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Guarantee and Warranty Costs

Moneyzine Editor
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Moneyzine Editor
2 mins
January 19th, 2024
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Guarantee and Warranty Costs

Definition

The term guarantee and warranty costs refers to the financial obligations of a company that result from a deficiency in the quality or performance of a product or service. Guarantee and warranty costs are considered loss contingencies, which are incurred if a future event is triggered. There are two ways to account for these costs: the cash and accrual basis.

Explanation

Current liabilities are defined as debts that must be paid within one year or one operating cycle, whichever is longer. In order to be classified as contingent, the debt obligation depends on one or more future events to confirm the amount owed.

Companies are permitted to account for guarantee and warranty costs using two approaches:

  • Accrual Basis: If the likelihood of the future event is probable, and the financial obligation can be reasonably estimated, the company should accrue the warranty expense and place the current liability on their balance sheet. This is sometimes referred to as the expense warranty approach.

  • Cash Basis: If the likelihood of the event meets only one of the two standards (probable or reasonably estimated, but not both), the company should use the cash basis. This approach requires the company to take a charge to an expense account when the company incurs a cost associated with a warranty or guarantee.

Example

Based on historical data, Company A estimates warranty costs are 0.25% of sales revenues. In the month of July, Company A had sales of $1,200,000. Based on this information, the warranty costs for Company A in July would be:

Sales Revenue

$1,200,000

Current Liability (warranty costs: 0.25% of Sales

$3,000

Since Company A believes these costs are both probable and reasonably estimated, the following journal entry is made in July (accrual basis):

Debit

Credit

Warranty Expense

$3,000

Current Liability (warranty costs)

$3,000

Note: Company A would also be required to make adjusting entries if the historical warranty costs did not align with those accrued.

Related Terms

  • Balance Sheet
    Also known as a statement of financial position, the balance sheet is used to show the financial health of a company at a particular point in time. The balance sheet consists of assets, liabilities, and owner's equity in the company. It is one of the four key financial statements issued by public companies.
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  • Contingent Current Liabilities
    The financial accounting term contingent liabilities refers to near-term debt obligations that cannot be precisely measured, or the actual existence of the liability is uncertain. Contingent liabilities are classified as a current liability if the debt obligation is reasonably expected to come due in a single operating cycle or one year.
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  • Pending Litigation, Claims and Assessments
    The term pending litigation, claims, and assessments refers to a potential near-term liability due to possible, threatened, or pending assertions, lawsuits, or monetary charges. Pending litigation, claims, and assessments are classified as a contingent liability and appear on the balance sheet as a current liability if the debt obligation is reasonably expected to come due in a single operating cycle or one year.
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  • Disclosing Loss Contingencies
    The term disclosing of loss contingencies refers to the reporting of potential liabilities that are both probable and can be estimated. A loss contingency is one that will be incurred by a company if a future event is triggered. Such contingencies are classified on the balance sheet as a current liability if they are both probable and can be reasonably estimated.
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  • The term premiums and coupons refers to promotions by companies offered to customers such as redeemable certificates, rebates, box tops, and cash discounts. Premiums and coupons are categorized as contingency losses, since they require a future event to trigger the liability.
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