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
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