Understanding Warranty Expense: Definition & Impact

Warranty expense is an expense related to the repair, replacement, or compensation to a user for any product defects. In other words, a vendor or manufacturerOriginal Equipment Manufacturer (OEM)An Original Equipment Manufacturer or OEM is a company that manufactures and sells products or parts of a product that their buyer, another company is committed to repair or replace a sold product during a certain time period if it breaks or does not function properly according to the terms of the warranty.

Summary

• Warranty expense is the cost associated with a defective product repair, replacement, or refund.
• A warranty comes with a warranty period during which the vendor or manufacturer of the good is liable for any defects that may appear during the use of the product.
• Warranty expense is subject to the matching principle, which means it is reported against revenue.

What is a Warranty?

A warranty represents a term of a contract that specifies the conditions under which the vendor or producer will repair, replace, or compensate for a defective item without any cost to the buyer or user.

Warranty agreements make companies liable for any defect or inefficiency of future product performance. The agreement compels the companies to compensate the user for such an issue, either through product repairment, replacement, or refund.

The warranty period refers to a period throughout which a vendor or manufacturer is obliged to repair, replace, or compensate for a defective product. When the warranty period for the product expires, the vendor or manufacturer is no longer liable for any defects.

Warranty Expense Recognition

From an accounting perspective, according to the Financial Accounting Standards Board (FASB), warranty expenses should be recognized when they are probable and can be estimated.

While recording the event in the financial statements, the company will debit (charge) the warranty expense account and credit (accrue) a liability account when the product is sold to a client.

Provided the product is defective and needs to be replaced, the company would reduce both the liability and inventory accounts because it would issue the replacement product out of its inventory. If the defective product needs to be repaired or refunded, the cost incurred reduces the liability account.

Warranty expense is recognized in the same period as revenue for the sold products if there is a probability that an expense will be incurred and if the company can estimate the amount of the expense. The practice is referred to as the matching principleMatching PrincipleThe matching principle is an accounting concept that dictates that companies report expenses at the same time as the revenues they are related when all expenses relevant to a product sale are recognized together in the same period.

The income statement is impacted by the full amount of warranty expense when a sale occurs, even if there are no warranty claims during the period and is part of COGS. When claims appear in subsequent accounting periods, the costs incurred will reduce the warranty liability account.

Warranty Expense Calculation

To estimate the warranty expense for a company, we need to know three main things:

• Number of units sold during a particular accounting period
• Percentage of the sold products that will probably need a repair or a replacement based on previous experiences
• Average cost of repairing or replacing products under warranty

To calculate the warranty expense, first, estimate the number of product units that will need to be repaired or replaced by using the following formula:

Afterward, compute the cost of repairs or replacement for the defective units:

Practical Example

ABC Co. produces fancy gyro scooters. Each gyro scooter comes with a one-year warranty against any manufacturing defects. The company refers to the previous five years of operations and estimates that 4% (defect rate) of the gyro scooters sold in the current year will be returned because of a defect. When it happens, the company replaces the defective gyro scooters, which cost $100 each to produce.

In 2018, the company sold about 36,000 gyro scooters. The task is to record the amount of warranty expense that the company should record for 2019.

1. First, calculate the number of units the company assumes will need to be replaced under the warranty contract:

36,000 units sold x 4% defect rate = 1,440 gyro scooters are potentially defective

2. Now, calculate the cost of replacement of the defective gyro scooters:

1,440 potentially defective units x $100 replacement cost = $144,000 estimated warranty expense

More Resources

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