Warranty Liability

A warranty liability, also called an estimated warranty liability or warranty provision, is an obligation a business records for the future cost of honoring product warranties on goods it has already sold. When a manufacturer or retailer promises to repair or replace defective products for a period after sale, it does not know exactly which items will fail, but experience tells it roughly how much the promise will cost. Accounting standards require that expected cost to be recognized at the time of sale, not years later when claims arrive.

The liability is an example of an estimated liability: the obligation definitely exists, but its amount must be estimated. Under US GAAP it is accounted for under the guidance for guarantees and contingent liabilities, and under IFRS as a provision under IAS 37. Recording it at the time of sale follows the matching principle, placing the warranty cost in the same period as the revenue from the sale.

Since the adoption of ASC 606 and IFRS 15, warranties are divided into two kinds:

• Assurance-type warranties promise only that the product works as intended and meets agreed specifications, such as a standard one-year manufacturer's warranty. These are accounted for as a cost: the seller records warranty expense and a warranty liability at the time of sale.
• Service-type warranties provide something extra, such as an extended warranty sold separately or cover beyond normal defects. These are a separate performance obligation: part of the transaction price is recorded as deferred revenue and recognized as revenue over the warranty period, with costs expensed as incurred.

If a customer can buy a warranty separately, it is a service-type warranty.

An appliance maker sells 50,000 washing machines in a year for $600 each, with a standard two-year warranty. Past experience shows that about 4 percent of machines need warranty repairs, at an average cost of $150 each. The expected warranty cost is:

Here units sold are 50,000, the expected claim rate is 0.04 and the average cost per claim is $150, giving $300,000. The company records the estimate with a debit to warranty expense and a credit to warranty liability for $300,000. During the year it actually spends $110,000 on parts and labor for claims; each repair is recorded as a debit to warranty liability and a credit to inventory, cash or wages payable. At year end the liability is $190,000, split between current and noncurrent portions according to when the remaining claims are expected.

If later experience shows failure rates rising to 5 percent, the estimate is revised as a change in accounting estimate, increasing the liability and the expense in the current period.

US GAAP requires companies to disclose their accounting policy for warranties and a reconciliation of the warranty liability for the period, showing the opening balance, new accruals, payments and adjustments, and the closing balance. These tables are found in the notes to the financial statements and are useful to analysts. A rising warranty accrual relative to sales may indicate quality problems, while a falling accrual at a time of steady claims may indicate that a company is underestimating costs to flatter profits. Vehicle makers, electronics companies and home builders often carry large warranty liabilities, and major product recalls can result in charges of billions of dollars.

Warranty expense is normally reported within cost of goods sold or selling expenses. For US income tax, warranty reserves generally cannot be deducted when accrued; costs are deductible when actually incurred, which creates a deferred tax asset. The liability is reported among current liabilities for the portion expected within a year, alongside other accrued expenses, and as a long-term liability for the rest.