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:

Who might be impacted by a decision to revise the estimate? How might they be impacted?

Explain the impact of revising a warranty expense estimate

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. The total amount of warranty expense is limited by the warranty period that a business typically allows. After the warranty period for a product has expired, a business no longer incurs a warranty liability.

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.

In order for a company to estimate the warranty expense and liability, we need to know three things:

• How many units of the product were sold during the period of time we need to record?
• What percentage of the products sold will need repairs or replacement based on previous experience?
• What is the average cost of the repair or replacement under warranty?

For instance, product specifications may have been changed over time. Secondly, distribution channels or locations may have been changing over the course of time, and may be distorting companies’ historical data. Additionally, a company’s data may only include a limited number of years. It is certainly possible that expected lifetimes may be longer than the historical timeframe, but well within the bounds of time as specified in revised extended warranty periods. In such cases, it is important to try to identify external sources of data or internal company experts to help assess cost emergence for periods outside of the experience period.

Many companies that issue extended warranties routinely revise their existing programs based upon what their competitors have been offering. Many times, salespeople are adamant that not providing warranties with as much coverage as the competitors (both in terms of covered perils as well as years of coverage) places the company at a competitive disadvantage, The perception in the marketplace is that the company in question does not ‘stand behind the quality of its product’. The result is that companies, for fear of losing market share, are often proactive in either making revisions to their current program to be more in line with their competition, or offering their own broader warranty coverage before their competitors do.