Accounting for standard and extended warranties
Companies often provide warranties to their customers. There may be standard warranties and extended warranties. Standard warranties are provided when a product is sold and may cover periods from a few months to multiple years. Extended warranties usually require a separate payment and cover periods in addition or after standard warranties. Companies need to account for standard and extended warranties appropriately. We will discuss such accounting in this article.
1. Accounting for standard warranties by product seller or manufacturer
Standard warranties are provided when a product is sold (or service is provided). Such warranties may cover the product’s defects, malfunction, etc. for a period of time from a few months to multiple years.
Warranties represent an uncertainty because one doesn’t know for sure when customers will submit warranty claims. As such, warranties fall within the definition of uncertainty and warranty reserves (accrual) should be recorded when two conditions are met. The conditions are presented below:
Condition |
Comment |
Information available before the financial statements are issued or are available to be issued indicates that it is probable that an asset had been impaired or a liability had been incurred at the date of the financial statements. |
This condition is considered to be met if, based on available information, it is probable that customers will make claims under warranties relating to goods or services that have been sold. |
The amount of loss can be reasonably estimated. |
This condition is considered met if management of a company can reasonably estimate warranty claims for products sold or services provided based on historical information, reference to other companies within the industry, etc. |
Note, for the second condition, a company may not necessarily have sufficient information to estimate the amount of warranty claims. In such cases, the company may refer to experience of other entities in the same industry.
In certain situations, a company may not be able to reasonably estimate future warranty claims (e.g., the company doesn’t have sufficient information; the company can’t make use of reference to other companies in the industry). If the potential warranty expenses may have a wide range, the company should question whether recognizing related revenue before the warranty loss can be reasonably estimated or the warranty period expires, is appropriate.
There may be a number of ways to estimate future warranty claims. Companies need to use the methodology to calculate warranty reserves considering the company’s warranty policies, available information and so forth.
Let’s look at an example of accounting for standard warranties. Company ABC has been selling gadget XYZ and has sufficient information to estimate warranty expenses based on historical claims data. Standard warranties cover defects in gadgets for one year after gadgets are sold. The company knows that, on average, for every $100,000 of gadgets XYZ sold (at selling price), there will eventually be approximately $5,000 of warranty claims related to the sold gadgets. The gross margin on the products is $50% (so, $100,000 worth of gadgets has a cost of goods sold of $50,000).
The company sells $100,000 of gadgets in May 20X3:
Account Titles |
Debit |
Credit |
Accounts Receivable |
$100,000 |
|
Sales |
$100,000 |
|
Cost of Goods Sold |
$50,000 |
|
Inventory |
$50,000 |
The company establishes warranty reserve for sales in May 20X3:
Account Titles |
Debit |
Credit |
Warranty Expense |
$5,000 |
|
Warranty Reserve |
$5,000 |
Customers submit $250 warranty claims in June 20X3:
Account Titles |
Debit |
Credit |
Warranty Reserve |
$250 |
|
Accounts Payable / Cash |
$250 |
When customers submit warranty claims, the company settles them by fixing defects in the gadgets. The cost of fixing the gadgets is recorded as a credit to accounts payable (e.g., vendor invoices for fixing the defects) or cash (e.g., company reimburses customers for repairs). The established warranty reserve of $5,000 will eventually be used for warranty claims as long as the company’s methodology for estimating such claims is accurate.
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