Warranty Reserve Accounting

This help topic explains why and how to set up a warranty reserve for system replacements and any other type of sale desired. The warranty reserve is money set-aside to cover anticipated but unpredictable expenses. The article also applies to callbacks, bad debt, lawsuits, and other “money reserved for something” type applications. All of these things are contingent liabilities.

What is an Installation Job Warranty Reserve?

A warranty reserve is money that is set aside to pay for warranty claims made by your customers against your products or service. The money you set aside is known as a contingent liability. It appears on your balance sheet. Each time you make a sale, you increase that liability. Every time you incur a warranty cost, you lower that liability.

What is a Standard Warranty?

Most of the products and services that contractors provide come with some type of warranty. A warranty is a guarantee that the contractor will repair or replace the product or redo the service for a certain period of time. You might offer a one-year warranty on service calls.

Please do not confuse standard warranties with extended warranties that customers purchase for an additional fee or extended warranties that your company purchases on behalf of your customers.

Why is it Important to Record a Warranty Liability?

When a company provides a warranty with its product or service, that company has an obligation to repair or replace the product if it is defective or redo the service they provided. That obligation creates a financial liability at the time the product is sold because the company has a liability that starts when the product is sold. Here is what’s in it for you and your business:

• Reduces your income taxes (short term) and saves you money.
• Makes your financial statements more accurate.
• Improves job costing accuracy and thoroughness.
• Enhances financial planning and budgeting.

When Should the Company Record the Warranty Expense?

When the sale is made. The matching principle states that a company must match revenue with expenses. If a contractor sells a furnace in 2022 but expenses a warranty claim in 2023, the company is violating the matching principle. The warranty expense occurs because the sale took place. The expense is a cost of the sale and therefore should be matched with the revenue generated by that sale.

It is acceptable to defer income to fund a warranty reserve account (as opposed to creating an expense). Deferred income is always treated as a liability anyway. That is the concept we will be using.

How to Create a Warranty Reserve for Installation Work

Warranty Reserve Step-by-Step Setup – Option 1

Create a Warranty Reserve Account

This option creates a liability account to hold dollars that will later be used to pay for warranty work. The liability account is funded by deferring a portion of the job’s income.

1. Create a chart of account. Set the type to “Other Current Liability” and call it “Warranty Reserve”.
2. Create a chart of account. Set the type to “Expense” and call it “Warranty”.
3. Create a new item. Set the type to “Other Charge” and enter “WarrantyReserveAdd” in the Name/Number field. The Item Description might be “Puts money into our Warranty Reserve account so that we can pay for warranty work in the future.” The income account should be your new Warranty Reserve account.
   1. Note: You can either set the Amount field to be a Dollar type (which can be changed on the invoice) or a Percentage type. The Percent type automatically calculates its price based on the retail price of the item above it on an invoice. See the Tips section below for more information.
4. Create a new item. Set the type to “Discount” and enter “WarrantyReserveRemove” in the Name/Number field. The COGS account should be your new Warranty Reserve account. The Item Description might be “Takes money out of our Warranty Reserve account to pay for warranty work.” Again, the Amount field could be set to a Dollar or Discount type.

Using Warranty Reserve Option 1

When creating an estimate or sale, add the “WarrantyReserveAdd” item to the item list. This will put money into your Warranty Reserve liability account and by-pass your income account.

When performing warranty work, create a detailed invoice as usual. Be sure you include all equipment, parts, and materials used. Your last step will be to add the WarrantyReserveRemove item. In the Amount field (the amount of the discount), enter the amount of money that should be used to cover the warranty work. In most cases, this will be the full amount of the invoice. You might also charge less than your usual retail price. That is up to the user. This action will lower your Warranty Reserve account and create your warranty expense.

Warranty Reserve Step-by-Step Setup – Option 2

This option also uses a Warranty Reserve liability account. Where it differs is that it uses a vendor to create a warranty expense through an adjusting journal entry. The first three steps below are identical to the option above.

1. Create a chart of account. Set the type to “Other Current Liability” and call it “Warranty Reserve”.
2. Create a chart of account. Set the type to “Expense” and call it “Warranty”.
3. Create a new item. Set the type to “Discount” and enter “WarrantyReserveRemove” in the Name/Number field. The COGS account should be your new Warranty Reserve account. The Item Description might be “Takes money out of our Warranty Reserve account to pay for warranty work.” Again, the Amount field could be set to a Dollar or Discount type.
4. Create a new vendor called “Warranty (internal use only)”. On the vendor, click Menu | Notes and enter a note that explains the use of this vendor.

Using Warranty Reserve Option 2

After you create an invoice for the job, create an adjusting journal entry. This AJE will create the warranty expense and create the warranty liability.

1. Click Banking | Make Journal Entry. In the Memo field, enter “Warranty Reserve”.
2. Line 1: In the Account field, select Warranty Reserve. In the Credit field, enter the amount that you want to “set aside” for the warranty liability. If you don’t know what to enter, 1% to 2% is a good rule of thumb. In the Cust:Job/Employee/Vendor field, select your new vendor called “Warranty (internal use only)”. Select the correct Department.
3. Line 2: Select your new expense account called Warranty. In the Debit field, enter the same amount you entered in the Credit field. In the Cust:Job/Employee/Vendor field, select the job name (from the invoice). Select the correct Department.

Other Warranty Reserve Setup Possibilities

1. You could simply create a discount item called WarrantyWork and select a COGS account called Warranty. You could create a detailed invoice as usual. You would add this item discount the invoice to zero. This will increase the Warranty expense on your income statement to reflect the cost of the work. This method is simple to set up and use but does not use the important “Matching Principle”.
2. Some users prefer using Adjusting Journal Entries (AJE) to move money in and out of their Warranty Reserve expense account and their Warranty Reserve liability account. This technique is covered in Option 2.
   1. When making Adjusting Journal Entries, you could do a week or even a month of jobs at a time. You don’t necessarily have to do them after each invoice.
   2. Use the “Stages” feature on the invoice to help remind the user to create an AJE.

Invoice Pricing Advice

Service technicians often complain about running warranty calls and how that affects their department’s performance numbers. You could alleviate this concern by creating invoices with retail pricing. The money is transferred from the install department to the service department.  If you want to invoice your install department the retail price of the repair, create the invoice as usual and follow the steps above. The discount item will zero out the invoice, but the service department will recognize the income and the install department will recognize the expense.

If you simply want the install department to recognize the cost of the items, do not mark up the items. Create an invoice with a markup of 1.0. You can create a Markup Method called “Warranty – Internal”. Use the Markup Direct Cost method and enter a multiplier of 1.0. Following this guideline, you do not need to reserve as much money, so 1% (as opposed to 2%) might be adequate.,

Warranty Reserve Tips

1. If you decide that you wish to add 2% to the total retail price of the job to cover your warranty liability, the “Percent” type can be very useful. You would add a Sub-Total to the estimate or invoice and then add the WarrantyReserve item. It will automatically set its retail price to 2% of the total.
2. When you place the item WarrantyReserve on an invoice, the retail price of that item will Credit (increase) the liability account called Warranty Reserve. That item will increase the price of the estimate or invoice, but that increase will not count as income, and it will not affect your income statement.
3. The WarrantyReserveAdd item defers the income and instead puts money into the Warranty Reserve account so that you have money set aside to pay for future warranty work.
4. The WarrantyReserveRemove item takes money out of the Warranty Reserve liability account. That’s money that was set aside to pay for warranty work.
5. Use the Item History feature to locate and analyze warranty activity. Since the warranty process relies on items, you have the full benefit of using item related features and reports.
6. If your company does a lot of warranty work or bills third-party warranty companies for warranty policies sold through them, consider setting up a department called “Warranty”. You might have one for residential work and another for commercial work (if you feel the warranty risk is different). This will allow you to print an income statement and other reports for warranty activity.
7. Warranty work may be considered a COGS (aka: top line) expense or a G&A (aka: bottom line) expense. This help topic had you creating a warranty item that used an “Expense” type of chart of account. Instead of an Expense chart of account, you could have created and used a “COGS” type chart of account. This can be changed later.
8. The concept of creating a liability that serves as a financial reserve can be applied to numerous other transactions. These might include pending lawsuits, malpractice, service contracts, callbacks, and bad debt. The principles of how to set up and use the system would essentially be the same.

Definition of Matching Principle

The matching principle is one of the basic underlying guidelines in accounting. The matching principle directs a company to report an expense on its income statement in the period in which the related revenues are earned. Further, it results in a liability that appears on the balance sheet for the end of the accounting period. The matching principle is associated with the accrual basis of accounting and adjusting entries.

If an expense is not directly tied to revenues, the expense should be reported on the income statement in the accounting period in which it expires or is used up. If the future benefit of a cost cannot be determined, it should be charged to expense immediately.

Definition Source: https://www.accountingcoach.com/blog/what-is-the-matching-principle (this is a great website)

Warranty Reserve FAQs

Here are the five most commonly asked questions and answers we hear on “Creating and Using a Warranty Reserve”:

Question: What is a warranty reserve and why is it important?

A warranty reserve is money set aside to pay for future warranty claims. It is important because it creates a financial liability on your balance sheet, helps reduce income taxes, makes financial statements more accurate, improves job costing accuracy, and enhances financial planning and budgeting.

Question: How do you set up a warranty reserve account in your chart of accounts?

First, create a new account type called “Other Current Liability” and name it “Warranty Reserve.” Then, create an expense account named “Warranty.” These accounts will be used to track the reserve funds and warranty expenses.

Question: When should a company record warranty expenses?

Warranty expenses should be recorded at the time of sale, following the matching principle which states that expenses should be matched with the revenue they help generate.

Question: What are the two options for setting up a warranty reserve in an accounting system?

Option 1: Create a liability account funded by deferring a portion of the job’s income and use items to add and remove money from this account.

Option 2: Use a vendor to create a warranty expense through an adjusting journal entry, crediting the warranty reserve and debiting the warranty expense.

Question: What percentage of job income should be set aside for a warranty reserve?

It is generally recommended to set aside 1% to 2% of job income for the warranty reserve, but this can vary based on historical warranty claim data and company policies.

Content Related to Warranty Reserve

Handling Core Charges and Returns

https://www.aptora.com/tips/handling-core-charges-and-returns/

Warranty Work & Reimbursement Management

https://www.aptora.com/tips/tips-warranty-work-reimbursement-management/

Further Reading on Warranty Reserve

https://www.accountingtools.com/articles/2017/5/14/warranty-accounting

https://www.accountingcoach.com/terms/W/warranty-liability