Warranty accounting

Overview of Warranty Accounting

A business may have a warranty policy, under which it promises customers to repair or replace certain types of damage to its products within a certain number of days following the sale date. If the company can reasonably estimate the amount of warranty claims likely to arise under the policy, it should accrue an expense that reflects the cost of these anticipated claims.

The accrual should take place in the same reporting period in which the related product sales are recorded. By doing so, the financial statements most accurately represent all costs associated with product sales, and therefore indicate the true profitability associated with those sales. If the period covered by the warranty is changed by management, this will alter the warranty expense not only for those sales in the current period, but also for sales in prior periods whose warranties have now been extended into the current period.

If the cost of warranty claims were to instead be recognized only when the company processes actual claims from customers, the costs may not be recognized until several months after the associated sales. The financial reporting under this approach would yield inordinately high initial profits, followed by depressed profits in later months, for as long as the warranty period lasts.

If there is no information from which to derive a warranty estimate for use in an accrual, consider using industry information about warranty claims.

If the amount of warranty expense recorded is significant, expect the company's auditors to investigate it. If so, develop a history of the actual cost of warranty claims, and calculate the relationship between costs incurred and the related amount of revenue or units sold. This information can then be applied to current sales levels, and forms the basis for a justification of the amount of accrued warranty expense.

If a warranty claim period extends for longer than one year, it may be necessary to split the accrued warranty expense into a short-term liability for those claims expected within one year, and a long-term liability for those claims expected in more than one year.

Example of Warranty Accounting

Lowry Locomotion produces toy dump trucks.  Historically, it has experienced a warranty cost of 1% of revenues, and so records a warranty expense based on that information.  However, the company has just developed a plastic dump truck that may be less durable than its more traditional metal toys. The toy could be subject to more breakage under a heavy load, and so may have a higher warranty claim rate.  No other companies in the industry sell a plastic dump truck, so there is no comparable information.  The Lowry controller elects to apply a high 3% warranty claim rate as the basis for an accrual, based on the results of initial product testing. The amount of the entry is for $40,000, as shown in the following journal entry:

  Debit Credit
Warranty expense 40,000  
     Accrued warranty liability   40,000

During the following month, Lowry receives claims for damaged trucks from its toy distributors totaling $12,000, which are covered by the company's warranty policy. The journal entry used to record this transaction is:

  Debit Credit
Accrued warranty liability 12,000  
     Cash   12,000