Estimated Liabilities: Warranties

pretty often a company will offer a warranty alongside the sale of its product to help guarantee to the customer that the product is gonna work. But this could end up costing the company money in the long run when they end up having to repair or replace the product. Let's see how we account for these warranties. So warranties, they go along with the sale of the product and why would a company offer a warranty? You might see it when you buy a laptop, they might offer a two year warranty or you see it in car commercials all the time, 100,000 mile warranty, 10 year warranty. They're guaranteeing that the product is going to work for a while and it helps the customer have confidence in the product. So it helps increase sales when the customer is confident that it's gonna be a good product, that it's backed by this warranty. This guarantee that it'll work. Well, they're gonna buy the product more likely. Okay. However, if the customer ends up using the warranty, it's gonna cost the company money, right? We have to repair the product or replace it. It's gonna end up costing us money. But how do we know how much it's gonna cost us at the time of sale? Well, that's why we're going to estimate the warranty liability. So these warranties, they're called an estimated liability or we use the term a contingent liability. Okay. A contingent liability because it's contingent on some future event. Will the product break down? Well, if it does break down, then we're gonna have to replace it, but we can't be 100% sure at the time of the sale, whether the customer is going to use the warranty or not. Okay. So what we need to do is we need to add the cost of what the repairs might be at the time of the sale. We remember we're always trying to match our expenses with our revenues and estimating warranty expenses. The estimation of these warranty expenses. It's an example of that matching principle. Remember when we talk about matching principle, we want to match the expenses that we're gonna incur to the year that we make the revenues. Okay, So I've got these boxes here, the red boxes, this is gonna be the wrong box here in red. Wrong. And then we're gonna have the right box down here in green. Okay, So the wrong way to do it right would be to not match the expenses. So let's see how that could work out in year one. Dell sells $100,000 of laptops with a two year warranty. So let's say they sell them in cash. Well, they're gonna get cash of 100,000 and let me do it in a different color. Red on red. Might be a little tough to see. Let me do it in blue. So the cash, they're gonna collect cash of $100,000 and that'll be our debit and we credit revenue, right? They earn this revenue, they sold these laptops, so will credit revenue for $100,000 but now time passes, we're in year two and some customers use the warranties and it costs Dell $5000 to repair these computers, whatever it might be. Well, if we didn't take that expense in year one, we're gonna take it in year two and that's no good. Right? We take a warranty expense in year two for sales that were in year one and that's no good because we're not matching our expenses with our revenues. So this will cost us cash, whatever it might be to fix those laptops. So we're debating our expense in year two and we're crediting our revenue in year one. Right? That's the problem here. We've got our revenue in year one and our expenses in year two. That's no good. Let's see how we do it correctly with the estimating principle that we're gonna use here for warranties. So Dell sells $100,000 of laptops with a two year warranty, but we're still gonna take our revenue in year one. That definitely makes sense. So let's say we got our cache of 100,000 and our revenue of 100,000 but now we're also gonna match with an estimation. So we're going to estimate how much we think we're gonna have to pay out when we actually have to repair these, uh, these computers from the warranty. So we don't know 100% sure what it's gonna cost us in the future. Maybe we think from past sales experience or past repairs, past warranty usage, maybe we expect 7%. Maybe we we come out to say hey we think $7000 of this, 100,000 will be used within the next two years. So what we're gonna do is we're gonna have a warranty expense In the first year notice. We're matching our expense with our revenue. So we're gonna take our expense of 7000 in year one. And we're gonna have an estimated, so I'm gonna put E. S. T. For estimated warranty liability. So we're gonna put payable, estimated warranty payable and this is a liability on our on our balance sheet for $7000. So we're expecting that in the next two years we'll have to end up paying $7000 off of this warranty. So look what we've done. We've matched our revenue with our expense or our expense with our revenue here because of the matching principle, right? We want those expenses to be matched with the revenues. So now in year two, what happens when the customers end up using the warranty? What we don't have to take an expense in year two? We already took the expense in year one. So what we're gonna do is we're going to debit the payable right because we have this liability, well now we're using up some of that liability when the customer uh ask for repairs. So we're going to debit the estimated warranty payable To reduce the liability. Because we're not expecting that much to be used anymore. It got used up by 5000. And we're going to credit cash, right? We ended up paying it with cash, so we're gonna lower our liability and we're gonna have cash there. Okay? So notice the main thing here is that we're matching or expense in year one with the revenue, even if it's not exact right, we're doing our estimation and that's better than having these unmatched expenses. We're gonna estimate as best as we you can, even if they don't end up working out perfectly in the future, what we can end up reconciling that in the future. All right, so let's pause here and then we'll do an example with some actual numbers and we're gonna see how this this uh warranty payable is very similar to a method that we used when we are doing the allowance for doubtful accounts. Okay? Let's check that out in the next video

Alright. So now we're gonna see how the estimated warranty payable is similar to the percentage of sales method that we used when we did our allowance for doubtful accounts. Remember we did allowance for doubtful accounts was the percentage of sales method where we said, okay, based on these number of credit sales, there's a percent that we don't think we're going to collect and we took our bad debt expense right away. What we're gonna do the same thing here, except we're talking about warranties, how much we expect based on the level of sales, how much of that level of sales, we expect a percentage to be paid as a warranty expense in the future. Okay, So let's go ahead and see this example, drones International sells drones with a one year warranty based on past experience, drones expects warranty costs to equal approximately 4% of sales. So remember when we did those bad debt expense, we were given a percentage of sales that were going to be bad debt. What's the same thing here? We're expecting a percentage of those sales to be paid in the future as warranty costs. Okay, During december, drones International had $2 million in sales. Alright, so what we're gonna do is we're gonna take an entry for our revenue, we had revenue of $2 million, but we're also gonna have to take our warranty expense. Right now, based on this estimation. So let's find out. Well, first, let's do our revenue part of our entry. We know we got cash, let's say or accounts receivable in the amount of two million. And we had revenue of two million. Right, so that would be a credit to revenue debit to cash. But what about the warranty? We also have to take our expense for warranty. So let's see how much that's gonna be. We had two million in sales. So this is the warranty expense. Two million times the 4%,, 4%, 0.04. So that's gonna be our warranty expense. So two million times .04. Well, our warranty expense is going to be $80,000. That means over the next one year when we're paying off, when we're repairing or replacing drones that were not up to quality. Well, we're gonna expect to spend $80,000 in those repairs and replacements. So we had our journal entry for revenue over here. Now let's make our journal entry for our warranty expense. We're going to debit warranty expense. It's an expense. So it's got to have a debit balance and that's going to be in the amount of 80,000 and we're going to credit our estimated warranty payable. Right, This is a liability that's going on to our balance sheet In the amount of 80,000. Okay, So notice we made two journal entries here, one for our revenue, whoops. One for our revenue and one for our related warranty expense. Okay, so what did we see happen? We had our cash going up in our assets by two million. And we had our equity going up for those revenues of two million. But then we also had the expense that we took. Now this 80,000 estimated expense. This is the warranty expense made our uh equity go down right expenses. And we now have a liability. So the warranty payable is a liability and we stay balanced here, right? Because the warranty payable and the warranty expense, those are on the same side in opposite directions and then the cash and the revenue going up. Cool, Alright, let's go ahead and see what happens in january of the next year When the customers finally exercise some of that money, some of those warranties to get replacements of the product. So it says in January, customers exercised warranties for replacement products at a cost to drones international of $6,000. So this is within the warranty period, right? They had a one year warranty and in January, some of those warranties got exercised. So what we're gonna do, we don't take an expense in january, right? We already took the expense when we sold the product, we took the expense last year when we had the revenue, But now we're in January. So what we're gonna do is reduce the liability because they, we estimated that this was gonna happen right? We already expected these, these warranties to be exercised. So we don't expect this amount to be exercised again, right? This was a portion of that 80,000 that we expected to be exercised. So we're gonna reduce our liability because this is taking away from the total amount we expected. So we're gonna reduce it by the 6000. Are our liabilities going down by 6000 And our cash is going down by 6000 because we had to actually physically pay money to replace these these products, right? We had to to make new new products. Whatever it might have been could have been cash accounts payable, maybe two to a vendor who's gonna fix them for us, whatever it might be, we have to reduce our cash there. Okay, so that's about it for our warranties. Why don't we do some practice problems to really drill this in? Alright, let's do that now in the next video.