What is Warranty Expense?
Warranty expense is an expense related to the repair, replacement, or compensation to a user for any product defects. In other words, a vendor or manufacturer is committed to repair or replace an already bought product during a certain period if it lacks the intended condition or does not function properly.
- Warranty expense is the cost associated with a defective product repair, replacement, or monetary compensation for it.
- A warranty comes with a warranty period during which the vendor or manufacturer of the good stays liable for any defects that may appear during the use of the product.
- Warranty expense is subject to the matching principle, which means it is reported alongside revenue.
What is a Warranty?
A warranty represents a term of a contract that specifies the conditions under which the vendor or producer will repair, replace, or compensate for a defective item without any cost to the buyer or user.
Warranty agreements make companies liable for any defect or inefficiency of future product performance. The agreement compels the companies to compensate the user for such an issue, either through product repairment, replacement, or monetary reimbursement.
The warranty period refers to a period throughout which a vendor or manufacturer is obliged to repair, replace, or compensate for a defective product. When the warranty period for the product expires, the vendor or manufacturer is no longer liable for any defects.
Warranty Expense Recognition
From an accounting perspective, according to the Financial Accounting Standards Board (FASB), warranty expenses should be recognized when they are probable and can be estimated.
While recording the event in the financial statements, the company will debit (charge) the warranty expense account and credit (report) a liability account when the product is sold to a client.
Provided the product is defective, and it needs to be repaired or replaced, the company would reduce both the liability and inventory accounts because, at the time of the warranty commencement on the product, the company simultaneously reported a liability and inventory.
Warranty expense is recognized in the same period as revenue for the sold products if there is a probability that an expense will be incurred, and the company can estimate the amount of the expense. The practice is referred to as the matching principle when all expenses relevant to a product sale are recognized in the same period.
The income statement is impacted by the full amount of warranty expense when a sale occurs, even if there are no warranty claims during the period. When claims appear in the later accounting periods, the only further impact is made on the balance sheet, since the company reduces both the warranty liability and inventory accounts.
Warranty Expense Calculation
To estimate the warranty expense for a company, we need to know three main things:
- Number of units sold during a particular accounting period
- Percentage of the sold products that will probably need a repair or a replacement based on previous experiences
- Average costs of repairment or replacement under warranty
To calculate the warranty expense, first define a number of product units that will need to be repaired or replaced by using the following formula:
Afterward, compute the cost of repairs or replacement for the defective units:
ABC Co. produces fancy gyro scooters. Each gyro scooter comes with a one-year warranty against any manufacturing defects. The company refers to the previous five years of operations and estimates that 4% (defect rate) of the gyro scooters sold in the current year will be returned because of a defect. When it happens, the company replaces the defective gyro scooters, which cost $100 each to produce.
In 2018, the company sold about 36,000 gyro scooters. The task is to record the amount of warranty expense that the company should record for 2019.
1. First, calculate the number of units the company assumes will need to be replaced under the warranty contract:
36,000 units sold x 4% defect rate = 1,440 gyro scooters are potentially defective
2. Now, calculate the cost of replacement of the defective gyro scooters:
1,440 potentially defective units x $100 replacement cost = $144,000 estimated warranty expense
CFI offers the Financial Modeling & Valuation Analyst (FMVA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful: