Warranty Payable

Warranty payable represents a company’s liability to repair or replace defective products. It arises when a company sells products which customers are entitled to return for repair or outright replacement.

Accounting for warranties is quite similar to accounting for bad and doubtful debts. It is based on matching concept, which requires a company to estimate the expected warranty payable (also called warranty liability or provision for warranty expense) and record it at the time of sale. Subsequently, when a customer is reimbursed for defective products or the product sold to him is repaired or replaced, the expense is written off against the warranty payable recorded at the time of sale.

In some cases, where no warranty is offered, the company offers a separate maintenance contract. In such a situation, the certain portion of the revenue representing the expected warranty expense over the lifetime of the product is deferred. Further, some companies do not record any warranty payable at all and records warranty expense when it is actually incurred.

Calculation

One method to estimate warranty payable is to base it on historical claim rate. The following formula applies this method.

Warranty Payable =A× C
B

Where,
A = Total historical warranty expense incurred in all periods
B = Total historical sales of the product for which warranty liability is determined
C = Actual sales of the product for the period

Example and Journal Entries

Flash Drives, Inc. launched a new product on 1 January 2013. In first quarter of the year, their sales amounted to $2 million. Historically, similar products resulted in lifetime warranty expense of $0.2 million for each $10 million of sales. Actual warranty claims amounted to $10,000 million during the quarter.

Journalize the recognition of initial warranty liability and payment of warranty claims and find out the closing balance of the warranty payable as the end of first quarter.

Solution

Estimated Warranty Liability =$0.2 million× $2 million = $40,000
$10 million

This is recorded as follows:

Warranty Expense$40,000
Warranty Payable$40,000

Actual payments reduce warranty payable:

Warranty Payable$10,000
Cash/Inventory$10,000

The closing balance of the warranty payable as at 31 March 2013 i.e. the end of first quarter would be $30,000 ($40,000 minus $10,000). This balance would be carried forward to the next quarter. Actual sales in next quarter will increase the liability balance and actual claims will reduce the balance.

Some companies may elect to directly write off any warranty related payments/replacements in the period in which they occur. However, such as policy is against the matching principle. If FD had opted for this accounting policy, it would not make the journal entries shown above, thereby not reporting any warranty payable. Instead, it would have made the following journal entry to directly expense out any warranty related payment/replacement:

Warranty Expense$10,000
Cash/Inventory$10,000

Written by Obaidullah Jan, ACA, CFA <--- Hire me on Upwork