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Obligations for Warranties in Financial Accounting
It is common business practice for companies to stand behind the quality of their products by offering assurances of repairs, replacements, and/or refunds in the event of product failures or customer dissatisfaction. The eventual costs of such obligations for warranties cannot be known with certainty at the date of sale, although most companies can make reasonable estimates; these costs are associated with current sales revenues. For revenues and expenses to be properly matched, the future costs of warranties and guarantees associated with the current period revenues must be estimated and recorded in the current period. Also, the related obligations must be reported on the balance sheet.
As an example, XYZ International provides warranties on many of its sales. Figure 7.1 in "Types of Current Liabilities" shows that XYZ reports among its current liabilities an obligation for product warranties in the amount of $165.6 million. This implies that XYZ’s managers estimate that the company will eventually make expenditures of about $165.6 million related to merchandise sold prior to the balance sheet date. If we assume that the entire obligation relates to 2000 sales and no costs have yet been incurred for warranties on 2000 sales, the company must have recognized the following event in 2000:
In subsequent years, the firm will spend cash or use other resources to perform warranty repairs. As the warranty repairs occur in subsequent periods, the liability will be eliminated.
In subsequent periods:
Note that no additional expenses are recognized at these points because the warranty expenses were matched against sales in 2000. Of course, the cost to be incurred for product warranties cannot be known for certain in the period of sale. For this reason, XYZ must rely on its past experience and on information from other firms engaged in similar activities to make a reasonable estimate of its obligations for warranties. If the amounts of warranty expenses and obligations are potentially significant to users of XYZ’s financial statements, the firm’s auditors will carefully evaluate the assumptions used to estimate this obligation.
Current Liabilities Topics
Managing Liquidity and Cash Flows
- Accounts payable
- Discounts in Current Liabilities
- Notes Payable
- Accrued Liabilities (Accrued Expenses)
- Current Maturities/Portion of Long-Term Debt
- Taxes Payable
- Accrued Restructuring Costs
- Advance Payments from Customers
- Obligations for Warranties
Commitments, Contingencies and Risks
