Estimated Liabilities: Warranties - Online Tutor, Practice Problems & Exam Prep

Warranties serve as a guarantee for product performance, enhancing customer confidence and sales. Companies estimate warranty liabilities, classified as contingent liabilities, to match expenses with revenues per the matching principle. For instance, if a company anticipates warranty costs at 4% of $2,000,000 in sales, the warranty expense would be $80,000. This amount is recorded as a liability, ensuring accurate financial reporting. When customers utilize warranties, the liability decreases, reflecting actual costs incurred without impacting current expenses.

Warranty Payable

Pretty often a company will offer a warranty alongside the sale of its product to help guarantee to the customer that the product is going to work. But this could end up costing the company money in the long run when they end up having to repair or replace the product. Let's see how we account for these warranties. So, warranties go along with the sale of the product, and why would a company offer a warranty? You might see it when you buy a laptop; they might offer a 2-year warranty or you see it in car commercials, a 1,000-mile warranty, a 10-year warranty. They're guaranteeing that the product is going to work for a while. And it helps the customer have confidence in the product, so it helps increase sales when the customer is confident that it's going to be a good product, that it's backed by this warranty, this guarantee that it'll work. Well, they're going to buy the product more likely, okay? However, if the customer ends up using the warranty, it's going to cost the company money, right? We have to repair the product or replace it. It's going to end up costing us money. But how do we know how much it's going to cost us at the time of sale? Well, that's why we're going to estimate the warranty liability. So these warranties, they're called an estimated liability or we use the term a contingent liability, okay? A contingent liability because it's contingent on some future event. Will the product break down? Well, if it does break down, then we're going to have to replace it. But we can't be 100% sure at the time of the sale whether the customer is going to use the warranty or not. Okay? So what we need to do is we need to add the cost of what the repairs might be at the time of the sale. We remember, we're always trying to match our expenses with our revenues. And estimating warranty expenses, the estimation of these warranty expenses, it's an example of that matching principle. Remember when we talk about the matching principle, we want to match the expenses that we're going to incur to the year that we make the revenues. Okay? So I've got these boxes here, the red boxes. This is going to be the wrong box here in red. Wrong. And then we're going to have the right box down here in green, okay? So the wrong way to do it, right, would be to not match the expenses. So let's see how that could work out. In year 1, Dell sells \$100,000 of laptops with a 2-year warranty. So, let's say they sell them in cash, well they're going to get cash of \$100,000 and they're Let me do it in a different color. Red on red might be a little tough to see. Let me do it in blue. So the cash, they're going to collect cash of \$100,000 and that'll be our debit and we'll credit revenue, right? They earn this revenue, they sold these laptops, so we'll credit revenue for \$100,000 But now time passes, we're in year 2 and some customers use the warranties and it cost Dell \$5,000 to repair these computers, whatever it might be. Well, if we didn't take that expense in year 1, we're going to take it in year 2 and that's no good, right? We take a warranty expense in year 2 for sales that were in year 1 And that's no good because we're not matching our expenses with our revenues. So this will cost us cash, whatever it might be to fix those laptops. So we're debiting our expense in year 2 and we're crediting our revenue in year 1, right? That's the problem here. We've got our revenue in year 1 and our expenses in year 2. That's no good. Let's see how we do it correctly with the estimating principle, that we're going to use here for warranties. So Dell sells \$100,000 of laptops with a 2-year warranty, but we're still going to take our revenue in year 1 that definitely makes sense. So let's say we got our cash of \$100,000 and our revenue of \$100,000, but now we're also going to match with an estimation. So we're going to estimate how much we think we're going to have to pay out when we actually have to repair these computers from the warranty. So we don't know 100% sure what it's going to cost us in the future. Maybe we think from past sales experience or past repairs, past warranty usage, maybe we expect 7%. Maybe we come out to say, hey, we think \$7,000 of this \$100,000 will be used within the next 2 years. So what we're going to do is we're going to have a warranty expense in the 1st year. Notice we're matching our expense with our revenue. So we're going to take our expense of \$7,000 in year 1 and we're going to have an estimated, so I'm going to put EST for estimated warranty liability. So we're going to put payable. Estimated warranty payable and this is a liability on our balance sheet for \$7,000 So we're expecting that in the next 2 years, we'll have to end up paying \$7,000 off of this warranty. So look what we've done. We've matched our revenue with our expense or our expense with our revenue here because of the matching principle, right? We want those expenses to be matched with the revenues. So now in year 2, what happens when the customers end up using the warranty? Well, we don't have to take an expense in year 2. We already took the expense in year 1, so what we're going to do is we're going to debit the payable, right? Because we have this liability. Well, now we're using up some of that liability when the customer, asked for repairs, so we're going to debit the estimated warranty payable to reduce the liability because we're not expecting that much to be used anymore. It got used up by \$5,000 and we're going to credit cash, right? We ended up paying it with cash, so we're going to lower our liability and we're going to have cash there. Okay? So notice, the main thing here is that we're matching our expense in year 1 with the revenue. Even if it's not exact, right? We're doing our estimation and that's better than having these unmatched expenses. We're going to estimate as best as we can. Even if they don't end up working out perfectly in the future, well we can end up reconciling that in the future, alright? So let's pause here and then we'll do an example with some actual numbers and we're going to see how this, warranty payable is very similar to a method that we used when we were doing the allowance for doubtful accounts, okay? Let's check that out in the next video.

Warranty Payable Journal Entries

Alright, so now we're going to see how the estimated warranty payable is similar to the percentage of sales method that we used when we did our allowance for doubtful accounts. Remember we did allowance for doubtful accounts, so it was the percentage of sales method where we said okay, based on these number of credit sales, there's a percent that we don't think we're going to collect, and we took our bad debt expense right away. We're going to do the same thing here, except we're talking about warranties. How much we expect, based on the level of sales, what percentage of that level of sales we expect to be paid as a warranty expense in the future, okay? So let's go ahead and see this example.

Drones International sells drones with a 1-year warranty. Based on past experience, Drones expects warranty costs to equal approximately 4% of sales. So remember when we did those bad debt expenses, we were given a percentage of sales that were going to be bad debt. Well, it's the same thing here. We're expecting a percentage of those sales to be paid in the future as warranty cost, okay? During December, Drones International had $2,000,000 in sales, alright?

So what we're going to do is we're going to take an entry for our revenue. We had revenue of $2,000,000, but we are also going to have to take our warranty expense right now based on this estimation. So let's find out well, first, let's do our revenue part of our entry. We know we got cash, let's say, or accounts receivable in the amount of $2,000,000, and we had revenue of $2,000,000, right? So that would be a credit to revenue, debit to cash, But what about the warranty? We also have to take our expense for warranty. So let's see how much that's going to be. We had $2,000,000 in sales, so this is the warranty expense. So $2,000,000 times the 4% 0.04, 4% is 0.04, so that's gonna be our warranty expense. So $2,000,000 times 0.04, well, our warranty expense is gonna be $80,000. That means over the next 1 year, when we're paying off, when we're repairing or replacing drones that were not up to quality well, we're gonna expect to spend $80,000 in those repairs and replacements. Debit expense. We're gonna debit warranty expense. It's an expense, so it's gonna have a debit balance and that's gonna be in the amount of $80,000, and we're going to credit our estimated warranty payable, right? This is a liability that's going on to our balance sheet in the amount of $80,000. Okay? So notice we made two journal entries here. One for our revenue and one for our related warranty expense. Okay? So what did we see happen? We had our cash going up in our assets by $2,000,000, and we had our equity going up for those revenues of $2,000,000, But then we also had the expense that we took now, this $80,000 estimated expense. This is the warranty expense made our equity go down, right? Expenses and we now have a liability. So the warranty payable is a liability and we stay balanced here, right? Because the warranty payable and the warranty expense, those are on the same side in opposite directions, and then the cash and the revenue going up. Cool?

Alright. Let's go ahead and see what happens in January of the next year when the customers finally exercise some of that money, some of those warranties to get replacements of the product. So it says in January, customers exercised warranties for replacement products at a cost to Drones International of $6,000. So this is within the warranty period, right? They had a 1 year warranty and in January some of those warranties got exercised. So what we're gonna do, we don't take an expense in January, right? We already took the expense when we sold the product. We took the expense last year when we had the revenue, but now we're in January. So what we're gonna do is reduce the liability because we've estimated that this was gonna happen, right? We already expected these warranties to be exercised. So we don't expect this amount to be exercised again, right? This was a portion of that $80,000 that we expected to be exercised, so we're gonna reduce our liability cause this is taking away from the total amount we expected. So we're going to reduce it by the $6,000, our liabilities going down by $6,000 and our cash is going down by $6,000 because we had to actually physically pay money to replace these products, right? We had to make new products, whatever it might have been. Could have been cash, accounts payable, maybe to a vendor who's gonna fix them for us. Whatever it might be, we have to reduce our cash there. Okay? So that's about it for our warranties. Why don't we do some practice problems to really drill this in, alright? Let's do that now in the next video.

ECB Company recently released a new product to compete with the product of TLR Company. ECB's product carries a two-year warranty against any manufacturing defects. Based on previous market experience, ECB estimates warranty costs to equal 2% of sales. At the end of the first year on the market, total sales equaled $15 million and actual warranty costs totaled $100,000. What amount (if any) should ECB report as a liability related to this data at year-end?

• A. $0
• B. $100,000
• C. $200,000
• D. $300,000
• E. $400,000

The American Tire Company provides a warranty for its tire sales that cover manufacturing defects for three years or 50,000 miles, whichever comes first. ATC estimates that warranty costs during the warranty period will equal 5% of sales. During the current year, ATC made sales of $337,000. ATC received cash equal to 35% of sales and accounts receivable for the remainder. Payments to satisfy warranty claims during the year totaled $9,700. If the beginning balance in estimated warranty payable was $7,000, what would be the final balance in the estimated warranty payable?

• A. $5,898
• B. $9,700
• C. $14,150
• D. $16,700
• E. $16,850

Here’s what students ask on this topic:

What is an estimated warranty liability?

An estimated warranty liability is a contingent liability that a company records to account for future costs associated with warranties on products sold. This liability is based on an estimation of the percentage of sales that will require warranty services, such as repairs or replacements. By recording this liability at the time of sale, companies adhere to the matching principle, ensuring that expenses are matched with the revenues they help generate. This practice provides a more accurate financial picture and helps in financial planning and reporting.

How do companies estimate warranty expenses?

Companies estimate warranty expenses by analyzing historical data on warranty claims and considering the nature of the product and its expected performance. They often use a percentage of sales method, where a certain percentage of total sales is anticipated to be used for warranty services. For example, if a company expects 4% of its $2,000,000 sales to result in warranty claims, it would estimate a warranty expense of $80,000. This estimation is recorded as a liability to match the expense with the revenue in the same period.

Why is it important to match warranty expenses with revenues?

Matching warranty expenses with revenues is crucial because it adheres to the matching principle in accounting, which states that expenses should be recorded in the same period as the revenues they help generate. This practice ensures that financial statements accurately reflect the company's financial performance and position. By estimating and recording warranty expenses at the time of sale, companies provide a more accurate picture of profitability and avoid distorting financial results in future periods when warranty claims are actually paid.

How are warranty liabilities recorded in financial statements?

Warranty liabilities are recorded in financial statements as follows: When a product is sold, the company debits warranty expense and credits estimated warranty payable, a liability account. For example, if a company sells $2,000,000 worth of products and estimates 4% will be used for warranties, it records a $80,000 warranty expense and a $80,000 estimated warranty payable. When customers use the warranty, the company debits the estimated warranty payable and credits cash or accounts payable, reducing the liability and reflecting the actual cost incurred.

What happens when customers exercise their warranties?

When customers exercise their warranties, the company does not record a new expense. Instead, it reduces the estimated warranty payable liability. For instance, if a customer uses $6,000 worth of warranty services, the company debits the estimated warranty payable by $6,000 and credits cash or accounts payable by $6,000. This reflects the actual cost incurred and reduces the liability, ensuring that the expense was matched with the revenue in the period the product was sold.