Question

Explain the treatment of warranty cost under financial accounting standards and under the tax code. From a theoretical perspective, why do the two differ? Does this create a deferred tax asset or a deferred tax liability? What will determine when this reverses? Explain.

Answer 1

Warranty cost will be created as a provision under financial accounting standards which will be arrived at by using the probability of how much cost may be incurred based on the sales and previous experience.

However under tax code warranty expenses are allowed as expenses only after they are being incurred actually, there is no concept of provision in tax code. Once the warranty is claimed by some of the customers then it will be allowed as an expense.

As a result of such a difference there will arise a deferred tax liability because under tax code the expenses are less than that under accounting records.

The occurence of future events will determine that whether this provision will be reversed or utilised. Here future events means that claims for warranty.