Sunday, December 30, 2007

Warranty Liabilities

What are Warranty Liabilities?

Warranty liabilities arise when a seller agrees to fix a product (or service) that fails to perform as expected within a specified period. To ensure conformity and compliance with the matching principle, the seller reports expected the warranty expense in the period when revenue from the sale is reported.

Most products sold by businesses come with a warranty or guarantee. After the point of sale, the business incurs costs to service, repair, or replace a product under the terms of its warranty or guarantee. The business should forecast the future costs of fulfilling these obligations.

At the end of the accounting period, the company will show an existing liability for the warranty costs it estimates to make in future years to customers it has sold products. Supplies and labor required to honor this service agreement are recorded when service is provided to a customer. The accountant would not try to go back and correct this estimate if it proves to be wrong instead the accountant merely watches the estimates and actual service costs and adjusts future estimates accordingly. Based on the matching principle, the company needs to record the warranty
expense in the same accounting period in which it sells you the product.

Example Estimated Warranty Liability Problem

During 2004, A Small Business Hardware company introduces a new product carrying a two-year warrranty. The estimated warranty costs are 4% of dollar sales. Sales and actual warranty expenditures for the years ended December 31, 2004 and 2005 follows:

Sales Actual Warranty expense
2004 $ 800,000 $21,000
2005 $ 1,000,000 $31,000

Set up a T-account for Estimated Warranty Liability:

24000 | 32000
30000 | 40000
| 18000

The 24000 and 30000 are the actual amount of money that the hardware company used to repair the stuff and the 32000 and 40000 are found by multiplying the 4% by the sales for that year, which is the Estimated warranty liability, or the amount of money the hardware company estimates that it will need to repair the hardware product. So the company is subtracting the "actual" money used for the amount of money the company estimated it would use.

Additional Accounting Examples:

How to Calculate Net Income

1 comment:

Anonymous said...

In the question, it says the Actual Warranty Expenses are $21,000 and $31,000 in 2004 and 2005. How can the actual warranty expense become $24,000 and $30,000 in the solution?

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