Question

. During Year One, Company A and Company Z both sell 1,000 computers for $1,000 each in cash. Company A provides a one-year warranty to its customers for free. Company Z sells a one-year warranty to all of its customers for $50 each. Both companies expect 5 percent of the computers to break and cost $600 each to repair. In Year Two, both companies actually have 6 percent of these computers break. However, the required cost to fix each one was only $550.

a. In financial reporting for Year One, which company will report the highest amount of net

income? What will be the difference in the two reported amounts?

b. In financial reporting for Year Two, which company will report the highest amount of net

income? What will be the difference in the two reported amounts?

Answer 1

a. Year 1 earnings :

	Company A	Company Z	Difference of reported amounts
Sales revenue	1000*$1000 = $1,000,000	1000*$1000 = $1,000,000
Add: Service revenue	0	1000*$50 = $50,000
Total revenue	$1,000,000	$1,050,000
Less: cost of repair (on warranty)	1000*5%*$600 = -$30000	- $30000
Net income	$970,000	$1,020,000	$50000, which is the service revenue difference

b. Year 2 earnings :

	Company A	Company Z	Difference of reported amounts
Sales revenue	1000*$1000 = $1,000,000	1000*$1000 = $1,000,000
Add: Service revenue	0	1000*$50 = $50,000
Total revenue	$1,000,000	$1,050,000
Less: cost of repair in 1st year warranty on second year sale	1000*5%*$600 = -$30000	-$30000
Less: cost of repair in 2nd year warranty on first year sale	1000*6%*$550 = -$33000	-$33000
Net income	$937,000	$987,000	$50000, which is the service revenue difference