This lesson first explains the theory of warranties and the associated accounting process. Once the fundamentals are covered, the next section identifies the various methods of estimating these costs. A final section covers the cash flow and the corresponding tax implications. I will also explain its impact with management reports.
Fundamentals of Warranties
I remember as a boy my mother demanding a guarantee for work done on the car. The repair shop provided a “100% Guarantee” which meant that they would replace or service their work for free. Since that time period many years ago, many shops realized they had less and less control over the underlying repair parts and more importantly no control over the customer’s driving habits. They basically ‘conditioned’ the guarantee which changes the entire relationship to that of a warranty. Conditions included: IF the car is driven less than X miles, we’ll replace the part for free if it fails; IF the part fails within X time period, we’ll replace it for free, etc.
A warranty is like a guarantee except it comes with restrictions. For the business owner the product or service rendered isn’t going to be perfect every time. Callbacks or replacements are necessary to maintain good rapport with customers. A business must set aside an obligation for callbacks and this is known as warranties. The owner is simply quantifying what he cannot control.
As a part of accrual accounting, the management team wants to recognize these future costs against the original revenue derived. The process is very similar to other estimates whereby the cost is posted to cost of sales under warranties and the corresponding credit is to accrued expenses. Look at the two section layouts below:
Cost of Sales
— Payroll Taxes
– Transportation (Shipping/Delivery)
– Supplier Accounts
– Subcontractor Payables
– Other Payables
– Credit Cards
– Accrued Payroll
— Payroll Taxes
– Accrued Expenses
— Contract Compliance
– Billings in Excess (Construction Industry)
– Contract Deposits
– Line of Credit
– Current Portion of Long-Term Debt
The debit for the estimated warranty amount is posted to cost of sales and the credit to accrued expenses – warranties. When the actual cash outlay is paid to satisfy the warranty obligation, the entry to the books is a debit to accrued expenses – warranties and a credit to cash. Often the work is done by in-house labor and the entry is posted through payroll by debiting labor just like normal. The follow-up entry credits labor over in cost of sales removing the dollar value from the income statement and the debit is to accrued warranties. Thus the warranty balance is decreased indirectly on the financials. Notice how this eliminates double counting of the costs associated with warranties on the income statement. The first entry was via estimating warranties and the second time was when the labor entry was posted to the labor account (dollars paid for actual work).
Just like estimates for depreciation, employee benefits and bad debt use a spreadsheet to track the monthly estimated amount and the actual amount paid out. There is one interesting tidbit about warranties that is different from other estimates. Often warranties cover more than one year of time. That is, in some industries, the business is assuring the product or service beyond the definition of a current liability; that is: an amount expected to be paid out over the next 12 months. In some cases, warranties can last several years. Technically, some part of the warranty value is long-term. How do you address this?
Well there are actually two outs to this quandary. First off, in small business the readers of financial statements are not so sophisticated as to expect a current value and a long-term value. Simply keeping this dollar amount in one account is OK. Secondly, there is another justification for just one account that is that most likely any warranty work and its associated cash outlay will occur within one year anyway. Callbacks for work more than a year later are rare and the associated dollar value is insignificant in comparison to amounts paid out in the first 12 months. With small business, there is no need to separate the two amounts; simply place the entire amount in the current liability section.
Now that you have an understanding of the accounting process, it is time to explain the various methods involved in estimating warranties.
Methods to Estimate Warranties
Estimating warranties is very similar to estimating bad debt or depreciation. Use either a historical pattern or an engineered approach. Both methods will result in a reasonable dollar value as a result. Let’s take a closer look.
Many industries perform a service or sell a product with a service included. The customers vary in their acceptance of the service. Some can identify discrepancies immediately, others defer until there is substantial volume of problems or evidence of a problem. But a pattern will develop over time. Here is an example.
AMR Software designs and customizes real estate software for local government purposes. It is essentially a software program for tax assessments and property analysis. Each customer uses a different formula and rates to calculate the respective parcel’s tax attributes. After design, fabrication, testing and implementation AMR warrants the work. The software has a citizen portal allowing them to view issues with their property. AMR receives a complaint from the local government representative that a citizen can’t see his state tax conservation credits for a part of his farming property. AMR rewrites the program to include these credits.
Over time, AMR’s error rate has fallen as they have learned the nuances of real estate assessments and taxation. However, each county or township doesn’t necessarily have an exact replica of regulations as its neighboring county. So adjustments (versions) of the software are needed. AMR’s pattern of warranty work followed this model over the last four years:
2013 2014 2015 2016 Total
Contract Billings $7,693,742 $8,997,218 $9,375,804 $10,642,137 $36,708,901
Upgrades/Warranty Work $506,753 $441,956 $428,691 $392,712 $1,770,112
Warranty Percentage 6.58% 4.91% 4.57% 3.69% 4.82%
AMR’s learning curve is consistently improving resulting from experience and improvements in design and testing. AMR’s warranty costs as a percentage of contract billings has significantly dropped over four years. In this case, it is best to use the 2016 rate as the estimate for warranty work in 2017. The average over the last four years will overstate the warranty costs as years 2015 and 2016 have resulted in warranty work costs less than average.
With each month’s contract billings, AMR accesses a 3.69% warranty cost via the general journal.
In some business situations the product or service is engineered and custom-built for the customer. In these cases, the warranty cost is tied to the weakest component of the product. For example, I had several custom home builders as clients and a very common issue with the homes was leakage. If often took several months and sometimes up to a year to discover the leaks. Fascinatingly enough, it turned out to be the same roofer used by all the contractors. Basically the roofer’s air pressure to shoot roofing nails was too high causing damage to the shingles which ultimately caused the shingle to fail.
In more custom engineered products the company may provide warranty work based on time yet many components fail after so many uses. The manufacturer builds into its formula the associated cost to replace these parts. Interestingly they know it will break but it is anticipated as an accepted cost for the sale of equipment. Good examples include major auto manufacturers with recalls for components of vehicles. This national recall is expected in advance and its associated cost is built into the sales price.
For many small businesses the owners will not go this far in developing the warranty reserve. There is simply no economies of scale. However, if he knows a component will have a high failure rate or that outside forces of nature will affect the product’s outcome, the owner sets aside an anticipated cost to cover this expected work. Here is an example.
R&D Homes installs and finishes out modular homes on land owned by a customer, they are basically a subcontractor to the modular home manufacturer. From start to finish, a modular home is completed in half the time of a custom-built home. A modular home’s structural integrity is superior to a stick built house due to engineering and fabrication in a controlled environment. After completion, R&D provides a warranty to the customer lasting three years. Over time R&D learns that little things like paint hues are off or gutters sag etc. Each home sold has a warranty reserve of $1,200 to address these issues within the allotted time period. R&D only warrants cosmetic items such as painting, trim work, flooring, gutters etc. Since warranty issues relate to subcontractors or actual product (flooring) the associated costs are held accountable to the subs that provided the product or service. The actual reserve augments or covers the cost in case the sub refuses to warrant their work or are no longer in business. The structural issues are warranted by the manufacture of the modular unit.
This is a simple approach taken by R&D because much of the work is engineered to last many years. But in some cases, the parts will fail and the manufacturer knows it and is willing to replace the part to sell the equipment. Look at this case.
Lochner engineers and builds fabrication equipment used in the metal and wood production industries. A common component is a chuck that holds the cutting tool. Over time, torque from the initial cutting tool insertion wears out the chuck gear. The equipment has a 20 year life expectancy except for the chuck gear. Lochner cannot find a material for the chuck gear to endure the stress associated with the torque from frequent insertion. Lochner simply agrees to replace the chuck gear if it fails within seven years knowing it will fail. The chuck gear is $48 each and is shipped to the customer free. Shipping is about $19. For every unit of equipment sold, Lochner sets aside $67 as a warranty expense.
Once each replacement gear is shipped, warrant liability under accrued expenses is debited and inventory is credited for the part and cash is credited for the shipping cost.
There are other methods to address warranties. Some companies shift the warranty cost expected to a third-party like a company that assumes the warranty responsibility. The cost of the policy is immediate and therefore there is no need to estimate and set up a warranty coverage liability. It is already paid for with the policy purchased.
Even though the accounting process is straight forward, there are other issues to address concerning warranties. This includes cash flow and tax implications.
Cash Flow Impact
When the warranty value is inserted in cost of sales and increases the current liabilities notice that no cash left the company. Cash flow from operations accounts for this by adding back this value to the net profit in determining cash flow. I have not covered these concepts in bookkeeping yet, suffice it to say, warranty work liability increases do not decrease cash flow. When the work is finally paid for via replacement parts or for labor, cash flow decreases as cash is used to pay for this cost. This is very similar to how it is addressed for tax purposes.
Small businesses almost always report their taxes on the cash basis. The tax code requires the business to demonstrate the tax and accrual adjustments between the two methods of accounting. Warranty costs are one of the adjustments for tax accounting.
The value reported on the income statement is on the accrual basis. Therefore the accountant has no idea of the amount paid in cash if looking at the accrual income statement. The profit as reported is a result of both cash and accrual costs.
Since warranty costs are debits (cost of goods sold), the profit must be increased by the warranty costs to determine the cash profit. But there is a second part to this equation. The actual cash expenditures are reported as decreases to the liability over in accrued expenses. If the accrued warranty liability increased during the year, then actual cash paid is less than what was reported on the income statement and vise versa. Take a look at this tax adjustment report for warranties:
Net Profit as Reported (Accrual Based) $143,702
Warranties (Accrual Based) in Cost of Sales + 9,381
Modified Net Profit 153,083
Accrued Warranties (Beginning of the Year) $8,919
Warranties Increase During the Year 9,381
Accrued Warranties (End of the Year) (9,005)
Actual Cash Expenditures for Warranties – 9,295
Net Profit Adjusted for Cash Due to Warranties $143,788
Remember if the liability increased during the year, it means the company did not spend cash to satisfy the responsibility and therefore must add the increase to its accrual profit to identify actual cash profit. For now, this is only an introduction to tax issues as Lessons 98 -102 cover tax accounting outcomes.
It is more important to understand that warranty values affect the company in many ways, including management reporting.
Unlike traditional accounting reports which present financial position and performance, management reports focus in on production and efficiency. Most management reports consist of project accounting, cost accounting and manufacturing outputs. These reports usually identify amounts earned in revenue and the direct costs of production. Most management reports do not include indirect costs (production management payroll, insurance, transportation and field communications) or overhead expenses and back office costs. Warranties are considered a direct cost of production. It is an essential element of delivering a product or service to the customer. Failure to estimate warranty costs greatly affects these production reports.
To complicate this further, project and production manager bonuses are often tied to the performance as reported in these management based outcomes. Overstate warranty costs and a field manager earns less bonus than he is entitled to for his work. It is important to get it right. Furthermore, project managers will invariable state that warranty estimates are too high and you must be able to justify your estimates. It is better to overstate than to lull management into thinking the profit is higher than warranted. Trust your instinct; the more intricate the project the greater the need for higher warranty reserves. More on this in Lessons 104 – 108 covering management reports.
Summary – Estimating Warranties
Warranties are a conditioned form of a guarantee to customers that the product sold or service rendered is of top quality. Invariably, it costs money to stand behind your product or service. This cost is estimated upfront as a function of accrual accounting.
A debit is posted to cost of sales for the estimated amount and a credit is posted to accrued expenses. As the liability is actually incurred, cash output for materials and labor reduces the liability.
There are two widely accepted methods to estimate warranty costs. The gross percentage method uses historical patterns as a percentage of sales to estimate future cost to warrant existing work. The second method is similar to depreciation and uses engineering specifications to value actual costs to comply with customer expectations for the product they purchased. Since warranty costs fluctuate from period to period, they affect both cash flow and tax reporting. Finally, always remember to use reasonableness in your calculations as the outcomes affect management decisions and corresponding reports. ACT ON KNOWLEDGE.