Warranty provision

What it means

A warranty provision is a provision for costs the company is likely to incur in future on complaints and repairs of products sold or work delivered before the end of the accounting period. The obligation arises at the point of sale, because the company has undertaken to remedy defects during the warranty period, even though it does not know how many complaints will come.

The provision covers both statutory liability for defects and any contractual quality guarantee the company has given beyond the law. Its amount is estimated, typically as a percentage of revenue based on past experience, or by units sold multiplied by the average cost of repair.

Depending on the warranty period, the provision can be short-term or long-term. It is used up against actual repair costs and adjusted at year-end to a new estimate. If the warranty expires without costs, the unused part is released to income.

How it works in practice

For the estimate we start from complaint statistics: what percentage of products are returned, in which part of the warranty period, and what an average repair costs including materials, labour and transport. For new products without history, manufacturer or industry data are used and the estimate refined later.

No provision is made for costs borne by a component supplier or insurer if reimbursement is certain. If a company resells goods and the manufacturer handles complaints, the provision may be small or nil. For construction companies and machinery makers, by contrast, it is often a significant balance sheet item.

Creating a warranty provision is not tax-deductible, so it is added back in the tax return. Actual repair costs become deductible in the year they arise. The provision and its movements should be explained in the notes, especially if the amount is significant.

What to watch out for

A common mistake is forgetting the provision entirely, especially in fast-growing companies. Revenue grows but warranty costs appear later and retrospectively worsen results. A missing provision distorts profitability and can mislead investors or the bank about the company's real condition.

The provision must not be used to smooth profits. Creating an excessive provision in a good year and releasing it in a weak one breaches accounting rules. The estimate must be backed by data and consistent from year to year, or the auditor will challenge it.