Question

Part 1: Warranty Expense Estimate

Greg Johnson, after completing the adjusting for his new company, Poly-Fix, was called to meet with the company controller to discuss his proposed entries. Greg, assumed that the controller was questioning his efforts as he was asked to bring his notes, calculations, and supporting documentation. Greg soon learned that his assumption was incorrect and that his boss wanted him to reconsider one of the adjusting entries for an estimated expense.

Poly-Fix is a new company, specializing in commercial fasteners. Their products have a long-term warranty against manufacturing defects. Greg's boss feels that 3% of sales is too high for their warranty expense estimate. This is a new product that has yet to be tested, and the company president is under pressure from their lenders to meet projected income and profit levels.

Address the following:

Should Greg change his warranty expense estimate? Why or why not?

Explain why a company should accrue warranty expense.

Answer 1

Warranty expense is the cost that a business expects to or has already incurred for the repair or replacement of goods that it has sold.

No he should not change the accrual amount for warranty expense.

Warranty expense is recognized in the same period as the sales for the products that were sold, if it is probable that an expense will be incurred and the company can estimate the amount of the expense. This is called the matching principle, where all expenses related to a sale are recognized in the same reporting period as the revenue from the sale transaction.

The income statement is impacted by the full amount of warranty expense when a sale is recorded, even if there are no warranty claims in that period. As claims appear in later accounting periods, the only subsequent impact is on the balance sheet, as the warranty liability and inventory accounts are both reduced.

It is very unlikely that actual warranty claims will exactly match the historical warranty percentage, so some adjustment of the warranty liability account to actual results will be justified from time to time.