What is Warranty Expense?
Warranty expense is an actual cost or the expected cost which a business incurs to repair or replace the goods sold. The total amount associated is limited to the warranty period permitted by the business. Once this time period has lapsed, businesses no longer incur a warranty liability. This facility is offered to attract and maintain a customer base in a variety of products especially consumer durables (refrigerator, televisions, etc).
These expenses are recognized in the same period as the sales for the products which were sold. This is basis the matching principle, whereby all expenses pertaining to a sale are recognized in the same reporting period as the revenue from the respective transactions.
Recording Warranty Expense
If a company provides a warranty with the product, they have an obligation to repair or replace the products if it’s defective. This creates a liability at the time the particular product is sold as the company has a liability which starts when the product is sold.
It might not be ideal for a firm to record an expense which has not occurred but similar to recording the Bad Debt Expenses, warranties also are required to be recorded on prior firm history and accordingly record the journal entry. There are 3 important aspects which should be known while recording the warranty expense journal entry:
- The number of units of product sold during the time period we require to record?
- The percentage of products sold which are expected to be repaired or replaced? This is based on prior experience and shall be an estimate
- The average cost of replacements or repair under warranty?
Let us consider the below example for a clearer understanding
Jim Corporation is selling Television Sets across Retail and large scale corporations. All the T.V. sets come with a 1-year warranty, whereby Jim Corporation shall replace or repair the T.V. in case of any fault.
The total sales for the year are $2,50,000. On the basis of past records, it’s believed that 1% of the sales would be encountered with problems and shall require be fixing or replacing.
During the next year, Jim Corporation had to service several of their T.V. sets ended up costing the firm $7,500. This amount of repair is not recorded as another expense since it was already considered when the sale was recorded in the previous year. Instead, the account of liability is further reduced by $7,500 and the inventory account is reduced accordingly.
One should also note that this liability treatment is essential for firms which have to consistently repair or replace their products. If the firm ever has a warranty claim, they do not require recording the liability. The costs can be recorded as and when they are incurred.
Warranty Expense Journal Entries
On every occasion there is a Repair or replacement under warranty facility, the impacted customer is required to file for a claim and the firm has to make a record of it. Depending from one case to another, the claim could either be:
- Accepted Completely
- Accepted partially
If the firm is fulfilling the claim (completely or partially), the warranty liability is also fulfilled. It means the company has to decrease this liability amount by the cost of fulfilling the claim.
There are multiple ways through which a firm can fulfill a claim:
- Replacement of an item from the inventory – this would reduce the inventory.
- Secondly, the firm can repair the product using the part from inventory and external labour (cash/bank) or internal labour (wages payable). The repair or replacement should be recorded at cost and not the retail value of the item or parts.
For e.g. on August 1, Tinker Automobiles Ltd. received 15 mobile phones which were returned by the consumers for replacement under warranty. Every piece costs $25 to produce and ultimately sell at $40.
The firm is required to fulfill a warranty claim in which the company needs to debit the estimated warranty liability. This is because part of the warranty obligation is being fulfilled and liability is decreasing. If we are removing them from the inventory, it should be removed at cost with below warranty expense journal entries:
15 containers X $25 per container = $375 cost of inventory
Apple Inc a smartphone manufacturer begins production of a new phone in October 2018 and sells 1000 units @ $500 per piece in one financial year for the year ending 31, March 2019. Every phone is under warranty of not less than one year. Accountants estimated an average of 4% of warranty cost per piece i.e. $20 per piece. As a result, of parts replacement and services rendered in compliance with machinery warranties, it incurs $4000 in warranty costs in the financial year 2018-19 and $16000 in next FY 2019-20.
#1 – Sales Recognition of Phones by the Company
#2 – Recording of Warranty Expense for the FY 2018-19
Understand the company sold 1000 phones and estimated warranty cost of $ 20 per phone. And in FY2018-19 the year of sales, the company serviced $4000 against warranty obligation by cash payment and parts replacements. So we use worth $4000 of warranty expenses out of total estimation i.e.
- Total estimated Warranty cost = $ 20000/-
- Warranty exp incurred in FY 2018-19 = – $4000/-
- Remaining un-incurred expenses=$ 16000/-
Now what to do with this un-incurred expense of $16000? The company has to record this $16000 also for the FY 2018-19 itself based on accrual accounting. Accrue means recording expenses or losses now which are going to recognize in the future.
So based on accrual methods we incur full $20000 as warranty expense. And in FY 2019-20 when actual recognition of $16000 happens
#3 – Recording of Warranty Liability for FY 2019-20
The amount of warranty expense occurred in FY 2019-20 is Nil or none. Because we have already expensed it in FY 2018-19.
This has been a guide to Warranty Expense. Here we discuss the definition, formula, and recording of warranty expense journal entries with practical examples. You may learn more about accounting from the following articles –