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Warranty Accounting

Overview of Warranty Accounting

If a company has a warranty policy on its products or services and it can reasonably estimate the amount of any warranty claims, it should accrue an expense for anticipated claims. The most appropriate time to accrue a warranty expense is in the same period when the related item is sold; this timing is validated under the matching principle, where all cost associated with a revenue-generating item should be recognized at the same time as the revenue. Otherwise, recognizing a warranty expense only when a customer makes a warranty claim separates the sale transaction from the warranty expense, possibly by many months; the result is the initial reporting of excessive profits, followed by additional expenses in later months.

You can use industry information to derive a warranty accrual if in-house warranty claim data is not available.  For warranty claims not expected to be received in the current operating cycle, you can split the accrued expense into current and long-term liabilities.

An accrual for anticipated warranty expenses can be quite large for companies selling particular types of products, such as consumer end products.  In these cases, it is worthwhile to record the historical warranty information on which the accrual is based, such as the historical claims information for both new product introductions and products that have been on the market for some time.  This information is useful for proving the validity of the accrual if it is challenged during an audit.

Example of Warranty Accounting

The Halloway Marine Company produces outboard motors for the sport fishing industry.  It has historically experienced a warranty expense of 1.5% of its revenues, and so records a warranty expense based on that information.  However, it has just developed a jet-powered engine for which it has no warranty experience.  The engine has fewer moving parts than a traditional engine, and so should theoretically have a low warranty claim rate.  No other companies in the industry offer a jet engine, so no comparable information is available.  The controller chooses to use the 4.8% warranty claim rate applicable to its prior new-engine introductions as the basis for an accrual, since this is the only valid warrant information pertaining to the new product. The amount of the entry is for $50,000, as shown in the following journal entry:

During the following month, Halloway receives claims for engine repairs from its dealers totaling $10,000, all of which are covered by the warranty. The entry to record this transaction is as follows, where the company pays out $10,000 and reduces its accrued liability by the same amount: