What is the impact on net income if warranty claims are over estimated?
When a company offers a warranty on a product or service, they must maintain a warranty liability on the balance sheet. As you can see in the illustrative warranty liability rollforward below, warranty expense increases the liability, while warranty claims paid reduces the liability
If you look at the journal entries below, when a company increases their warranty liability for new warranty claims, this is when the expense is recorded. When warranty claims are actually paid, there is no impact to the income statement. The impact is only to the balance sheet.
So, if a company estimates that warranty claims are going to be high, they will increase their warranty liability account by debiting warranty expense. The additional warranty expense in the income statement would reduce overall net income.
However, if actual warranty claims are significantly lower than estimated warranty claims (i.e. warranty claims are overstated), then that means there warranty liability is overstated. If the company doesn’t record an entry to remove warranty expense from the income statement, their warranty liability account will be overstated, and their net income will be understated (too much expense is recorded in the P&L).
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