Warranty is often given by companies selling certain products such as electronic items for e.g., cell phones, laptops etc. Similarly, companies can offer warranty on any of its products to attract the customers. But what is a warranty?
Warranty is a promise by the company to its customers to repair or replace faulty products free of cost. Some companies explicitly announce the warranty by mentioning the warranty period and terms and condition on the sales agreement or separately issuing a warranty card. In such cases, a contractual obligation to repair or replace faulty products arises at the time of sale.
Some companies do not explicitly offer warranty, but their customary business practice of repairing and replacing faulty products develops a valid expectation in the minds of the customers. In such cases, there is an implicit warranty and a constructive obligation to repair or replace faulty products arises at the time of sale.
A provision is recorded at the time of sale as the obligation of uncertain timing or amount to repair or replace the faulty products arises at the time of sale. Companies need to develop a best estimate of the provision by analyzing the past trends. Following factors can be considered in calculation of warranty provision.
- Expected frequency of warranty claims: Past trends of claims are analyzed and compared with total sales to work out the expected number of future claims. The expected number of claims can be adjusted for any upgrades in the development of technologies that are expected to result in fewer faulty products.
- Expected cost of repair and replacement: Past trends of minor and major repairs, and replacement costs are analyzed to estimate the expected costs of repair and replacement.
Warranty provision rate can be calculated by using the following formula. This rate is multiplied with the sales to arrive at the value of provision for warranty.
Warranty provision rate = Total historical warranty cost / Total historical sales
Provision for warranty = Warranty provision rate* x Sales
* Historical warranty provision rate calculated can be adjusted for any developments or improvements in the production technologies that are expected to reduce the faults in the products.
Following formula for warranty provision rate can also be used, particularly if there is any adjustment required in the frequency of warranty claims expected in future.
Warranty provision rate = (No. of minor repairs expected x Minor repairs cost) + (No. of major repairs expected x Major repairs cost) / Total historical sales
Let’s not complicate it further and have a look at the following example to better understand the topic.
Example – Provision for warranty
ABC Company is preparing its financial statements for the year ended 31 December 20X1. The company offers a one-year warranty on all its products. Sales revenue for the year is $122,000.
For the calculation of warranty provision, the company has selected the data of the last three years to analyze the trends of warrant claims and costs of repairs. Opening balance of provision for warranty is $10,000. Warranty claims entertained during the year costed $9,000. How should the provision for warrant be accounted for in the books of account?