Module 2-WARRANTY LIABILITY and PROVISION AND CONTINGENT LIABILITY

NEW BRIGHTON SCHOOL OF THE PHILIPPINES, Inx`C.
Module No. 2
Subject: Intermediate Accounting 2 Date of Submission: ____________
Name of Student: __________________________________________________
Course and Year: __________________________________________________
Semester and School Year: __________________________________________
PRETEST. Encircle the letter of the best answer.

1. The accrual approach in accounting for warranty
a. Is required for income tax reporting.
b. Is frequently justified on the basis of expediency.
c. Finds the expense account being charged when the seller performs in compliance with the warranty.
d. Represents accepted practice and should be used whenever the warranty is an integral and inseparable part
of the sale.
2. Which of the following best describes the accrual approach of accounting for warranty cost?
a. Expensed when paid
b. Expensed when warranty claims are certain
c. Expensed based on estimate in ear of sale
d. Expensed when incurred
1. Which of the following best describes the expense as incurred as incurred approach of accounting for
warranty cost?
a. Expensed based on estimate in year of sale
b. Expensed when liability is accrued
c. Expensed when warranty claims are certain
4. Which is the correct definition of a provision?

a. A possible obligation arising from past events
b. A liability of uncertain timing or uncertain amount
c. A liability which cannot be easily measured
d. An obligation to transfer funds to an entity
5. It is an event that crates a legal or constructive obligation because the entity has no other realistic alternative
but to settle the obligation.
a. Obligation event
b. Past event
c. Subsequent event
d. Current event
WARRANTY
Home appliances like television sets, stereo sets, ratio sets, refrigerators and the like are often sold under guarantee or
warranty to provide free repair service or replacement during a specified period if the products are defective.
Such entity policy may involve significant costs on the part of the entity if the products sold prove to be defective in the
future within the specified period of time.
Recognition of warranty provision

PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the financial statements under the
following conditions:
a. The entity has a present obligation, legal or constructive, as a result of past event.
Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 1

b. It is probable that an outflow of resources embodying economic benefits would be required to settle the
obligation.
c. The amount of the obligation can be measured reliably.
Past event
The past event, often referred to as the obligating event, must have occurred.
The obligating event in this case is the sale of the product which gives to a constructive obligation.
Probable outflow resources
The warranty results in an outflow of resources embodying economic benefit in settlement. It is probable that there will
be some claim against the warranty.
Reliable estimate
The amount recognized as the warranty provision should be the best estimate of the expenditure to settle the present
obligation.
Where no reliable estimate can be made, no warranty liability is recognized.
Accounting for warranty

There are two approaches followed in accounting for the warranty cost, namely:
a. Accrual approach
b. Expense as incurred approach
Accrual approach
The accrual approach has the soundest theoretical support because it properly matches cost with revenue. As stated
earlier, at the time of sale a liability for warranty cost arises and therefore should be given accounting recognition.
Following this approach, the estimated warranty cost is recorded as follows:
Warranty expense xx
Estimated warranty liability xx
When actual warranty cost is subsequently incurred and paid, the entry is:

Cash xx
Any difference between estimate and accrual cost is a change in estimate and therefore treated currently or
prospectively, if necessary. Thus if the actual cost exceeds the estimate, the difference is charged to warranty expense as
follows:
Warranty expense xx
The subsequent payment of the warranty cost is then charged to the estimated liability account.
If the actual cost is less than the estimate, the difference is an adjustment to warranty expense as follows:

Warranty expense xx
Illustration
An entity sells 1,000 units of television sets at P9,000 each for cash. Each television set is under warranty for one year
and the entity has estimated from past experience that warranty cost will probably average P500 per unit and that only
60% of the units sold will returned for repair. The entity incurs P180,000 for repairs during the year.

Journal entries
1. To record the sales:
Cash 9,000,000
Sales 9,000,000
2. To set up the estimated liability on the warranty:
Warranty expense 300,000

Estimated warranty liability 300,000
Estimated sets to be returned (60% x 1,000) 600 sets

Multiply by estimated warranty cost per set 500
Estimated warranty cost 300,000
3. To record the payment of the actual cost:

Cash 180,000
The statement of financial position at the end of the year would report estimated warranty liability of P120,000 as a
current liability.
The income statement for the year would show warranty expense of P300,000.
If the warranty runs over a period of more than one year, a portion of the estimated warranty liability shall be reported
as current liability and the remaining portion as noncurrent liability.
Expense as incurred approach
The “expense as incurred approach” is the approach of expensing warranty cost only when actually incurred. This
approach is popular in practice because it is the recognized for income tax purposes and frequently justified on the
basis of expediency when warranty cost is not very substantial or when the warranty period is relatively short.
The actual warranty cost of P180,000 is simply recorded by debiting warranty expense and crediting cash.
Another illustration
An entity sells refrigerators that carry a 2-year warranty against defects. The sales and warranty repairs are made evenly
throughout the year:
Based on past experience, the entity projects an estimated warranty cost as a percentage of sales as follows:
First year of warranty 4%

Second year of warranty 10%
2020 2021
Sales 5,000,000 6,000,0000
Actual warranty repairs 140,000 300,000
Journal entries
2020
Cash 5,000,000
Sales 5,000,000
2. To record the warranty expense:

(14% x 5,000,000)
Note that the total warranty expense each year is 14% to be incurred over 2-year warranty period.
3. To record the actual warranty repairs:

Cash 140,000
2021
Cash 6,000,000
Sales 6,000,000
2. To record the warranty expense:

(14% x 6,000,000)
3. To record the actual warranty repairs:

Cash 300,000
At this point, on December 31, 2021, the estimated warranty liability is P1,100,000.
Warranty expense
2020 700,000
2021 840,000 1,540,000
Actual warranty repairs

2020 140,000
2021 300,000 440,000
Estimated warranty liability – December 31, 2021 1,100,000
Testing the accuracy of warranty liability
On December 31, 2021, the estimated warranty liability account may be analyzed based on the 4% and 10% estimate to
determine whether the actual warranty costs approximate the estimate.
Sales made evenly
To have an easier interpretation or understanding of sales accruing evenly during the year, it is fair to assume that half
of the sales were made on January 1 and the other half on July 1.
Thus, the first contract year under a 2-year warranty of the sales made on January 1, 2020 will be within January 1,
2020 to December 31, 2020, and the second contract year will be within January 1, 2021 to December 31, 2021.
The first contract year under a 2-year warranty of the sales made on July 1, 2020 will be within July 1, 2020 to June
30, 2021, and the second contract year will be within July 1, 2021 to June 30, 2022.
Computations
If sales and warranty repairs are made evenly during the year, the warranty expense for 2020 and 2021, and the
estimated warranty liability on December 31, 2021 are determined as follows:
Warranty expense related to 2020 sales
2020

First contract year of January 1, 2020 sales (2,500,000 x 4%) 100,000
First contract year of July 1, 2020 sales (2,500,000 x 4% x 6/12) 50,000
2021
Second contract year of January 1, 2020 sales (2,500,000 x 10%) 250,000
Second contract year of July 1, 2020 sales (2,500,000 x 10% x 6/12) 125,000
2022
Total warranty expense for 2020 700,000
Warranty expense related to 2021 sales
2021
First contract year of January 1, 2021 sales (3,000,000 x 4%) 120,000
2022
Second contract year of January 1, 2021 sales (3,000,000 x 10%) 300,000
2023
Total warranty expense for 2021 840,000
The warranty costs after December 31, 2021 represent the estimated warranty liability on December 31, 2021.
2020 sales still under warranty after December 31, 2021:
Second contract year of July 1, 2020 sales 125,000
2021 sales still under warranty after December 31, 2021:
First contract year of July 1, 2021 sales 60,000

Second contract year of January 1, 2021 sales 300,000
Second contract year of July 1, 2021 sales (150,000 + 150,000) 300,000
Estimated warranty liability – December 31, 2021 785,000
Estimated warranty liability per book 1,000,000
Decrease in warranty liability ( 315,000)
The decrease in warranty liability is an adjustment of the warranty expense of 2021.

Sale of warranty
A warranty is sometimes sold separately from the product sold. When products are sold, the customers are entitled to
the usual manufacturer’s warranty during a certain period.
However, the seller may offer an “extended warranty” on the product sold but with additional cost. The amount
received from the sale of the extended warranty is recognized initially as deferred revenue and subsequently amortized
using straight line over the life of the warranty contract.
Illustration
An entity sold product for P3,000,000. The regular warranty period for the product is two years. The entity sold an
additional warranty of two years at a cost of P60,000.
The sale is recorded as follows:

Cash 3,060,000
Sales 3,000,000
Unearned warranty revenue 60,000
The extended warranty contract starts only after the expiration of the regular two-year warranty period.
Accordingly, the unearned warranty revenue is amortized at the end of the third year as follows:
Unearned warranty revenue 30,000

Warranty revenue (60,000/2 years) 30,000
What is provision?
A provision is an existing liability of uncertain timing or uncertain amount. The essence of a provision is that there is
uncertainty about the timing or amount of the future expenditure. It is this uncertainty that distinguishes provision from
other liabilities.
The liability definitely exists at the end of reporting period but the amount is indefinite or the date when the obligation
is due is also indefinite, and in some cases, the payee cannot be identified or determined.
Actually, a provision may the equivalent of an estimated liability or a loss contingency that is accrued because it is both
probable and measurable.
Recognition of provision
PAS 37, paragraph 14, provides that a provision shall be recognized as a liability in the financial statements under the
following conditions:
1. The entity has a present obligation, legal or constructive, as a result of past event.
2. It is probable that an outflow of resources embodying economic benefits would be required to settle the
obligation.
3. The amount of the obligation can be measured reliably.
Present obligation
The present obligation may be legal or constructive.
A legal obligation is an obligation arising from a contract, legislation or other operation of law.
A constructive obligation exists when the entity from an established pattern of practice or stated policy has created a
valid expectation that it will accept certain responsibilities.
Past event
The past event that leads to a present obligation is called an obligating event.
An accounting provision cannot be created in anticipation of a future event.
The event must have already occurred which gives rise to the legal or constructive obligation.
An obligating event is an event that creates a legal or constructive obligation because the entity has no realistic
alternative but to settle the obligation created by the event.
Probable outflow of economic benefits
For a provision to qualify for recognition, there must be not only a present obligation but also a probable outflow of
resources embodying economic benefits to settle the obligation.
An outflow of resources is regard as “probable” if the event is more likely to occur, meaning that the probability that
the event will occur is greater than the probability that it will not occur. As a rule of thumb, “probable” means more
than 50% likely or substantially more.
Possible means 50% or less likely to occur.

Remote means 10% or less likely to occur or very slight occurrence.
Reliable estimate
Paragraph 25 of PAS 27 provides that the use of estimate is an essential part of the preparation of financial statements
and does not undermine their reliability.
This is especially true in the case of provision because by nature, a provision is more uncertain that items in the
statement of financial position.
The standard suggests that by using a range of possible outcomes, an entity usually would be able to make an estimate
of the obligation that is sufficiently reliable.
Where no reliable estimate can be made, no liability is recognized.
Measurement of provision
The amount recognized as a provision should be best estimate of the expenditure required to settle the present
obligation at the end of reporting period.
The best estimate is the amount that an entity would rationally pay to settle the obligation at the end of reporting period
or to transfer it to a third party at that time.
Where a single obligation is being measured, the individual most likely outcome adjusted for the effect of other
possible outcomes may be the best estimate.
Where there is a continuous range of possible outcomes and each point in that range is as likely as any other, the
midpoint of the range is used.
Where the provision being measured involves a large population of items, the obligation is estimated by “weighting” all
possible outcomes by their associated possibilities. The name for this statistical method of estimation is “expected
value”.
Illustration – “expected value” method
An entity sells goods with warranty under which customers are covered for the cost of repairs of any manufacturing
defects that become apparent within 6 months after purchase.
If minor defects are detected in all products sold, repair costs would be about P1,000,000. If major defects are detected
in all products sold, repair costs of P5,000,000 would result.
The entity’s past experience and future expectations indicate that 75% of the good sold will have no defects, 20% will
have minor defects and 5% will have major defects.
The expected value or cost of repairs is measured as follows:

75% sales None
20% sales (20% x 1,000,000) 200,000
5% sales (5% x 5,000,000) 250,000
Total expected value or cost of repairs 450,000
Other measurement consideration
1. Risks and uncertainties

2. Present value of obligation
3. Future events
4. Expected disposal of assets
5. Reimbursements
6. Changes in provision
7. Use of provision
8. Future operating losses
9. Onerous contract

Risk and uncertainties
The risks and uncertainties that inevitably surround events and circumstances shall be taken into account in reaching
the best estimate of a provision.
Risk describe variability of outcome. A risk adjustment may increase the amount at which a liability is measured.
Present value of obligation
Where the effect of the time value of money is material, the amount of provision shall be the present value of the
expenditure expected to settle the obligation.
In other words, the provision shall be discounted where the effect is material and shall not be discounted if the effect is
immaterial.
Future events
Future events that affect the amount required to settle an obligation shall reflected in the amount of a provision where
there is a sufficient evidence that they will occur.
Such future events include new legislation and changes in technology.
Expected disposal of assets
Gains from expected disposal of assets shall not be taken into account in measuring a provision. Instead, an entity shall
recognize gain on disposal at the time of the disposition of the assets.
In other words, any cash inflows from disposal are treated separately from the measurement of the provision.
Reimbursements
Where some or all of the expenditure required to settle a provision is expected to be reimbursed by another party, the
reimbursement shall be recognized when it is virtually certain that reimbursement would be received if the entity
settles the obligation.
The reimbursement shall be treated as a separate asset and not netted against the estimated liability for the provision.
The amount of reimbursement shall not exceed the amount of the provision. However, in the income statement, the
expense relating to the provision may be presented net of the reimbursement.
Change in provision
Provision shall be reviewed at every end of the reporting period and adjusted to reflect the current best estimate.
The provision shall be reversed if it is no longer probable that an outflow of economic benefits would be required to
settle the obligation.
Use of provision
A provision shall be used only for expenditures for which the provision was originally recognized.
Setting expenditures against a provision which was originally recognized for another purpose would conceal the impact
of two different events.
Future operating losses
Provision shall not be recognized for future operating losses.
This is explicitly prescribed by paragraph 63 of PAS 37 because operating losses do not meet the definition of a liability
and the general recognition criteria set forth for provision in the standard.

In other words, a provision for operating losses is not recognized because a past event creating a present obligation
has not occurred.
Onerous contract
If an entity has an onerous contract, the present obligation under the contract shall be recognized and measured as a
provision.
An onerous contract is a contract in which the unavoidable costs of meeting the obligation under the contract exceed
the economic benefits expected to be received under it.
PAS 37, paragraph 68, mandates that the unavoidable costs under a contract represent the “least net cost of exiting from
the contract”, which is the lower amount between the cost of fulfilling the contract and the compensation or penalty
arising from failure to fulfill the contract.
Examples of provision
1. Warranties – The best estimate of the warranty cost is recognized as a provision because in this case there is
clear legal obligation arising from an obligating event which is the sale of the product with warranty.
2. Environmental contamination – If an entity has an environmental policy such that other parties would expect
the entity to clean up any contamination, or if the entity has broken current environmental legislation then a
provision for environmental damage shall be made.
The obligating event is the contamination of the property which gives rise to constructive or legal obligation.
A provision is recognized for the best estimate of the cost of cleaning up the contamination.
3. Decommissioning or abandonment costs – When an oil entity initially purchase an oil field, it is put under a
legal obligation to decommission the site at the end of its life.
The costs of abandonment or decommissioning shall be recognized as a provision and may be capitalized as
cost of the oil field.
4. Court case – After a wedding in the current year, ten people died possibly as a result of food poisoning from
products sold by the entity, Legal proceedings are started seeking damages from the entity.
When the entity prepares the financial statements for the current year, its lawyers advice that owing to the
developments in the case, it is probable that the entity would be found liable.
A provision is recognized for the best estimate of the damages because on the basis of available evidence,
there is a present obligation.
5. Guarantee – In the year, an entity gives a guarantee of certain borrowings of another entity.
During the year, the financial condition of the borrower deteriorates and at year-end, the borrower files a
petition for bankruptcy.
A provision is recognized for the best estimate of the guarantee obligation because there is legal obligation
arising from the obligating event which is the guarantee and because there is petition for bankruptcy, it is
probable that an outflow of resources embodying economic benefits would be required to settle the guarantee
obligation.
Restructuring
PAS 37, paragraph 10, defines restructuring as a “program that is planned and controlled by management and
materially changes either the scope of a business of an entity or the manner in which that business is conducted”.
Events that may qualify as restructuring include:

a. Sale and termination of line of business

b. Closure of business location in a region or relocation of business activities from one location to another or
relocation of headquarters from one country to another.
c. Change in management structure, such as elimination of a layer of management or making all functional units
autonomous.
d. Fundamental reorganization of an entity that has a material and significant impact on it operations.
Provision for restructuring
Recognition of the provision for restructuring is required because a constructive may arise from the decision to
restructure. A constructive obligation for restructuring arises when two conditions are present:
1. The entity has a detailed formal plan for the restructuring outlining at least the business or part of the business
being restructure, the principal location affected, the location, function and approximate number of employees
who will be compensated for terminating their employment, when the plan will be implemented, and the
expenditures that will be undertaken.
2. The entity has raised valid expectation in the minds of those affected that the entity will carry out the
restructuring by starting to implement the plan and announcing its main features to those affected by it.
Amount of restructuring provision
A restructuring provision shall include only direct expenditures arising from the restructuring.
These expenditures that are necessarily incurred for the restructuring and not associated with the ongoing activities of
the entity.
For example, salaries and benefit of employees to be incurred after operations cease and that are associated with the
closure of the operations shall be included in the amount of the restructuring provision.
PAS 37, paragraph 81, specifically excludes the following expenditures from the restructuring provision:
a. Cost of restraining or relocating continuing staff.
b. Marketing or advertising program to promote the new company image.
c. Investment in new system and distribution network.
Such expenditures are categorically disallowed as restructuring provisions because these are considered to be expenses
relating to the future conduct of the business of the entity, and thus are not liabilities relating to the restructuring
program.
Contingent liability
PAS 37, paragraph 10, defines a contingent liability in two ways:
A contingent liability is a possible obligation that arises from past event and whose existence will be confirmed only by
the occurrence or nonoccurrence of one or more uncertain future events not wholly within the control of the entity.
A contingent liability is a present obligation that arises from past event but is not recognized because it is not probable
that an outflow of resources embodying economic benefits will be required to settle the obligation or the amount of the
obligation cannot be measured reliably.
The present obligation is either probable or measurable but not both to be considered a contingent liability. If the
present obligation is probable and the amount can be measured reliably, the obligation is not a contingent liability but
shall be recognized as a provision.
Treatment of contingent liability

A contingent liability shall not be recognized in the financial statement but shall be disclosed only. The required
disclosures are:
a. Brief description of the nature of the continent liability.
b. An estimate of its financial effects.
c. An indication of the uncertainties that exist.
d. Possibility of any reimbursement.

If a contingent liability is remote, no disclosure is necessary.
Contingent asset
PAS 37, paragraph 10, defines contingent asset as “possible asset that arises from past event and whose existence will
be confirmed only the occurrence or nonoccurrence of one or more uncertain future events not wholly within the
control of the entity”.
A contingent asset shall not be recognized because this may result to recognition of income that may never be realized.
However, when the realization of income is virtually certain, the related asset is no longer contingent asset and its
recognition is appropriate.
A contingent asset is only disclose when it is probable. The disclosure includes a brief description of the contingent
asset and an estimate of its financial effects.
If a contingent asset is only possible or remote, no disclosure is required.
Decommissioning liability
A decommissioning liability is an obligation to dismantle, remove and restore an item of property, plant and
equipment as required by law or contract.
A decommissioning liability is also called asset retirement obligation.
Illustration
An entity extracts natural gas and oil in the Philippine Deep.
On January 1, 2020, the entity constructed a drilling platform for P25,000,000 and is required by Philippine law to
remove and dismantle the platform at the end of its useful life of 10 years.
The straight line method is used in depreciating the drilling platform.
The entity has estimated that such decommissioning will cost P5,000,000. Based on a 12% discount rate, the present
value of 1 for 10 years is 0.322
Thus, the present value of the decommissioning liability is P5,000,000 times 0.322 or P1,610,000.
The decommissioning liability is initially recognized at present value and included in the cost of the related asset.
Journal entries for 2020 and 2021

2020
Jan. 1 Drilling platform 26,610,000
Cash 25,000,000
Decommissioning liability 1,610,000
Dec. 31 Depreciation 2,661,000

Accumulated depreciation 2,661,000
(26,610,000/10 years)
Dec. 31 Interest expense 193,200

Decommissioning liability 193,200
2021
Dec. 31 Depreciation 2,661,000

Decommissioning liability – January 1, 2020 1,610,000

Interest expense for 2020 193,200
Carrying amount – December 31, 2020 1,803,200
Interest expense for 2021 (12% x 1,803,200) 216,384
Settlement of decommissioning liability
On December 31, 2029, after 10 years, the entity contracted with another entity to dismantle and remove the drilling
platform for P5,500,000.
The journal entry to record the settlement of the decommissioning liability is:
Decommissioning liability 5,000,000

Loss on settlement of decommissioning liability 500,000
Cash 5,500,000
On January 1, 2020, the decommissioning liability is P1,610,000. This amount plus 12% interest compounded annually
will build up to P5,000,000 after 10 years on December 31, 2029. Thus, the decommissioning liability is debited at
P5,000,000.
The journal entry to recognize the carrying amount of the drilling platform on December 31, 2029 is:

Drilling platform 26,610,000
Change in decommissioning liability

Under IFRIC 1, changes in the measurement of an existing decommissioning liability shall be accounted for as follows:
1. A decrease in the liability is deducted from the cist of the asset.
If the decrease in liability exceeds the carrying amount, the excess is recognized in profit or loss.
2. An increase in liability is added to the cost at the asset.
However, the entity shall consider whether this is an indication that the carrying amount of the asset may not be
fully recoverable. If there is such an indication, the asset should be tested for impairment.
Illustration
On January 1, 2020, the plant of Seaoil Company is 10 years old. The cost of the plant is P12,000,000 with
accumulated depreciation of P4,000,000. The plant has a useful life of 30 years and was depreciated using the straight
line with no residual value.
Because of the unwinding discount of 6% over 10 years, the decommissioning liability has grown from P1,000,000 to
P1,790,000. On January 1, 2020, the discount rate has not changed.
However, the entity has estimated that as a result of technological advances, the net present value of the
decommissioning liability has decreased by P800,000.
Journal entries for 2020

Jan. 1 Decommissioning liability 800,000
Plant asset 800,000
Dec. 31 Depreciation Accumulated depreciation 360,000

Accumulated depreciation 360,000
Cost of plant 12,000,000

Reduction of decommissioning ( 800,000)
Net cost 11,200,000
Accumulated depreciation ( 4,000,000)
Carrying amount 7,200,000

Depreciation for 2020 (7,200,000/ 20 years) 360,000

Decommissioning liability – January 1, 2020 1,790,000

Reduction ( 800,000)
Adjusted carrying amount – January 1, 2020 990,000
Interest expense for 2020 (6% x 990,000) 59,400
Post Test
Multiple Choice (Easy). Encircle the letter of the best answer.
1. The accrual approach in accounting for warranty

a. Is required for income tax reporting.
b. Is frequently justified on the basis of expediency.
c. Finds the expense account being charged when the seller performs in compliance with the warranty.
d. Represents accepted practice and should be used whenever the warranty is an integral and inseparable part
of the sale.
2. Which of the following best describes the accrual approach of accounting for warranty cost?
a. Expensed when paid
b. Expensed when warranty claims are certain
c. Expensed based on estimate in ear of sale
3. Which of the following best describes the expense as incurred as incurred approach of accounting for
warranty cost?
a. Expensed based on estimate in year of sale
b. Expensed when liability is accrued
c. Expensed when warranty claims are certain
4. Which is the correct definition of a provision?

a. A possible obligation arising from past events
b. A liability of uncertain timing or uncertain amount
c. A liability which cannot be easily measured
d. An obligation to transfer funds to an entity
5. It is an event that crates a legal or constructive obligation because the entity has no other realistic alternative but
to settle the obligation.
a. Obligation event
b. Past event
c. Subsequent event
d. Current event
6. Wall Company sold a product under a two-year warranty. The estimated cost of warranty repairs is 2% of net
sales.
During the first two years in business, the entity made the following sales and incurred the following warranty
repair code.
2018 2019

Net Sales 2,500,000 3,000,000
Total repair costs incurred 45,000 50,000
What amount should be reported as warranty expense for 2019?

a. 60,000
b. 50,000
c. 10,000
d. 59,000
7. Bass Company manufactures high-end home electronic systems. The entity provides a one-year warranty for
all products sold.
The entity estimated that the warranty cost is P200 per unit sold and reported a liability for estimated warranty
cost of P650,000 at the beginning of the year.
During the current year, the entity sold 5,000 units for a total of P9,000,000 and paid warranty claims of
P750,000 on current and prior year sales.
What is the warranty liability at year-end?

a. 250,000
b. 350,000
c. 900,000
d. 750,000
8. Toyo Company owns a car dealership that it uses for servicing cars under warranty. The entity sold 500 cars
during the year.
The entity’s experience with warranty claims is that 60% of all cars sold in a year have zero defect, 25% of all
cars sold in a year have normal defect, and 15% of all cars sold in a year have significant defect.
The cost of rectifying a “normal defect” in a car is P10,000. The cost of rectifying a “significant defect” in a
car is P30,000.
What is the “expected value” of the provision for warranty for the current year?
a. 3,500,000
b. 1,750,000
c. 1,400,000
d. 4,000,000
9. Chato Company sold electrical goods covered by a one-year warranty for any defect. Of the sales of
P70,000,000 for the year, the entity estimated that 3% will have a major defect, 5% will have minor defect and
92% will have no defect.
The cost of repairs would be P5,000,000 if all the products sold has a major defect and P3,000,000 if all had
minor defect.
What amount should be recognized as a warranty provision?

a. 8,000,000
b. 5,600,000
c. 300,000
d. 190,000

10. During 2018, Manfred Company guaranteed a supplier’s P500,000 loan from a bank. On October 1, 2018, the
entity was notified that the supplier had defaulted on the loan and filed for bankruptcy protection. Counsel
believed that the entity would probably have to pay P250,000 under the guarantee.
As a result of the supplier’s bankruptcy, the entity entered into a contract in December 2018 to retool its
machines so that the entity could accept part from other suppliers. Retooling costs estimated to be P300,000.
What amount should be reported as liability on December 31, 2018?

a. 250,000
b. 450,000
c. 550,000
d. 750,000
11. On February 5, 2019, an employee filed a P2,000,000 lawsuit against Steel Company for damages suffered
when one of Steel’s plant exploded on December 29, 2018.
The legal counsel believed the entity would probably lose the lawsuit and estimated the loss to be P500,000.
The employer offered to settle the lawsuit out of court for P900,000 but the entity did not agree to the
settlement.
On December 31, 2018, what amount should be reported as liability from lawsuit?
a. 2,000,000
b. 1,000,000
c. 900,000
d. 500,000
12. During 2018, Beal Company became involved in a tax dispute with the BIR. On December 31, 2018, the tax
advisor believed that an unfavorable outcome was probable and a reasonable estimate of additional taxes was
P500,000.
After the 2018 financial statements were issued, the entity received and accepted a BIR settlement of P50,000.
What amount of accrued liability should have been reported on December 31, 2018?
a. 650,000
b. 550,000
c. 500,000
d. 0
13. Nia Company is involved in litigation regarding a faulty product sold in prior year. The entity has consulted
with an attorney and determined that it is possible that the entity may lose the case.
The attorney estimated that there is 40% chance of losing. If this is the case, the attorney estimated that the
amount of any payment would be P5,000,000.
What is the required journal entry as a result of this litigation?

Debit litigation expense and credit litigation liability P5,000,000.
No journal entry is required.
14. On November 5, 2018, a Dunn Company truck was in an accident with an auto driven by Bell. Dunn received
notice on January 15, 2019 of a lawsuit for P700,000 damages for personal injuries suffered by Bell.

The entity’s counsel believed it is probable that Bell will be awarded an estimated amount in the range
between P200,000 and P450,000 and no amount is a better estimate of potential liability than any other
amount because each point in the range is as likely as any other.
The 2018 financial statements were issued on March 1, 2019.
What amount of loss should be accrued on December 31, 2018?

a. 450,000
b. 200,000
c. 325,000
d. 0
15. Winter Company is being sued for illness caused to local residents as a result of negligence on the entity’s part
in permitting the local residents to be exposed to highly toxic chemicals from its plant.
The entity’s lawyer stated that it is probable that the entity would lose the suit and be found liable for a
judgment costing the entity anywhere from P1,200,000 to P6,000,000. However, the lawyer estimated that the
most probable cost is P3,600,000.
What amount should be accrued and disclosed.

a. Accrue a loss contingency of P1,200,000 and disclose an additional contingency of P4,800,000.
b. Accrue a loss contingency of P3,600,000 and disclose an additional contingency of P2,400,000.
c. Accrue a loss contingency of P3,600,000 but not disclose any additional contingency.
d. No loss accrual but disclose a contingency of P1,200,000 to P6,000,000.
PROBLEM SOLVING – AVERAGE
Problem 1
Socorro Company sells color television sets with a two-year repair warranty. The sale price for each set id P15,000.
The average repair cost per set is P800.
Research has shown that 20% of all sets sold are repaired in the first year and 40% in the second year.
2020 2021
Number of sets sold 300 500
Total payments for warranty repairs 40,000 150,000
Required:
1. Prepare journal entries in connection with the warranty using the “expense as incurred” approach.
2. Prepare journal entries in connection with the warranty using the “accrual” approach.
Problem 2
Bizarre Company gives warranties at the time of sale to purchasers of its product. The entity undertakes to make good,
by repair or replacement, manufacturing defects that become apparent within one year from the date of sale. Sales of
P10,000,000 were made evenly throughout 2018.
The expenditures for warranty repairs and replacements for the products sold in 2018 are expected to be made 50% in
2018 and 50% in 2019.
The 2019 outflows of economic benefits related to the warranty will take place on June 30, 2018.

The entity estimates that 95% of products sold require no warranty repairs, 3% of the products sold require minor
repairs costing 10% of the sale price, and 2% of the products sold require major repairs or replacement costing 90% of
sale price.
The appropriate discount factor for cash flows expected to occur on June 30, 2019 is 0.95.
An appropriate risk adjustment factor reflected the uncertainties in the cash flow estimates is an increment of 6% to the
probability-weighted expected cash flows.
What is the warranty liability on December 31, 2018?
Problem 3
Mill Company sells washing machines that carry a three-year warranty against manufacturer’s defects.
Based on the entity’s experience, warranty costs are estimated at P300 per machine.
During the current year, the entity sold 2,400 washing machines and paid warranty costs of P170,000.
Requirement:
a. What amount should be reported as warranty expense for the year?
b. What amount should be reported as warranty liability at year-end?
Problem 4
On March 1, 2018, a suit was filed against Dean Company for patent infringement, Dean’s legal counsel believed an
unfavorable outcome is probable and estimated that Dean will have to pay between P850,000 and P900,000 in
damages.
However, Dean’s legal counsel is of the opinion that P600,000 is a better estimate than any other amount in the range.
The situation was unchanged when the December 31, 2018 financial statements were released on February 15, 2019.
What amount should be accrued as liability on December 31, 2018 in connection with this suit?
Problem 5
On November 25, 2018, an explosion occurred at a Rex Company plant causing extensive property damage to area
buildings. By March 10, 2019, claims had been asserted against the entity.
The management and counsel concluded that it is probable that the entity would be responsible for damages, and that
P3,500,000 is a reasonable estimate of the liability.
Rex’s P10,000,000 comprehensive public liability policy has a P500,000 deductible clause. The financial statements
were issued on March 31, 2019.
Requirement:
a. What amount of loss from lawsuit should be reported for 2018?
b. What amount of liability from lawsuit should be reported on December 31, 2018?
Problem 6
Tone Company is the defendant in a lawsuit filed by Witt in 2018 disputing the validity of copyright held by Tone.
On December 31, 2018, Tone determined that Witt would probably be successful against Tone for an estimated amount
of P400,000.

Appropriately, a P400,000 loss was accrued by a charge to income for the year ended December 31, 2018.
On December 31, 2019, Tone and Witt agreed to a settlement providing for each cash payment of P250,000 by Tone to
Witt, and transfer of Tone’s copyright to Witt.
The carrying amount of the copyright on Tone’s accounting records was P50,000 on December 31, 2019.
What amount would be the effect of the settlement on Tone’s income before tax in 2019?
PROBLEM SOLVING – DIFFICULT
Problem 1
Bold Company estimated annual warranty expense at 2% of annual net sales. The net sales for 2018 amounted to
P4,000,000.
On January 1, 2018, the warranty liability was P60,000 and the warranty payments during 2018 totaled P50,000.
Requirement:
a. What is the warranty expense for 2018?
b. What is the warranty liability on December 31, 2018?
Problem 2
In 2018, Dubious Company began selling new line of products that carry a two0year warranty against defects.
Based upon past experience with other products, the entity estimated warranty costs as a percentage of peso sales.
First year of warranty 2%

Second year of warranty 5%
2018 2019
Sales 5,000,000 7,000,000
Actual warranty cost 100,000 300,000
Requirement:
b. What is the warranty liability on December 31, 2018?
c. What is the warranty expense for 2019?
d. What is the warranty liability on December 31, 2019?
Problem 3
During 2018, Namnama Company introduced a new product carrying a two-year warranty against defects.
The estimated warranty costs related to peso sales are 45 within 12 months following sale and 6% in the second 12
months following sale.
The entity reported sales of P5,000,000 for 2018 and P6,000,000 for 2019.
The actual expenditures incurred amounted to P150,000 for 2018 and P550,000 for 2019.
Requirement:
b. What is the estimated warranty liability on December 31, 2018?
c. What is the warranty expense for 2019?

d. What is the estimated warranty liability on December 31, 2019?
Problem 4
Toy Company provided the following facts regarding pending litigation on December 31, 2018:
 The entity is defending against a first lawsuit and believes there is a 51% chance it will lose in court. The
entity estimates that damages will be P1,000,000.
 The entity is defending against a second lawsuit for which management believes it is virtually certain to lose
in court. If it loses the lawsuit, management estimates that damages will fall somewhere in the range of
P3,000,000 to P5,000,000 with each amount in the range equally likely to occur.
 The entity is defending against a third lawsuit but te relevant loss will only occur far into the future. The
present value of the endpoints of the range are P1,500,000 and P2,500,000/
The management believes the effects of time value of money on these amounts are material.
 The entity is defending against a fourth lawsuit and believes there is only 25% chance it will lose in court. If
the entity loses, management believes damages will fall somewhere in the range of P3,000,000 to P4,000,000
with each amount in the range equally likely to occur.
What total amount should be reported as accrued litigation liability on December 31, 2018?
Problem 5
Western Company provided the following selected transactions related to contingencies. The fiscal year ends on
December 31, 2018. Financial statements are issued on April 1, 2019.
 In December 2018, Western became aware of an engineering flaw in a product that poses a potential risk of
injury.
As a result, a product recall appears inevitable. This move would likely to cost the entity P1,500,000.
 IN November 2018, the City of Manila filed suit against Western asking civil penalties and injunctive relief
for violations of clean water laws. Western reach a settlement with the city government to pat P4,200,000 in
penalties on February 15, 2019.
 Western is the plaintiff in a P4,000,000 lawsuit filed against a customer for costs and lost profit from contract
rejected in 2018.
The lawsuit is in final appeal and attorney advised that it is virtually certain that Western will be awarded
P3,000,000.
Requirement:
a. What is the accrued liability on December 31, 2018?
b. What amount should be reported as gain from lawsuit in 2018?
Problem 6
During 2018, Odyssey Company is the defendant in a patent infringement lawsuit. The entity’s lawyers believe there is
a 30% chance that the court will dismiss the case and the entity will incur no outflow of economic benefits.
However, if the court rules in favor of the claimant, the lawyers believe that there is a 20% chance that the entity will
be required to pay damages of P200,000 and an 80% chance that the entity will be required to pay damages of
P100,000. Other outcomes are unlikely.
The court expected to rule in late December 2019. There is no indication that the claimant will settle out of court.
A 7% risk adjustment factor to the probability-weighted expected cash flows is considered appropriate to reflect the
uncertainties in the cash flow estimates.
An appropriate discount rate is 5% per year. The present value of 1 at 5% for one period is 0.95.
What is the measurement of the provision for lawsuit?

References
Valix, C. & Valix, C.A. (2018). Practical Accounting 1 vol 2. GIC Enterprises and Co., Inc. Manila, Philippines
Valix, C. & Valix, C.A. (2013). Theory of Accounts 2013 edition. GIC Enterprises and Co., Inc. Manila, Philippines
Valix, C. Valix, C.A. (2019). Financial Accounting and Reporting vol 2. GIC Enterprises and Co., Inc. Manila,
Philippines
Robles, N. & Empleo P. (2016). The Intermediate Accounting Series Vol 2. Millenium Books, Inc., Mandaluyong City
Uberita, C. (2012). Practical Accounting 1 2013 Edition. GIC Enterprises and Co, Inc. Manila, Philippines
Testbanks and CPA Examination Reviewers
–End-

Module 2-WARRANTY LIABILITY and PROVISION AND CONTINGENT LIABILITY

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Module 2-WARRANTY LIABILITY and PROVISION AND CONTINGENT LIABILITY

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NEW BRIGHTON SCHOOL OF THE PHILIPPINES, Inx`C.

PRETEST. Encircle the letter of the best answer.

4. Which is the correct definition of a provision?

Recognition of warranty provision

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 1

Probable outflow resources

Where no reliable estimate can be made, no warranty liability is recognized.

Accounting for warranty

Estimated warranty liability xx

Estimated warranty liability xx

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 2

2. To set up the estimated liability on the warranty:

Warranty expense 300,000

Estimated sets to be returned (60% x 1,000) 600 sets

3. To record the payment of the actual cost:

Estimated warranty liability 180,000

Expense as incurred approach

First year of warranty 4%

2. To record the warranty expense:

Warranty expense 700,000

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 3

3. To record the actual warranty repairs:

Estimated warranty liability 140,000

2. To record the warranty expense:

Warranty expense 840,000

3. To record the actual warranty repairs:

Estimated warranty liability 300,000

Actual warranty repairs

Testing the accuracy of warranty liability

Sales made evenly

Warranty expense related to 2020 sales

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 4

Warranty expense related to 2021 sales

2020 sales still under warranty after December 31, 2021:

Second contract year of July 1, 2020 sales 125,000

2021 sales still under warranty after December 31, 2021:

First contract year of July 1, 2021 sales 60,000

The decrease in warranty liability is an adjustment of the warranty expense of 2021.

Estimated warranty liability 315,000

The sale is recorded as follows:

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 5

Unearned warranty revenue 30,000

An accounting provision cannot be created in anticipation of a future event.

Probable outflow of economic benefits

Possible means 50% or less likely to occur.

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 6

Where no reliable estimate can be made, no liability is recognized.

Illustration – “expected value” method

The expected value or cost of repairs is measured as follows:

Other measurement consideration

1. Risks and uncertainties

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 7

Present value of obligation

Such future events include new legislation and changes in technology.

Expected disposal of assets

Future operating losses

Provision shall not be recognized for future operating losses.

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 8

Events that may qualify as restructuring include:

Module for Intermediate Accounting 2, Jonard S. Baloyo, CPA Page 9

Provision for restructuring

Amount of restructuring provision

PAS 37, paragraph 10, defines a contingent liability in two ways: