A company may have a warranty policy that commits to replacing or repairing specific types of product damage within a predetermined period of time after the sale date. If the business can determine how many warranty claims are likely to be filed under the policy, it should set aside money to cover these anticipated claims.
The same reporting period as the accrual should be used to record the relevant product sales. This makes sure that all costs associated with product sales are accurately recorded in the financial statements, revealing the true profitability of those sales in the process.
A warranty is a clause in a contract that outlines the circumstances in which the seller or maker would fix, replace, or pay for a defective product without charging the purchaser or user anything.
Under warranty agreements, businesses are liable for any flaw or potential product performance inefficiency. The companies are required by the agreement to provide the user with compensation for such a problem, either in the form of product repair, replacement, or refund.
The time limit during which a seller or manufacturer is required to repair, replace, or pay for a defective good is known as the warranty term. Following the expiration of the product's warranty, the seller or manufacturer is no longer liable for any faults.
There are three key factors we need to know in order to evaluate a company's warranty costs:
- Units sold within a specific accounting period
- percentage of sold goods that, based on prior experiences, are likely to need repair or replacement
- Cost of replacing or repairing equipment covered by a warranty on average.
Using the following formula;
Total No. Of Units Sold * Percentage Of Defective Units
Units To Be Repaired * Cost/Unit To Repair
ABC Co. manufactures opulent gyro scooters. A one-year warranty is included with each gyro scooter against any manufacturing flaws. The company anticipates that 4% (defect rate) of the gyro scooters sold in the current year will be returned due to a problem based on its five previous years of operations. When this occurs, the business replaces the damaged gyro scooters, which are produced at a cost of $100 apiece..
The company sold roughly 36,000 gyro scooters last year. The assignment is to calculate the warranty expense that the business needs to report for 2019.
- First, determine how many units the organization anticipates would require replacement under the warranty agreement: 1,440 gyro scooters are possibly defective out of 36,000 units sold at a defect rate of 4%.
- Now, figure out how much it will cost to replace the faulty gyro scooters: 1,440 potentially defective units x $100 in replacement costs equals an estimated $144,000 in warranty costs.
The expenses may not be recognized for several months after the corresponding sales if the cost of warranty claims were to be recognized only when the business actually processes claims from consumers. This kind of financial reporting would result in abnormally high initial earnings followed by low profits in subsequent months over the duration of the warranty period.
Consider using market data on warranty claims if there is no data from which to derive a warranty estimate for use in an accrual. This is especially helpful when the company's goods are comparable to those of other products in the market.