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Definition: Warranty Costs
Warranty costs are the costs that the company or a business expects to incur or has already incurred to replace or repair the goods that it had already sold. These warranty costs are incurred by the company for any product which gets damaged or stops functioning in the prescribed time duration set by the company, after the product is bought by a customer. This time period is most commonly referred to as the warranty period. After the warranty period expires, the company is not liable to incur any warrant costs.
The warranty costs are recognized in the same period I which the sale of the products took place. The warranty costs which will be incurred by the company during a period can be estimated by the amount expense. This is achieved using the matching principle, where all the expenses in relation to sales are recorded and reported in the same time period as the revenue from the sales transactions.
The warranty costs can be calculated by:
• For the goods for which the warranty costs have to be determined, calculate the historical percentage of warranty costs to the expense incurred on sales
• Now use the same percentage to the sales in the current accounting period to determine the warranty costs that will be incurred. This amount can be adjusted to take into account the unusual factors related to goods sold, like indications related to the failure rate of a batch of goods
• Now, we accrue the warranty costs with a debit to the warranty expense account. Simultaneously a credit is done to the liability account of warranty
• As actual warranty claims are received, debit the warranty liability account and credit the inventory account for the cost of the replacement parts and products sent to customers.
Thus, when a sale is recorded, the full amount of warranty costs impact the income statement. When the claims appear at a later date, the only significant impact is on the balance sheet, as both the inventory accounts and warranty liability are reduced.