for year 1 is as follows:
|Warranty costs liability||8,000|
The estimated warranty costs are debited as an expense to the income statement, and credited to the warranty costs liability account (sometimes referred to as a warranty reserve) to reflect the contingent liability the business has for products sold in year 1.
Actual Warranty Costs
During the next accounting period (year 2) warranty claims will be made for products already sold by the business and actual costs will be incurred in repairing and replacing the defective products.
Suppose for example, the business incurred actual costs of 6,570 during the accounting period relating to products sold in year 1, as these costs have already been estimated and allowed for when the product was sold, the expense for the period can be debited to the warrant costs liability account in the balance sheet and not to the income statement.
Assuming for simplicity all costs were paid for in cash, the journal to record them is as follows:
|Warranty costs liability||6,570|
The balance on the warranty costs liability account is now calculated as 8,000 – 6570 = 1,430. The business must now check that this is sufficient to cover the remaining potential claims for products sold in year 1. If for whatever reason (e.g. increasing claims %, or repair costs) the estimate has changed then this must be reflected in the accounting records.
For example, suppose the business estimates that the remaining claims are likely to result in warranty costs of 2,500, then the estimate needs to be increased by 2,500 – 1,430 = 1,070 with the following journal.
|Warranty costs liability||1,070|
This process must now continue until the warranties expire and no further warranty costs need to be allowed for
Of course each year additional products will be sold and an additional warranty costs contingent liability must be estimated and established for those products using the process described above.
Warranty Costs Liability in the Balance Sheet
The estimation of warranty costs is a contingent liability and is included in the balance sheet as either a current liability is the warranty period is shorter than 1 year, or under long term liabilities if the warranty claims are expected to arise in more than one year.