When a firm sells products or renders services with a warranty, the firms has an obligation towards the customer when the warranty is honored. The warranty liability is an estimate of the obligations. Hence, a product warranty for some product is based on expected breakdowns, the probability that the product is returned for repair, and estimates for material and labor needed to repair the product.
The matching principle requires that the expense of providing warranty needs to be allocated in the period of the sale, at the same time the gain of the sale is recognized. At the time of sale the firm expenses the expected cost of the warranty, which is added to the warranty liability. When at a future point in time the warranty is honored, no expenses need to be booked as for this purpose the warranty liability was created. Thus, at the time warranty is honored, the liability is reduced.
Warranty Liability Example
The firm sells phones with a one year warranty. In the current month, the firm has sold 1,000 units. The expected percentage of phones that need to be replaced is 1%. The expected cost of replacement is 20.
The journal entry at the time of sale related to the warranty:
During the same month, 15 previously sold phones were required to be replaced under the warranty.
The journal entry for the replacements under the warranty:
It is possible that the warranty liability will appear to be too high (or too low) at some point in time. If the liability turns out to be too low, additional expenses need to be booked. (See Dell’s 4.1 million laptop battery recall program, for example.) If the liability is too high, some of the expenses can be reversed.
Warranty Liability Example
At the end of the period, the firm has a warranty liability of 100,000. However, the expected cost of honoring warranty is expected to be 60,000. Thus, the liability is overstated by 40,000.
The journal entry to correct the warranty liability:
The use of the warranty liability is similar in nature as the allowance for uncollectible accounts. The warranty liability is about the risk in the products sold, whereas the allowance for uncollectible accounts is about the risk of non-payment by customers. The main difference between the two is that the warranty liability is a liability, whereas the allowance for uncollectible accounts is a correction on an asset.
Warranty Liability Explained
– at the time of the sale, the expected cost of warranty is expensed by recognizing a warranty liability, which is in line with the matching principle
– when the firm is using resources to honor the warranty, the warranty liability is reduced
– when the warranty is either too high or too low, a correcting entry is made so that the warranty liability is in line with expected future warranty obligations