Mullen Music Limited (MML) carries a
wide variety of musical instruments, sound reproduction equipment, recorded
music, and sheet music. MML uses two sales promotion techniques-warranties and
premiums-to attract customers.
Musical instruments and sound equipment
are sold with a one-year warranty for replacement of parts and labour.
The estimated warranty cost, based on
experience, is 2% of sales.
A premium is offered on the recorded and
sheet music. Customers receive a coupon for each dollar spent on recorded music
or sheet music. Customers may exchange 200 coupons plus $20 for a CD player.
MML pays $34 for each CD player and estimates that 60% of the coupons given to
customers will be redeemed.
MML's total sales for 2011 were $7.2
million: $5.4 million from musical instruments and sound reproduction equipment,
and $1.8 million from recorded music and sheet music. Replacement parts and
labour for warranty work totalled $164,000 during 2011. A total of 6,500 CD
players used in the premium program were purchased during the year and there
were 1.2 million coupons redeemed in 2011.
The accrual method is used by MML to
account for the warranty and premium costs for financial reporting purposes.
The balances in the accounts related to
warranties and premiums on January 1, 2011, were:
Inventory of premium CD players ………………… $
39,950
Estimated premium liability ………………………. 44,800
Estimated liability for warranties
…………………. 136,000
Instructions
(a) MML is preparing its financial
statements for the year ended December 31, 2011. Determine the amounts that
will be shown on the 2011 financial statements for the following:
1. Warranty expense
2. Estimated liability for warranties
3. Premium expense
4. Inventory of premium CD players
5. Estimated premium liability
(b) Assume that MML’s auditor determined
that both the one-year warranty and the coupons for the CD players were, in fact,
revenue arrangements with multiple deliverables that should be accounted for
under the revenue approach.
Explain how this would change the way in
which these two programs were accounted for in part (a).
(a)
|
1.
|
Sales
of musical instruments and sound equipment
|
$5,400,000
|
|
|
Estimated
warranty rate
|
.02
|
|
|
Warranty
expense for 2011
|
$ 108,000
|
|
|
|
|
|
2.
|
Estimated
liability for warranties—1/1/11
|
$ 136,000
|
|
|
2011
warranty expense (Requirement 1)
|
108,000
|
|
|
Subtotal
|
244,000
|
|
|
Actual
warranty costs during 2011
|
164,000
|
|
|
Estimated liability for
warranties—12/31/11
|
$ 80,000
|
|
|
|
|
|
3.
|
Coupons
issued (1 coupon/$1 sale)
|
1,800,000
|
|
|
Estimated
redemption rate
|
.60
|
|
|
Estimated
number of coupons to be redeemed
|
1,080,000
|
|
|
Exchange
rate (200 coupons for a CD player)
|
¸ 200
|
|
|
Estimated
number of CD players to be issued
|
5,400
|
|
|
Net
cost of CD players ($34 – $20)
|
14
|
|
|
Premium
expense for 2011
|
$ 75,600
|
|
|
|
|
|
4.
|
Inventory
of premium CD players—1/1/11
|
$ 39,950
|
|
|
Premium
CD players purchased during 2011
|
|
|
|
(6,500 X $34)
|
221,000
|
|
|
Premium
CD players available
|
260,950
|
|
|
Premium
CD players exchanged for coupons
|
|
|
|
during 2011 (1,200,000/200 X $34)
|
$ 204,000
|
|
|
Inventory of premium CD
players—12/31/11
|
$ 56,950
|
|
|
|
|
|
5.
|
Estimated
premium claims liability—1/1/11
|
$ 44,800
|
|
|
2011
premium expense (Requirement 3)
|
75,600
|
|
|
Subtotal
|
120,400
|
|
|
Actual
redemptions during 2011
|
|
|
|
[1,200,000/200 X ($34 – $20)]
|
84,000
|
|
|
Estimated premium claims
liability—12/31/11
|
$ 36,400
|
(b) If the warranty and premium offers are
considered revenue arrangements with multiple deliverables and the revenue
approach is used to account for the warranties, a portion of the sales revenue
from musical instruments and sound equipment, and recorded and sheet music will
have to be deferred as unearned revenue. This revenue will be recognized over
the term of the warranty period and premium offer period as revenue as coupons
are redeemed and warranties are honoured. Management will need to determine
what portion of the sales price represents revenue from warranties and
premiums.
When the musical instruments and sound
equipment are sold, a portion of the sales price will be credited to Unearned
Warranty Revenue. For the premiums, a portion of the recorded and sheet music
sales will be credited to Unearned Premium Revenue.
As warranties are claimed a portion of
the Unearned Warranty Revenue will be earned and will be transferred to the
income statement. Actual warranty costs will be recorded as warranty expenses.
As coupons for premiums are redeemed,
a portion of the Unearned Premium Revenue will be earned and will be
transferred to the income statement. The premium expense (or cost of premium)
will be transferred to the income statement.
