If your business issues a warranty on the products it sells, it must record a liability to reflect the estimated costs of repairing or replacing items under warranty. You book the estimated warranty liability in the same period as the sale, which means you front-load the warranty expense. Later on, you reduce the liability when you pay for warrantied repairs. In this way, your financial reports accurately match expenses with revenues.
Research warranty costs. You can look at your own historical data for warranty costs vs. sales to find a reasonable percentage of revenues that go to warrantied repairs and replacements. If you don't have historical data, use industry averages published by trade journals or industry websites.
Apply the percentage to your sales forecast for the upcoming period. For example, suppose you project $100,000 in sales for the next quarter. If you estimate that 1 percent of revenues will pay for warranty costs, multiply $100,000 by 0.01 to find the warranty liability of $1,000.
At the start of the accounting period, record the warranty liability. In this example, debit the warranty expense account and credit the warranty liability account for $1,000.
Acknowledge warranty costs as they occur. For example, if you must make a $75 warrantied repair on an item you sold, debit warranty liability and credit cash for $75.
The warranty liability account appears in the "current liabilities" section of the balance sheet. However, if you offer warranty coverage that extends beyond a year, you need to split the warranty liability between the current and long-term liability sections of the balance sheet.
Consider product differences when estimating the warranty liability. For example, suppose you previously sold only metal toys but have recently switched to plastic ones. Your warranty liability estimate should account for the fact that the plastic toys are less sturdy than the metal toys. You should also consider the relative cost of repairing or replacing a plastic item instead of a metal one.
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