Do you offer Warranties, if so, do you know how they should be accounted for?

How to Account for  Warranty Liability

Article written by EricBank

Many businesses, large and small, issue warranties on the products they sell and the services they deliver. A warranty is actually a contract between a company and its customers guaranteeing that specific facts and conditions are or will be true. Normally, the warranty permits the customer to seek redress for faulty purchases, through either refund, repair or replacement, for a stated period following purchase.

Accounting Steps

The purpose of warranty accounting is to allow your business to record a liability that estimates warranty costs for your offerings -- that is, the goods and services you offer. Under generally accepted accounting principles (GAAP), you front-load the estimated expenses for servicing the warranty by booking the liability in the period of the sale. As you actually process warranty claims, you debit (reduce) the warranty liability account by the amount you spend to fulfill the warranty. The result is that you accurately match warranty expenses with the revenues they support on your financial reports. This makes sense, because a warranty is an added inducement to a potential customer that helps to close a sale.

Step 1

You need to estimate your warranty costs for the upcoming period. To do so, research warranty costs by examining your own historical data to find an appropriate relationship between sales revenues and warranty costs. If you are a new business or otherwise don't have access to such data, use average warranty cost rates for your industry, which you can find by searching websites that publish this kind of information.

Step 2

However you develop the warranty costs as a percentage of sales, apply that number to your sales forecast for the new period. Suppose you manufacture, sell and warranty hard cases for cell phones. You guarantee customers that the cases will not to crack, scratch or chip for one year. You project $500,000 in revenues for the upcoming quarter, and experience tells you that you will need 1 percent of those revenues to cover warranty expenses. Your projected warranty liability is therefore 1 percent of $500,000, or $5,000.

Step 3

Make an accounting entry on the first day of the quarter debiting the warranty expense account and crediting the warranty liability account for the estimated expense, which in this case is $5,000.

Step 4

Relieve the warranty liability as you incur warranty costs. For example, if you replace a $50 hard case you sold, debit the warranty liability account and credit cash or accounts payable for $50.

Keep in Mind

If you provide warranties that cover periods beyond one year, split the warranty liability on the balance sheet between the sections for current and long-term liabilities. Make sure you consider product changes when you estimate your warranty liability. For example, imagine you previously sold only plastic hard cases, but have recently changed over to aluminum ones. Your new warranty liability estimate for the upcoming period should reflect the fact that the metal cases are sturdier and less prone to damage than are the plastic ones. Of course, you'll also need to factor in the different repair/replacement costs for metal vs. plastic hard cases.