What is a warranty?
Most of the products we purchase come with some type of warranty. A warranty is guarantee that the manufacturer of the product will repair or replace the product for a certain period of time. In 2013, I bought my husband a , because he likes to smoke meat and I like to eat smoked meat. It works out well for everyone! This product came with a 10-year limited warranty. That means that if something breaks because of a defect (not normal wear and tear or abuse), the company will replace the part that broke. This was not something that we purchased in addition to the product. It came with the product as part of the purchase.
Do not confuse standard warranties with extended warranties that consumers purchase for an additional fee.
Why must companies record a liability?
When a company provides a warranty with its product, the company has an obligation to repair or replace the product if it is defective. That obligation generates a liability at the time the product is sold because the company has a liability that starts when the product is sold.
When must the company record the warranty expense?
The matching principle states that a company must match revenue with expenses. If Weber sells a smoker in 2013 but expenses a warranty claim in 2020 (remember it is a 10-year warranty), the company is violating the matching principle. The warranty expense occurs because the sale took place. The expense is a cost of the sale and therefore should be matched with the revenue generated by that sale.
How does the company record an expense for a repair that has not happened yet?
It might seem a little strange to ask a company to record an expense when it hasn’t occurred yet but we have done this many times in accounting. Accounting requires the use of many estimates. Warranties are no exception. Remember when we recorded Bad Debt Expense under the allowance method and had to estimate the expense at the time of the sale? Warranty expense is very similar. We must estimate the expense based on previous company history and record the journal entry.
In order for a company to estimate the warranty expense and liability, we need to know three things:
- How many units of the product were sold during the period of time we need to record?
- What percentage of the products sold will need repairs or replacement based on previous experience?
- What is the average cost of the repair or replacement under warranty?
All of this information is readily available to managers and accounts within the company. To calculate the warranty expense, first figure out how many products will need repair or replacement:
Total number of units sold X Percentage of units that are defective
Next, calculate the cost of repair or replacement for those units:
Units needing repair or replacement X cost per unit to repair or replace
Let’s look at an example to see how a company would estimate and record warranty expense.
Hydration-on-the-Go makes stylish water bottles. Each water bottle includes a one-year warranty against manufacturing defects. Based on five years worth of data, the company estimates that 3% of the water bottles sold will be returned because of a defect. When this occurs the company replaces the water bottle. Each water bottle costs $4 to produce.
In 2013, the company sold 250,000 water bottles. Record the amount of warranty expense that the company should record for 2013.
To record the warranty expense, we need to know three things: units sold, percentage that will be replaced within the warranty period, and the cost of replacement.
First calculate the number of units the company believes will need to be replaced under warranty.
250,000 water bottles sold x 3% defect rate = 750 water bottles potentially defective
Next, calculate the cost of replacing those potentially defective water bottles.
750 water bottles potentially defective x $4 replacement cost = $3000 estimated warranty liability
That is all there is to it. Recording the expense and the liability as an adjusting journal entry.
Recording customer warranty claims
When a customer requests a repair or replacement under warranty, the customer files a claim. The company must record this claim. Every time the company fulfills a claim, a portion of the warranty liability is also fulfilled. In other words, every time a claim is fulfilled, the company must decrease the amount of the liability by the cost of fulfilling the claim.
There are a number of ways that the company can fulfill a claim. It can replace the item with an item from inventory, therefore decreasing inventory. The company could repair the product using parts from inventory and outside labor (which would require cash) or inside labor (wages payable). Always record the replacement or repair at cost, not at the retail value of the item or parts.
On February 1, Hydration-on-the-Go received 14 water bottles in the mail that had been returned by customers to be replaced under warranty. Each water bottle costs $4 to produce and sells for $9. Record the entry for fulfillment of the warranty claims.
The problem is asking us to record the warranty claim. When the company fulfills a warranty claim, we need to debit the estimated warranty liability. This is because part of the warranty obligation is being fulfilled. The amount of liability is decreasing.
Now to determine the account to credit. Ask yourself how how the liability is being fulfilled. How is the company fulfilling the liability in this case? The company is replacing the water bottle. Water bottles are the product that the company sells. They are inventory. Therefore, we will reduce inventory by the amount that the bottles cost. When we use inventory to fulfill the warranty liability, the value of inventory falls.
How much should we record as the cost of the water bottles? If we are removing them from inventory, we should remove them at cost. Therefore, use $4 per water bottle.
14 water bottles x $4 per water bottle = $56 cost of inventory
We have all the information we need to record the journal entry.