Definition of Product Warranty Liability
A product warranty means the manufacturer or seller has a potential liability and expense if its product or service fails to live up to the warranty during the period of the warranty. This type of warranty is referred to as an assurance-type warranty.
In accounting jargon, the assurance-type warranty is an example of a contingent that is both probable and can be estimated. Therefore, a company must record in the period of the sale the estimated cost of repairing or replacing the product during the warranty period. That expected cost is recorded as a liability on its balance sheet and as an expense on its income statement. Note that the expected future cost to repair or replace is matched with the sales revenue in the period of the sale. When the repair or replacement occurs, the warranty liability is reduced. Think of those future repair/replacement costs as a selling or promotion expense to get the sale to occur.
Periodically, the credit balance in the Warranty Liability account is reviewed to be certain that the estimated amounts were reasonable. If they are not, the amount recorded at the time of each sale will be increased or decreased.
Example of Product Warranty Liability
Assume that an automobile manufacturer has found that it spends $1,000 in labor and parts for the necessary repairs covered under its two year warranty. If the manufacturer sells 5,000 cars in the first month of its accounting year, the manufacturer must debit Warranty Expense for $5,000,000 (5,000 cars X $1,000)and will credit Warranty Liability for $5,000,000.
When warranty work is done, the manufacturer debits Warranty Liability for the actual cost and will credit Parts Inventory, Wages Payable, etc.