Selzer Equipment Limited sold 500 Rollomatics on account during

Selzer Equipment Limited sold 500 Rollomatics on account during 2011 at $6,000 each. During 2011, Selzer spent $30,000 servicing the two-year warranties that are included in each sale of the Rollomatic. All servicing transactions were paid in cash.

Instructions

(a) Prepare the 2011 entries for Selzer using the expense approach for warranties. Assume that Selzer estimates that the total cost of servicing the warranties will be $120,000 for two years.

(b) Prepare the 2011 entries for Selzer assuming that the warranties are not an integral part of the sale, but rather a sep arate service that is considered to be bundled with the selling price. Assume that of the sales total, $160,000 is identified as relating specifically to sales of warranty contracts. Selzer estimates the total cost of servicing the warranties will be $120,000 for two years. Because the repair costs are not incurred evenly, warranty revenues are recognized based on the proportion of costs incurred out of the total estimated costs.

(c) What amounts would be shown on Selzer's income statement under parts (a) and (b)? Explain the resulting difference in the company's net income.

(d) Assume that the equipment sold by Selzer undergoes technological improvements and management now has no past experience on which to estimate the extent of the warranty costs. The chief engineer believes that product warranty costs are likely to be incurred, but they cannot be reasonably estimated. What advice would you give on how to account for and report the warranties?

(a)	Accounts Receivable..........................................................	3,000,000
	Sales..........................................................................		3,000,000
	(500 X $6,000)
	Warranty Expense...............................................................	30,000
	Cash, Inventory,                  Accrued Payroll...................................................		30,000
	Warranty Expense...............................................................	90,000
	Estimated Liability Under                  Warranties............................................................		90,000
	($120,000 – $30,000)
(b)	Accounts Receivable..........................................................	3,000,000
	Sales..........................................................................		2,840,000
	Unearned Warranty Revenue...............................		160,000
	Warranty Expense...............................................................	30,000
	Cash, Inventory,                  Accrued Payroll...................................................		30,000
	Unearned Warranty Revenue...........................................	40,000
	Warranty Revenue...................................................		40,000
	[$160,000 X ($30,000/$120,000)]

(c)

Sales  $3,000,000                                                         $2,840,000

Warranty Revenue                                                                         0                     40,000

Warranty Expense                                                            (120,000)                  (30,000)

Income                                                                            $2,880,000             $2,850,000

Treating the warranty as an integral part of the sale will trigger a larger expense. This is because the full cost of servicing the product over the course of the warranty period must be estimated and disclosed in the period of sale. The warranty expense under a “sales-warranty” approach records only expenses incurred in the current period.

The presentation of revenues will also differ under the two approaches. Under the “expense-warranty” approach, the sales proceeds from selling the product generate only one revenue source. Under the “sales-warranty” approach, the sale of the product generates two different revenue streams, the sale of the product and the sale of the warranty contract as a service revenue as well as two gross profit sources (Sales less cost of sales and warranty revenues net of warranty expenses).

Since the same selling price is used under both approaches, we can see that the “sales-warranty” approach generates a lower income in the current year because a portion of the profit is deferred to future periods until it is earned as the service is provided.

(d)       If the warranty costs are considered to be immaterial, the cash basis method could be used and warranty costs expense recognized in the year they are incurred. However, if the warranty costs are considered material to the company’s financial statements, the company may have to defer recognizing the revenue from the sale of the product until all costs can be measured and matched against the related revenues.