Updated July 19, 2023
Definition of Warranty Expense
The business sells goods and services which are covered under certain warranty period. Warranty Expenses refer to those expenses incurred or to be incurred by the business during the warranty period as part of the sale of its goods and services.
These expenses are apportioned by the business and are applicable during the warranty period only and once the warranty period is over the Warranty liability cease to exist for the business. Warranty expenses are recorded in the accounting year in which appropriate sales relevant to the same are made and it is based on the concept of matching principle.
Explanation
Whenever a business makes the sale of goods and services it provides a certain period also known as warranty period during which any damage or underperformance of the product and service sold by it will be rectified by the business at no cost subject to fulfillment of certain terms and conditions known as Warranty Period. To apportion for the expenses that might be incurred to fulfill these liabilities which may or may not arise in the future, businesses determine its Warranty expense. Normally these expenses are estimated based on past historical data of actual claims, management discretion, and treatment of warranty claims by competitors in the same business line.
How to Calculate Warranty Expense?
Calculating Warranty expenses is a blend of Historical claims rate, management discretion as well as peer analysis. Businesses usually base their decision to determine Warranty expenses based on the following:
- Actual warranty claims based on Historical data for the said goods and services. This is the most authentic and objective method of calculating Warranty expenses; however, it is based on the fact that history repeats itself which any or may not be the case.
- Warranty Expenses provisioning is based on a management viewpoint, their outlook about the default rate, and likely claims during the warranty period. This is based on a subjective viewpoint and is usually impacted by management discretion to boost profitability. A lower estimate of the Warranty provision indirectly results in higher profits for the business.
- The third way to calculate the Warranty expense is peer group estimation. In the case of a new product launch where adequate Historical claim data is not available, businesses usually opt for peer analysis and apportioned warranty expenses based on Peer Analysis. For instance, the company straightforward apportioned a percent of its sales as warranty expense as determined through the percentage apportioned by its peer in the same business line.
It is pertinent to note here that a business can have significantly fewer warranty expenses than its peer business if the product is of high quality with a proven track record of lower admissible claims.
Example of Warranty Expense
ABC Limited made sales of $50000 during the year 2019-20. The company normally expect 2% of its sales as warranty expense and apportion the same amount as its Warranty liability for the year. Accordingly, the Warranty Liability account is credited with $1000 (2% of $50000)
During the year Company received warranty claims of $200.The warranty claim will be adjusted against the Warranty liability provision with a debit to the Warranty Liability account amounting to $200 and a credit to Customer Claim amounting to $200.
Recording of Warranty Expenses
Warranty expenses are usually recorded through a four-step process:
- Step 1: Use the historical data to determine the actual claims against the sales undertaken. Usually, the data needs to be for a good number of years to get a better idea.
- Step 2: Apply the percentage obtained under step 1 to the total sales undertaken by the business during the period for which such expenses are to be determined. This percentage determined in step 1 doesn’t need to be for the whole product class but can be for different product lines as well and accordingly the same is applied to the sales.
- Step 3: The warranty expenses determined in Step 2 are debited I the warranty expense Account and credited to warranty Liability Account (Balance Sheet line item).
- Step 4: All warranty claims received by the business for the said period are settled by crediting the warranty expense account and debiting the Warranty Liability Account created in Step 3. Any balance left in warranty Liability Account after the completion of the Warranty period is credited back to Income Statement.
Warranty Expense Tax Treatment
Warranty expenses are estimate basis as they can’t be reliably judged since they are to be incurred in the future and the future is uncertain. Underestimation of Warranty expenses by the business gives a temporary flip to the profit whereas overestimation will lead to reduced profits.
Warranty Expenses reduce profit and the consequent tax liability for the business. Warranty Expenses are estimated and debited under Warranty Expenses with credit to an exclusive Warranty Liability Account.
Journal Entry is as follows:
Warranty Expense Dr.
To Warranty Liability Cr.
As and when actual claims are settled the following journal entry is passed:
Warranty Liability Dr.
To Customer Claim Account Cr.
An important thing to observe in the case of warranty expense is the fact that Warranty expense is not tax-deductible until the warranty work is actually performed by the business and usually the warranty claims are futuristic which means they will be admissible in future by the business for sales undertaken today which implies that the tax base of warranty liability is zero. The delayed recognition of this expense for tax purposes results in the creation of what is popularly known as Deferred Tax Assets or DTA. The rationale behind the creation of Deferred tax Assets is because the carrying value of the liability is greater than the tax base leading to temporary deductible differences.
Conclusion
Warranty expenses are common business expenses which form part of the Income Statement and Balance Sheet. These expenses hold more relevance in the case of manufacturing units where warranty expenses are more common and impact the business bottom line. Warranty expenses are always estimates and it is highly probable that actual expenses to satisfy warranty claims may not be the same requiring certain adjustments by the business.
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