Definition: Warranty expense is the cost associated with a vendor or manufacturer’s commitment to repair or replace a product, should it not perform as intended during a specified period of time. In other words, it’s the cost of repairing or replacing defective products after they have been sold to customers.
What Does Warranty Expense Mean?
Many companies offer guarantees on their products as a way to show customers that their products are reliable and risk free. These warranty agreements effectively bind the company to future performance on the contingent basis that their products fail after the customers have purchased them.
According to FASB, these costs should be recognized if they are both estimable and probable. To record this event, the company would debit the warranty expense account and credit a liability account when the product is sold to a customer. If the product needs to be replaced in the future, the liability and inventory accounts are reduced accordingly.
This might seem a little strange because it at face value it seems like this treatment goes against the matching principle, but it doesn’t. By recording the expense at the time of sale, we are matching revenues and expenses because the warranty cost is really a byproduct of the sale.
Let’s look at an example.
Star Digital Systems sells projectors to large corporations, mainly movie theaters. All projectors sold come with a two year warranty, in which Star Digital Systems will replace or repair the projector should it stop working as intended. Its projectors sales for the year are $2,000,000. Based on Star Digital Systems’ previous experience, it believes that 1 percent of sales will have problems and need to be fixed or replaced. Thus, SDS records a $20,000 warranty liability and expense for the year by debiting the expense account and crediting the liability account.
During the next year, SDS had to service several of their projectors that ended up costing the company $5,000. This $5,000 repair is not recorded as another expense because it was already recorded when the sale was recorded in the prior year. Instead, the liability account is reduced by $5,000 and the parts/inventory account is also reduced accordingly.
Keep in mind that this liability treatment is only necessary for companies that have to consistently repair or replace their products. If the company rarely ever has a warranty claim, they don’t need to record the liability. Instead, they can simply record the costs when they are incurred.