Novack Machinery Corporation manufactures equipment to a
very high standard of quality; however, it must still provide a warranty for
each unit sold, and there are instances where the machines do require repair
after they have been put into use. The company started in business in 2011, and
as the controller, you are trying to determine whether to use the expense or
the revenue approach to measure the warranty obligation. You would like to show
the company president how this choice would affect the financial statements for
2011, and advise him of the best choice, keeping in mind that the revenue
approach is consistent with the approach being taken under IFRS, and there are
plans to take the company public in a few years. You have determined that sales
for the year were 1,000 units, with a selling price of $3,000 each. The
warranty is for two years, and the estimated warranty cost averages $200 per
machine. Actual costs of servicing warranties for the year were $105,000. You
have done some research and determined that, if the revenue approach were to be
used, the portion of revenue allocated to the warranty portion of the sale
would be $350, 40% of which would be earned in the first year of the warranty,
with the balance being recognized in the second year.
Instructions
(a) For both the expense and the revenue approach,
prepare the necessary journal entries to record all of the transactions
described, and determine the warranty liability and expense amounts for 2011.
(b) What are the advantages and disadvantages of the two
choices? What do you think is the best choice in this situation? Why?
(a) Expense
Approach:
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Cash / Accounts Receivable..............................................
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3,000,000
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Sales..........................................................................
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3,000,000
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(1,000 X $6,000)
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|
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Warranty Expense...............................................................
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105,000
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Cash,
Inventory,
Accrued Payroll...................................................
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105,000
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Warranty Expense...............................................................
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95,000
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Estimated
Liability Under
Warranties............................................................
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95,000
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[(1,000 X $200) – $105,000]
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December
31, 2011 financial statement amounts reported:
Balance
Sheet
Estimated liability under warranty $95,000
Income
Statement
Sales $3,000,000
Warranty expense 200,000
Revenue
Approach:
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Cash / Accounts Receivable..............................................
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3,000,000
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|
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Sales..........................................................................
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2,650,000
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Unearned
Warranty Revenue...............................
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350,000
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Warranty Contract Expense...............................................
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105,000
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Cash,
Inventory,
Accrued Payroll...................................................
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105,000
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|
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Unearned Warranty Revenue...........................................
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140,000
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|
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Warranty
Revenue...................................................
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140,000
|
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($350,000
X 40%)
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December
31, 2011 financial statement amounts reported:
Balance
Sheet
Unearned warranty revenue $210,000
Income
Statement
Sales $2,650,000
Warranty revenue 140,000
Warranty contract expense 105,000
(b) When
the expense approach is used to account for warranty costs, the revenue will be
higher because it is all considered to be earned on the sale of the
product. As well, the expense on the
income statement will represent the actual costs of servicing the warranty,
plus a year end adjustment for expected future costs.
When the revenue method is used, the
sales revenue will be lower because the total selling price is allocated
between the sale of the product and the sale of the warranty service. There
will be an unearned warranty revenue liability account for the portion of the
warranty that has not been taken into revenue at year end. Warranty contract expense will be equal to
the actual costs of servicing the warranty during the year. In summary, the
profit on the warranty work is recognized in a later period under the revenue
approach—in the period the warranty work is performed.
In this situation, it makes the most
sense to choose the revenue method. As the company is considering going public
in a few years, and the bifurcation of revenues to multiple deliverables is
required by IFRS , this would be
consistent with what will be required after they go public. It would make sense to adopt this policy now
so a retroactive change is not required later.
