Estimated Liabilities: Warranties: Videos & Practice Problems

Warranties serve as a guarantee for product performance, enhancing customer confidence and sales. Companies estimate warranty liabilities, classified as contingent liabilities, to match expenses with revenues per the matching principle. For instance, if a company anticipates warranty costs at 4% of $2,000,000 in sales, the warranty expense would be $80,000. This amount is recorded as a liability, ensuring accurate financial reporting. When customers utilize warranties, the liability decreases, reflecting actual costs incurred without impacting current expenses.

Warranty Payable

Warranties are often offered by companies to assure customers that their products will function properly for a specified period. This assurance can enhance customer confidence and boost sales, as seen with products like laptops or cars that come with warranties ranging from one year to ten years. However, if customers utilize these warranties, it can lead to significant costs for the company due to repairs or replacements.

To manage these potential costs, companies estimate warranty liabilities at the time of sale. This estimation is classified as a contingent liability, which depends on future events, such as whether a product will fail. Since it is impossible to predict with certainty if a warranty will be used, companies must estimate the associated costs based on historical data or industry standards. This practice aligns with the matching principle in accounting, which aims to match expenses with the revenues they generate within the same period.

For example, if a company sells $100,000 worth of laptops with a two-year warranty, it recognizes the revenue immediately. However, to adhere to the matching principle, the company must also estimate the warranty expense. If the company anticipates that 7% of the sales will result in warranty claims, it would record a warranty expense of $7,000 in the first year, alongside a corresponding estimated warranty liability of $7,000 on the balance sheet.

In the following year, when customers begin to use their warranties, the company does not need to record an additional expense since it has already accounted for it. Instead, it will reduce the estimated warranty liability by debiting it for the amount spent on repairs, say $5,000, and crediting cash for the same amount. This process ensures that the expenses related to warranty claims are matched with the revenues from the sales, maintaining accurate financial reporting.

Ultimately, estimating warranty liabilities allows companies to prepare for future costs while adhering to accounting principles, ensuring that financial statements reflect a true and fair view of the company's financial position.

Warranty Payable Journal Entries

Understanding the estimated warranty payable is crucial for accurately reflecting future expenses related to product warranties. This concept is similar to the percentage of sales method used for the allowance for doubtful accounts, where a percentage of sales is anticipated to be uncollectible. In the case of warranties, businesses estimate the percentage of sales that will result in warranty claims.

For instance, consider a company, Drones International, which sells drones with a one-year warranty. Based on historical data, the company estimates that warranty costs will be approximately 4% of sales. If Drones International reports $2,000,000 in sales for December, the expected warranty expense can be calculated as follows:

Warranty Expense = Sales × Estimated Warranty Percentage

Warranty Expense = $2,000,000 × 0.04 = $80,000

This $80,000 represents the anticipated cost of fulfilling warranty claims over the next year. When recording this transaction, two journal entries are made: one for the revenue and another for the warranty expense. The revenue entry would involve debiting cash or accounts receivable and crediting revenue for $2,000,000. The warranty expense entry would involve debiting warranty expense for $80,000 and crediting estimated warranty payable for the same amount, reflecting a liability on the balance sheet.

As a result, the company’s assets increase by $2,000,000 due to cash or accounts receivable, while equity increases by the same amount from revenue. However, the warranty expense reduces equity by $80,000, and the estimated warranty payable establishes a liability of $80,000, keeping the accounting equation balanced.

In the following month, if customers exercise warranties costing $6,000, the company does not record a new expense since the warranty expense was already recognized at the time of sale. Instead, the company reduces the estimated warranty payable by $6,000, reflecting the actual cost incurred. This is recorded by debiting estimated warranty payable and crediting cash or accounts payable, thereby decreasing both the liability and cash by $6,000.

This process illustrates the importance of accurately estimating warranty costs and the impact of these estimates on financial statements. Understanding these entries and their implications is essential for effective financial management and reporting.

ECB Company recently released a new product to compete with the product of TLR Company. ECB's product carries a two-year warranty against any manufacturing defects. Based on previous market experience, ECB estimates warranty costs to equal 2% of sales. At the end of the first year on the market, total sales equaled $15 million and actual warranty costs totaled $100,000. What amount (if any) should ECB report as a liability related to this data at year-end?

• A. $0
• B. $100,000
• C. $200,000
• D. $300,000
• E. $400,000

Answer: (C)

The American Tire Company provides a warranty for its tire sales that cover manufacturing defects for three years or 50,000 miles, whichever comes first. ATC estimates that warranty costs during the warranty period will equal 5% of sales. During the current year, ATC made sales of $337,000. ATC received cash equal to 35% of sales and accounts receivable for the remainder. Payments to satisfy warranty claims during the year totaled $9,700. If the beginning balance in estimated warranty payable was $7,000, what would be the final balance in the estimated warranty payable?

• A. $5,898
• B. $9,700
• C. $14,150
• D. $16,700
• E. $16,850

Answer: (C)

Here’s what students ask on this topic:

What is an estimated warranty liability?

An estimated warranty liability is a contingent liability that a company records to account for future costs associated with warranties on products sold. This liability is based on an estimation of the percentage of sales that will require warranty services, such as repairs or replacements. By recording this liability at the time of sale, companies adhere to the matching principle, ensuring that expenses are matched with the revenues they help generate. This practice provides a more accurate financial picture and helps in financial planning and reporting.

How do companies estimate warranty expenses?

Companies estimate warranty expenses by analyzing historical data on warranty claims and considering the nature of the product and its expected performance. They often use a percentage of sales method, where a certain percentage of total sales is anticipated to be used for warranty services. For example, if a company expects 4% of its $2,000,000 sales to result in warranty claims, it would estimate a warranty expense of $80,000. This estimation is recorded as a liability to match the expense with the revenue in the same period.

Why is it important to match warranty expenses with revenues?

Matching warranty expenses with revenues is crucial because it adheres to the matching principle in accounting, which states that expenses should be recorded in the same period as the revenues they help generate. This practice ensures that financial statements accurately reflect the company's financial performance and position. By estimating and recording warranty expenses at the time of sale, companies provide a more accurate picture of profitability and avoid distorting financial results in future periods when warranty claims are actually paid.

How are warranty liabilities recorded in financial statements?

Warranty liabilities are recorded in financial statements as follows: When a product is sold, the company debits warranty expense and credits estimated warranty payable, a liability account. For example, if a company sells $2,000,000 worth of products and estimates 4% will be used for warranties, it records a $80,000 warranty expense and a $80,000 estimated warranty payable. When customers use the warranty, the company debits the estimated warranty payable and credits cash or accounts payable, reducing the liability and reflecting the actual cost incurred.

What happens when customers exercise their warranties?

When customers exercise their warranties, the company does not record a new expense. Instead, it reduces the estimated warranty payable liability. For instance, if a customer uses $6,000 worth of warranty services, the company debits the estimated warranty payable by $6,000 and credits cash or accounts payable by $6,000. This reflects the actual cost incurred and reduces the liability, ensuring that the expense was matched with the revenue in the period the product was sold.