Tutorials – Page 3 – Financial Memos

Accounting for warranties is an excellent example of how accounting supports business decisions and operations. Accounting students can sometimes forget about this business support as they come to grips with many credits and debits. In addition to our accounting tutorial series, we look at the journal entry required to account for a warranty expense correctly. As you will see, there are several different entries that we cover, providing a comprehensive review. If you are in a hurry, the quick answer is the warranty expense (a debit) is brought about by a credit to a provision (liability) for estimated warranty claims. For more details, please read on. What is a Warranty? Warranties, dating as far back as the 1300s, have formed a standard part of trade. Warranties enabled businesses to provide customers with assurances about the goods and services they purchased. Generally set for a specific time from purchase, a warranty gives the customer a commitment that the seller will repair or replace the item or correct the service provided. From an accounting view, this assurance brings with it potential obligations on the part of the seller. And it's the conditions that are required for us to bring to account this obligation that we will look at next, under provisions. What is a Provision? We have a much more extensive article on accounting for provisions under International Accounting Standard (IAS) 37, and you can find that article here. We also cover warranty provisions there too, but as we mentioned above, we'll go into a bit more detail in this one - in particular when a warranty claim is made or there is a lack of provision made. In the meantime, we'll do a quick summary of what is required for a warranty provision to be made. Although you may well be asking why we are talking about provisions when you are here for the expense journal ... but hold on, it will soon be apparent. There must be a present economic obligation in place for a business to record a provision. The obligation is either a legal or constructive obligation, but whatever form must arise from a past event. As a result of that obligation, the business must face the probability of paying for something; in accounting speak, we would talk about the "outflow of economic benefits". And with a probable outflow of these benefits, they must be measured reliably. Normal Liability v Provision? As a quick aside, a question we often see from accounting students is: what is the difference between a liability and a provision? In terms of the debits and the credits, very little. They are both naturally credit accounts. However, provision accounts tend to be contra asset accounts. A contra account is used to offset another account with an opposite natural debit balance. A well-known example of a provision account is accumulated depreciation (or more commonly referred to as provision for depreciation). Although not offset on the face of the balance sheet, this account reduces the respective fixed asset account balance it is associated with. However, our provision for warranties expense isn't used in this way. A provision account will appear in the balance sheet under the liabilities section, similar to a regular liability account. So the other significant difference is the probability of occurrence or the amount of the liability. We know with a trade creditor how much is owed and when. However, with provisions, these can a little less certain - but still must be accounted for. Example Journal Entry of a Warranty Expense As we noted under our other article looking at provisions in general, IAS 37 does specifically address warranty provisions. As mentioned above, there must be a present obligation arising from past activities, and measurement must be reliable. Let us say our ABC Ltd sells widgets to the general public to work through a few journal entries. The widgets come with a one year warranty for repair or replacement. ABC sells 1,500 units per month, and from five years of historical data, it receives approximately 5 per cent of annual units sold as claims. These claims are running at an average cost of approximately $100 each. Armed with this data, the accounting team make the following provision for the year for its widget warranty cover: (1,500 units x 12 months) x 5 % x $100 = $90,000 DateAccount NameDebitCreditApril 1Warranties Expense90,000Provision for Warranties90,000 So now, it is more apparent that a warranty expense comes from the warranty provision. The debit entry brings to account the expense or anticipated outflow of economic benefits for the year. While the credit creates the liability account, reflecting the estimated debt the company thinks it has at present. ABC Ltd then accounts for warranty claims through the year as they occur. We'll show you three different journal entries that may need to be made. The first is a refund to the customer. Refund to Customer The widgets ABC Ltd sells retail at $300 each. ABC Ltd refunds the customer the total retail price and then prepares the following journal entry. DateAccount NameDebitCreditApril 1Provision for Warranties300Bank300 The debit to the provision for warranties account reduces this liability balance, reflecting a reduction in anticipated future warranty claims. At the same time, the credit of the bank account mirrors the money paid back to the customer. Replacement of Product for Customer The second scenario is where ABC Ltd replaces the widget instead of repairing it. DateAccount NameDebitCreditApril 1Provision for Warranties100Inventory100 The debit reduces the provision liability while the credit to the inventory asset account reflects the reduction in stock held. The debit and credit are a widget's cost price rather than the sale price, in the example above. Repair of Product for Customer We now move onto an example of where ABC Ltd decides to repair the widget instead of offering a refund. In this scenario, we make the following journal entry: DateAccount NameDebitCreditApril 1Provision for Warranties100Repair Stocks100 The debit again to the provision account reduces the anticipated future warranty claims expected during the year. This time though, the credit is to repair parts stock. Not to be confused with a credit entry to inventory, which is a credit to the finished widget asset account. Conclusion That brings us to the end of this article, which looked at creating the journal entry for recognising a warranty expense. We also looked at the different types of journal entries that would be made depending on whether a warranty claim is settled through a full refund, replacement or repair. We welcome your feedback on our articles, so please drop a comment below. If you have any questions about warranty expenses, drop us a message through our contact us or better still raise a question under the "ask a question" section.