Warranty Expense

What Is Warranty Expense?

A warranty expense includes costs associated with fixing, replacing, or compensating a customer for product flaws, along with provisions for estimated future warranty-related costs. 

In other words, if a product supplied by a vendor or manufacturer breaks or fails to operate as intended under the warranty, the vendor or manufacturer is obligated to fix or replace the product.

This service is provided to draw in consumers for various goods, particularly consumer durables like refrigerators, televisions, cars, etc.  

The warranty conditions must be upheld for the duration of the business's warranty period. After the stated warranty period, enterprises may have reduced liability for standard warranty claims, but other obligations or legal requirements may still exist, impacting their liabilities.

These costs are recorded either as a separate expense or may be offset against sales, depending on the accounting treatment chosen by the business.

It is based on the matching principle, ensuring that costs associated with a sale, including estimated warranty expenses over the product's life, are recognized in the same reporting period as the income from the related transactions.

What is a Warranty?

A warranty is a promise that a producer or comparable entity makes about the state of its goods. It also refers to the conditions and circumstances under which fixes or exchanges will be provided if the product does not perform as originally intended or stated.

Limiting conditions are expected in warranties. For the manufacturer to uphold the guarantee, the customer must perform certain obligations.

Apart from that, there are two main types of warranty. These are:

1. Implied

A product's fitness for use and satisfaction with the buyer's expectations are guaranteed by an implied warranty. These implicit guarantees may be expressed orally or in writing.

Federal law, including the Magnuson-Moss Warranty Act, regulates implied guarantees, ensuring consumer protection in product warranties.

Fitness and merchantability are the two main categories of implied guarantees. A product must be suitable for its intended use to be considered fit for sale, which implies it must reasonably satisfy the buyer's expectations. 

When vendors show and sell an excellent suitable for a specific function, implied guarantees also apply. To acquire the product, the customer relies on the seller's knowledge. Assurances include any claims the merchant makes about the goods.

2. Expressed

An express warranty, as its name indicates, is a written assurance given to a customer by a manufacturer or seller that the item they have purchased will meet their expectations.

The vendor is willing to repair or replace the broken item if there are defects. The warranty may be stated verbally, on paper, on the product, or elsewhere.

Exaggerated statements made to grab customers' attention are not considered guarantees; instead, they constitute puffery, serving to promote a product and attract buyers through persuasive marketing.

Terms of the warranty may include free repairs or total replacement. Shipping options like sending the item to the manufacturer, the vendor, or the closest authorized repairman may vary.

Although many other warranty subtypes exist, extended warranties and particular warranty deeds are the most popular.

Extensive warranties are offered on items with a high value, such as automobiles, electronics, and appliances. The manufacturer would carry out the extended warranty on behalf of the consumer, even if the merchant sold it.

Particular warranty deeds are used to transfer real estate ownership. They guarantee the buyer that the title is clear of any liens, claims, or encumbrances at the time of sale—this deed grants ownership to the grantee with an express assurance of title.

Denied Warranty Claims

Typically, warranties only cover goods not changed or modified after being bought. 

For instance, some people like swapping car exhausts or improving a vehicle's transmission to achieve a specific performance.

Due to their potential to have unintended dependability effects on the vehicle for which the dealer and manufacturer are not liable, many modifications have the potential to void the warranty protection for the modified and impacted components.

Each business has a distinct procedure for handling warranties, typically outlined in the warranty terms or accompanying documentation. Even if a warranty covers a device, the manufacturer may want further evidence to prove that it malfunctioned under ordinary usage. 

The warranty is unlikely to be fulfilled if the product malfunctions due to the owner's activities rather than a flaw in the manufacturing or design.

For instance, if the product is used in extreme temperatures outside the specified operating range, it may void the warranty. Check the product manual for recommended usage conditions.

It is simple to get confused about the coverage that a warranty offers. However, if you think a warranty should cover a specific problem you faced with a product, read the warranty and any instructions, then speak with the seller before contacting the manufacturer.

How to Account For Warranty Expenses

In terms of accounting, if it is likely that an expense will be incurred, and the company can estimate the expense's size, warranty expense is recognized in the same period as the sales for the products sold, according to the Financial Accounting Standards Board (FASB). 

All costs associated with a sale are recorded within the same reporting period as the sale's income, known as the matching principle.

First, you should find the historical ratio of warranty costs to sales for the same categories of products for which the warranty is being decided now.

To calculate the warranty expenditure that has to be incurred, apply the same proportion to the sales for the current accounting period. 

This number may be adjusted to reflect unexpected circumstances related to the sold items, such as preliminary findings indicating a recent batch of the products had an extremely high failure rate. Adjustments should be made following accounting standards.

Even in the absence of warranty claims during the period, including the estimated warranty expenditure in COGS impacts the income statement when a sale occurs, reflecting the anticipated cost of future warranty obligations. 

The expenses incurred will be deducted from the warranty liability account when claims are made in succeeding accounting periods.

Warranty Expense Example

The number of product units requiring Repair or replacement must first be estimated to determine the warranty expense.

Units for Repair = Number of Units Sold * Percentage of Defective Units

Then, we have to estimate the repair costs (warranty expense).

Repair Expenses = Units for Repair * Cost of Repair per Unit

XYZ Co. sells vending machines. A one-year warranty against any manufacturing flaws is included with each unit. 

Based on the preceding five years of operation, the firm anticipates that 5% (defect rate) of the vending machines sold in the current year will be returned due to a problem. When this occurs, the business repairs the faulty items produced at the cost of $1,000 per unit.

The business sold roughly 200 machines in 2021.

The assignment is to calculate the warranty expenditure the business must report for 2022.

First, we determine how many units the firm anticipates will require replacement or Repair by the warranty agreement:

200 units sold x 5% defect rate = 10 vending machines are potentially defective

Next, we determine how much it will cost to replace the broken machines.

Estimated warranty expense:

10 possible defective units x $1,000 replacement cost = $10,000

Researched and authored by Chadi Kattoua | LinkedIn

Reviewed and edited by James Fazeli-Sinaki | LinkedIn

Free Resources

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• Accrual Accounting
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• Expenses
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