Warranty is a term often associated with electronics. It represents a promise from the manufacturer about the condition of the underlying product. Usually, it includes compensation to the buyer if that product is defective or doesn't work as expected. This compensation may come in many ways, for example, repairs and exchanges that are free of cost to the customer.
An issue with warranties arises when accounting for them. It occurs as accounting principles are stricter toward liabilities and losses. With a warranty, both come into play. The promise from the manufacturer creates an obligation. However, the likelihood of it materializing may be complex to estimate. Accounting standards may require companies to record a warranty provision in these cases.
What is a Warranty Provision?
A warranty provision is an obligation created in the financial statements by manufacturers offering warranties. This provision includes an estimation of the warranty claims that the seller expects to materialize. As stated above, estimating the value may not be as straightforward. Companies may use historical data about warranties and products to reach a reasonable amount for warranty provision.
The warranty provision does not include the actual amount of warranties that customers will claim during the period. Practically, this amount may be higher or lower than the provision created for warranty claims. Nonetheless, it allows companies to conform to accounting principles, more specifically, the conservatism principle. Overall, manufacturers must record a warranty provision if they offer warranties on their products.
What is the accounting for Warranty?
The above explanation provides insights into what the accounting treatment for warranties is. Essentially, this treatment involves estimating the value of warranty claims during an accounting period. It is the same period a company sells products with a warranty. Usually, companies use a percentage of sales to estimate the warranty claims associated with it.
Once the company estimates the warranty provision, it must record it as an expense. On the other hand, the company must also create a provision for the same amount. After that, every warranty claim does not become an expense. Instead, it decreases the warranty provision recorded in the financial statements. Accounting for warranty impacts the balance sheet and income statement.
What is the journal entry for Warranty?
When a company estimates its warranty provision, it must record it in its accounts. The journal entry to do so is as below.
| Dr | Warranty expense |
| Cr | Warranty provision |
Once the provision gets records, any actual claims go into the provision account. The journal entry to record warranty claims by customers is as below.
| Dr | Warranty provision |
| Cr | Inventory |
Example
Red Co. estimates 5% warranty claims on its sales. During an accounting period, the company made sales of $100,000. Red Co. records a warranty provision of $5,000 ($100,000 x 5%) for the period. The company uses the following journal entry for the transaction.
| Dr | Warranty expense | $5,000 |
| Cr | Warranty provision | $5,000 |
During the accounting period, Red Co. received warranty claims of $4,000 on its products. The company recorded these claims as follows.
| Dr | Warranty provision | $4,000 |
| Cr | Inventory | $4,000 |
Conclusion
A warranty represents a promise from a seller regarding the condition of its products. When accounting for warranties, companies must create a provision. This provision estimates warranty claims for an accounting period. Recording a warranty provision conforms to accounting principles that require prioritizing recording losses and liabilities.
Originally Published Here: Accounting for Warranty: Treatment, Journal Entry, Example, How to
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