Question

Testing Product Warranty Liabilities.

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The product warranty liability is often a difficult accrual to audit. Clients need to make their best estimate of an amount to be incurred for warranty related to current sales. They estimate this number based on historical trends, sales data, and other factors. Because it is impossible to create an actual amount, judgment comes into play.

The audit of product warranty accruals is often performed by an experienced auditor based on the scrutiny and estimates involved. Expenses for warranty need to be recognized when the product is sold, not when the claim is exercised, which makes it difficult to estimate--especially with long term warranties. Auditors must apply judgment, industry knowledge, and expertise when auditing this sensitive area.

Read the case. Then answer the questions based on it.

Products in a manufacturing environment are often sold with a warranty--a promise to repair or replace a product that malfunctions during a designated period. In recent years, based on a competitive economy, many companies are extending this warranty for longer periods. GAAP requires that the expense for these warranties be recorded to match with the product sale. Therefore, a product sold in 20XX with a 5-year warranty needs to have an estimate of its future warranty claims expensed in 20XX, although many of those claims may not result for five years. This is an area of great scrutiny and judgment for both auditors and clients alike.

Tanner CPA is conducting a second year audit on its client, Lucas Manufacturing, Inc. Lucas Manufacturing offers a standard 5-year warranty on all products sold. The client calculates its accrued product warranty based on historical trends in warranty claims and claims incurred to-date. Traditionally, its estimates have proven reliable. Tanner CPA is ready to audit the accrued product warranty for the period 20XX.

A, How should Tanner CPA approach the audit of Lucas Manufacturing's accrued warranty if the products sold are consistent with prior years?

B. Would Tanner's audit approach be different if a brand new product was sold in the current year (20XX)?

C. What else (in addition to sales and claims history and product mix) should Tanner consider?

Answer 1

Answer:-

A)         Tanner, CPA, should see that the warranty claims as expensed are in sync with the number of products sold. As mentioned, products sold are consistent with prior years.

So Tanner should determine the historical trends of "warranty expense to sales" ratio or percentage. This ratio or percentage should be applied to the sales for the period 20XX to arrive at the figure of warranty expense accrued.

B).        If a brand new product was sold, then historical figures of a similar type of product, along with its warranty expense will have to be used to arrive at a ballpark percentage.

Suppose Lucas is introducing a new type of automobile battery, which was not present in its product portfolio earlier. This is a brand new product for Lucas. However, such a product is being sold by company ABC for the last 2 years.

In such a case, Tanner should look at the historical warranty expense and sales figure of the automobile battery of company ABC to arrive at a ballpark percentage. This ballpark percentage should then be applied to Lucas's sales figure for the current year.

C)         Tanner should also look at batch wise figures. Usually, products are made in different batches. Tanner should see if any particular batch has high amount of warranty expense, what the reason behind it is. Why is that particular batch witnessing high failure rate?