So, the warranty’s accounting nature is an expense for the entity that will be debited to the company’s accounts at the time of sale against the warranty provision account. And this journal entry of honored warranty contracts on 45 products will decrease both total assets and total liabilities on the balance sheet by $2,700 as of 2022. Warranty expenses are allocated by the business and are only applicable during the warranty period. Once the warranty period is over, the warranty liability no longer exists for the business. The company needs to debit warranty expenses and credit prepaid expenses. Sellers also provide a service agreement that covers maintenance, repairs, and service for products.

The taxation authorities do not accept warranty provisions as a deductible expense, and hence, there is no impact on the taxable income of the profit. However, if the business needs to incur expenses under Warranty, it’s allowed and reduces taxable income. On the other hand, in the service warranty case, the deferred income (liability) is credited against receipt of the cash. And deferred income is recorded and released when service is performed under Warranty. And due to this reason, the expected warranty claim rate is higher than that of other toy cars.

Therefore, we will talk about the process of warranty, issuing warranties, and accounting for warranties by an entity. Everything needs to be logged in records to view the profitability accurately. That means, when a company gives warranties, it will have to be recorded in one way or another. What if you know the loss or debt will occur but it has not happened yet?

Assurance-Type Warranties

The implied warranty of merchantability applies to new as well as used products. Implied warranty of merchantability confirms that the products meet the reasonable buyer’s expectations and are merchantable. Since we are discussing the accounting treatment of the warranty, so we will look into that.

Assume that Sierra Sports is sued by one of the customers who purchased the faulty soccer goals. A settlement of responsibility in the case has been reached, but the actual damages have not been determined and cannot be reasonably estimated. This is considered probable but inestimable, because the lawsuit is very likely to occur (given a settlement is agreed upon) but the actual damages are unknown. No journal entry or financial adjustment in the financial statements will occur. Instead, Sierra Sports will include a note describing any details available about the lawsuit. When damages have been determined, or have been reasonably estimated, then journalizing would be appropriate.

The debit impact of the transaction is a recording of the warranty expense in the financial statement, which leads to a reduction in the accounting profit. However, it does not impact the taxable income as the provision is not taxed allowable expenses. A business’ warranty expense is the cost of repairing or replacing items it has sold or is expecting to incur in the future. A business’s warranty period determines how much warranty expense it can incur, and the company no longer incurs warranty liabilities after a product’s warranty period has expired. When a product is sold that has a warranty attached, the company records the warranty expense and warranty liability in the same period. There is no cash outflow when the initial warranty liability is recorded.

• If there is no information from which to derive a warranty estimate for use in an accrual, consider using industry information about warranty claims.
• The revenue is recognized, most likely on a straight-line basis, over that time.
• It is that type of warranty that is exercisable regardless of whether the seller or manufacturer has explicitly expressed the assurance.

The revenue earned account is credited, and the liability as unearned warranty revenue is decreased, therefore, debited. Under this principle, assurance-type warranties are treated as an expense related to the sale of goods. To undergo an accounting treatment for a warranty, the first thing to question is what kind of warranty your customers have. Depending on the type of warranty, the accounting treatment also varies. We already discussed that the manufacturers’ warranty is mostly a standard of 1 year or 2 years. Many vendors go for an extended warranty to ensure that their customers are satisfied.

Implied Warranty

Finally, how a loss contingency is measured varies between the two options as well. Under US GAAP, the low end of the range would be accrued, and the range disclosed. Warranty is an implied or expressed promise of a manufacturer/vendor to a buyer, assuring that the product’s specifications, facts, and conditions are true and valid. For a vendor or manufacturer, the warranty has different purposes, being the most important one as the marketing tool to promote their product by providing support. The majority of warranties are restricted since they do not cover damage caused by accidents, abuse, or other non-defective issues. A warranty is a promise from the product’s maker that the product will perform as promised.

Also, sales for 2020, 2021, 2022, and all subsequent years will need to reflect the same types of journal entries for their sales. In essence, as long as Sierra Sports sells the goals or other equipment and provides a warranty, it will need to account for the warranty expenses in a manner similar to the one we demonstrated. By accepting money for an extended warranty, the seller agrees to provide services in the future. The revenue is not earned until the earning process is substantially complete in the future. Thus, the $50 received for the extended warranty is initially recorded as “unearned revenue.” This balance is a liability because the company owes a specified service to the customer. As indicated previously, liabilities do not always represent future cash payments.

If the contingent liability is considered remote, it is unlikely to occur and may or may not be estimable. This does not meet the likelihood requirement, and the possibility of actualization is minimal. In this situation, no journal entry or note disclosure in financial statements is necessary.

Accounting for Warranty Under US GAAP, ASC 606

In other words, every time a claim is fulfilled, the company must decrease the amount of the liability by the cost of fulfilling the claim. This journal entry is made when we honor the warranty contract that we have provided to the customers by repairing the products for free during the warranty period. On December 31, we have made a total sales of $500,000 from 1,000 units of products sold during the year. We expect that 30 products which are equivalent to 3% of products sold will be returned for the repair service during the warranty period.

For estimating the warranty expenses, companies use historical data that shows how much it costs to replace or repair defective or malfunctioning products. And the warranty contract’s estimated cost of honoring it should be recognized in the period when the sale occurs under the matching principle of accounting. Let’s expand our discussion and add a brief example of the calculation and application of warranty expenses. Warranties will create a liability account when the costs are probable and if the cost of the warranty can be reasonably estimated. Warranty liabilities will thus, be considered contingent liabilities.

Provision for Warranty Example

It helps to ensure that new iPhone will work fine in the first year and there is no defective product sale to customers. Historically, the warranty cost has been 1% venture debt 101 of revenue, and company A records warranty expenses based on that information. However, the company developed a plastic car that is less durable than metal toys.

Why do Companies Record Liability?

Although, taxation rules require to add up of the Warranty provided for calculating taxable income. Whenever a person buys a product, there are a lot of thoughts going on in his mind; for instance product design, durability, specifications, etc. However, the biggest concerns of a consumer while buying a product are its durability, security, and longevity. The determination of whether a contingency is probable is based on the judgment of auditors and management in both situations. This means a contingent situation such as a lawsuit might be accrued under IFRS but not accrued under US GAAP.

3 Define and Apply Accounting Treatment for Contingent Liabilities

A contingency occurs when a current situation has an outcome that is unknown or uncertain and will not be resolved until a future point in time. A contingent liability can produce a future debt or negative obligation for the company. Some examples of contingent liabilities include pending litigation (legal action), warranties, customer insurance claims, and bankruptcy. Assume in the year following the sale (Year Two) that repairs costing $13,000 are made for these customers at no charge. The expense has already been recognized in the year of sale so the payments made by the company serve to reduce the recorded liability. Although no repairs are made in Year One, the $27,000 is recognized in that period.