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How to Account for Warranties – Warranty Payable

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Warranty payable is the obligation of the company to repair or replace the defective products purchased by the customers. Warranty Payable arises when the company sells products that the customer has the right to return for repair or direct replacement.

The accounting of warranties is very similar to accounting for bad debts and doubtful debts. It is based on the concept of matching, which requires companies to estimate the expected warranty costs payable (also known as warranty liability or provision for warranty expense) and record them at the time of sale. Subsequently, when the customer returns the defective product or repairs or replaces the product sold to him, the cost will be written off from the deposit payable recorded at the time of sale.

If the company does not provide a warranty and some company offers a separate maintenance contract. In such a case, a certain portion of the revenue representing the expected warranty expense over the useful life of the product is deferred. Therefore, some companies do not record any warranty payable at all and records warranty expense when is actually incurred.

Formula of Warranty Payable

Warranty payable are estimated and is to base it on historical claim rate following formula are as follows:

Warranty Payable = A / B * C

Whereas,

A equals total historical warranty expense incurred in all period

B equals total historical sales of the product for which warranty liability is determined

C equals actual sales of the product for the period

Example and Journal Entries

Casio Inc. launched a new product on 1 January 2019. In the first quarter of the company of the year, their sales amounted to $4 million. Previously, similar products resulted in a lifetime warranty expense of $0.4 million for each $ 15 million of sales. Actual warranty claims amounted to $15,000 million during the quarter.

Pass the journal entry and recognize the initial warranty liability and payment of warranty claims and find out the closing balance of the warranty payable at the end of the first quarter.

Solution:

Estimated Warranty liability = $0.4 million / $15 million * $ 4 million = $80,000

The journal entries as follows:

Warranty Expense           $80,000

  Warranty Payables                       $80,000

Warranty payables are reduce by actual payments:

Warranty Payables          $15,000

     Cash/Inventory                          $15,000

The closing balance of the warranty payable as of 31 March 2019 i.e. the end of the first quarter would be $65,000 ($80,000 minus $15,000). The balance would be carried forward to the next quarter. In the next quarter, the actual sales will increase the liability balance and actual claims will reduce the balance.

Some of the companies may elect to directly write off any warranty related payments/replacements in the period in which they occur. Therefore, such as policy is against the matching principle. If a warranty claim period extends for longer than one year, it should be necessary to split the accrued warranty expense into a short-term liability which is eligible to claim within one year if it crosses more than one year than it is recognized as long term liability.

Warranty Expense           $15,000

     Cash/Inventory                          $15,000

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