A warranty liability is a liability account in which a company records the amount of the repair or replacement cost that it expects to incur for products already shipped or services already provided. This can be a significant liability for more complex products that are subject to breakage.
The appropriate time to record a warranty liability is in the same reporting period when the associated revenue is recognized; doing so ensures that all revenues and expenses related to a sale are recorded at the same time (known as the matching principle).
The warranty liability amount is based on the historical experience of the business in providing warranty repairs or replacements. Thus, if a company experiences a 0.5% historical warranty expense on its sales, it would be appropriate to continue to recognize the same amount on new sales, until such time as the historical rate changes.
A warranty is a contingent liability, so the party providing it should record a liability and warranty expense when it records the associated sale of goods or services. As the selling party incurs actual warranty costs, it charges them against the liability account. The initial recordation of a liability increases the balance in the liability account, while charges for actual warranty costs decrease the balance in the liability account.
If there is a history of minimal warranty expenditures, there is no need to record a contingent liability in advance of actual warranty expenses, since the expectation is that this ongoing expense will be immaterial.
The warranty liability concept is used considerably less in service companies, since they have a more difficult time determining what is a warranty liability, and because services are more customized, and therefore less amenable to warranty liability analysis.
Warranty Liability Example
ABC Company sells blue widgets. It has historically experienced a warranty expense of 0.1% of sales. In the current period, it sold $500,000 of blue widgets, so it records a debit of $500 to the warranty expense account and $500 to the warranty liability account. Early in the following month, it receives a warranty claim to replace a blue widget. The cost of this claim is $40, which ABC records as a debit to the warranty liability account (thereby reducing the account balance) and a credit to the inventory account (to reduce the reduction of widget inventory).