Accounting for warranties is a great example of how accounting is there to supporting the decisions and operation of business. This sometimes can be forgotten as the accounting student comes to grip with so many different credits and debits. In this addition to our accounting tutorial series we look at the journal entry required to correctly account for a warranty expense. As you will see there are actually a number of different entries that we cover, providing a comprehensive review.
If you are in bit of 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?
Dating as far back as the 1300’s, warranties have formed a common part of trade whereby businesses provide warranties or assurances to their customers for the performance of the goods and services they are sold. Normally set for a specific period of time from purchase, a warranty provides the customer with an assurance that the seller will repair or replace the item or make-right the service provided.
Now 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 mention 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 mean time, 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 clear.
For a provision to be recorded the business must have a present economic obligation in place. This can either be in the form of a legal or constructive obligation, but it must arise from a past event. As a result of that obligation the business must face the probability of having to pay 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 able to be measured in a reliable fashion.
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, nothing really. They are both naturally credit accounts. However, provision accounts tend to be contra asset accounts. These are accounts that are used to offset another account with an opposite natural debit balance. A well known and good example would be 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.
Having said all of that, our provision for warranties expenses isn’t used in that way and like a normal liability account will appear in the balance sheet under the liabilities section.
So the other major difference is the probability of occurrence or the amount of the liability. Say with a trade creditor, you know exactly how much and when it is owed. 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. Like we mentioned above, there must be a present obligation arising from past activities, costs will be incurred and we need to be able to reliably measure it.
To work through a few journal entries let us say our ABC Ltd sells widgets to the general public. The widgets come with a one year warranty for repair and/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
|April 1||Warranties Expense||90,000|
|Provision for Warranties||90,000|
So now it is clearer where the warranty expense journal entry comes from – it comes from the generation of a provision for those warranties. 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 estimated debt the company thinks it has at present.
Then during the year warranty claims will be made and these need to be accounted for too. 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 per unit. So when a full refund is provided to the customer the following entry would be made:
|April 1||Provision for Warranties||300|
The debit to the provision for warranties account reduces this liability balance, reflecting a reduction in anticipated future warranty claims. While the credit of the bank account of course reflects the money paid back to the customer.
Replacement of Product for Customer
The second scenario to look at is a journal entry for a warranty expense where the customer has requested or the company has decided to replace the widget.
|April 1||Provision for Warranties||100|
The debit reduces the provision liability while the credit to the inventory asset account reflects the reduction in stock held. The amount of the debit and credit is at the cost price of the widget, rather than at the sale price in the example above.
Repair of Product for Customer
Now moving onto where ABC Ltd decides to the repair the widget instead of offering the customer a refund – or perhaps the customer requested a repair instead.
|April 1||Provision for Warranties||100|
The debit again to the provision account reduces the anticipated future warranty claims expected during the year. This time though the credit is repair parts that are held in stock. Not to be confused with the example above this with a credit to inventory – this is a credit to the finished widget asset account.
That brings us to the end of this article looking at the creation of 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.