Question

The Kaufman car company sells cars with a warranty that they will work properly. based on its historic experience, it expects the cost of honoring this warranty to be about 1% of sales. In 2014, it makes $500 million of sales. Assume all the warranties for these cars expire at the end of 2016. The actual costs to fix the cars was $1,700,000 in 2014, $2,000,000 in 2015, and $1,200,000 in 2016. What expense would the company record:

A. In 2014, as it sells the cars?

B. In 2014, as it pays the $1,700,000 in claims?

C. In 2015, as it pays the $2,000,000 in claims?

D. In 2016, as it pays the $1,200,000 in claims?

E. At the end of 2016, when the warranties expire?

F. In total, over the 2014-2016 period?

Answer 1

A . When company sells the cars for $ 500 million in the year 2014

A warranty provided by company at the time of sale of the car is a liability of of the company i.e company agrees to fix any problems of the car for the coming 2 years 2014 to 2016therefore it is regarded as an expense at the time of sale. It is generally taken at estimated percentage set on the basis of historic experience which is 1 % of sales.

therefore at the time of sale warranty expense account is debitted and the warranty liability account is credited with $ 5 million ( 1% of 500 million).

journal entry:

particulars	debit ( $ in million)	credit ( $ in million)
warranty expense account	5
warranty liability account		5

Being warranty expense recognised at the time of sale

B. In the year 2014 as it pays $ 1,700,000 in claims

When warranty claim is recieved by the company and as it is honoured the warranty liability amounting to $1.7 million is reveresed by debitting warranty liabilty account and creditting spare part inventory account ( reducing the spare parts used to fix the car from the spare parts inventory).

particulars	debit ( $ in million)	credit ( $ in million)
warranty liability account	1.7
spare parts inventory account		1.7

Being warranty claim of $ 1.7 million honored in the year 2014

C. In the year 2015 as it pays $ 2,000,000 in claims

The warranty claim recieved and honored by the company in 2015 the warranty liability amounting to $ 2 million is reveresed by debitting warranty liabilty account and creditting spare part inventory account ( reducing the spare parts used to fix the car from the spare parts inventory).

particulars	debit ( $ in million)	credit ( $ in million)
warranty liability account	2
spare parts inventory account		2

Being warranty claim of $ 2 million honored in the year 2015

D.  In the year 2016 as it pays $ 1,200,000 in claims

The warranty claim recieved and honored by the company in 2016 the warranty liability amounting to $ 1.2 million is reveresed by debitting warranty liabilty account and creditting spare part inventory account ( reducing the spare parts used to fix the car from the spare parts inventory).

particulars	debit ( $ in million)	credit ( $ in million)
warranty liability account	1.2
spare parts inventory account		1.2

Being warranty claim of $ 1.2 million honored in the year 2016

E. At the end of 2016 when warranties expire

The warranty liability recorded at time of sale is $ 5 million and the total amount of warranties claimed is $ 4.9 million [ 1.7 million + 2 million + 1.2 million ] therefore the balance liability $ 0.1 million is no more a liability as the period of warranty has expiered and it has to be treated as revenue in the year suceeding year 2016

so, in the year 2017 the warranty liability of $ 0.1 million is reversed by debitting warranty liabilty and creditting warranty income account .

F. In total over 2014 to 2016 period

The total amount of warranties honoured in the period 2014 to 2016 amounts $ 4.9 million. The warranty liability balance as on the year end of 2016 is $ 0.1 million.