Learning Resource 1, Liabilities Lesson 3, Warranty Liability

Learning Resource 1: Liabilities

Lesson 3
WARRANTY LIABILITY

Learning Outcomes:

At the end of this lesson, the students shall be able to:

a. Explain the various concepts pertaining to warranty liability;
b. Demonstrate understanding of the concepts by applying them in solving related
problems;
c. Analyze crucial situations besetting the rigor in solving related problems; and
d. Check on the accuracy of solutions through the concepts and principles applicable to
warranty liability.

Activity 1
Discussion of Accounting Principles

1. Warranty or guarantee is a privilege granted to buyers of appliances to enjoy free repair

service or replacement during a specified period if the products are defective (e.g.,
television sets, refrigerator, etc.).

2. Recognition of Warranty Provision (PAS 37, paragraph 14)

The principle 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.
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 or the obligating event must have occurred. The obligating event is
represented by the sale of the product which gives rise to a constructive obligation.

Probable flow of resources is represented by the resources embodying economic benefit

in settlement of some claims against the warranty.

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.

3. Accounting for Warranty

a. Accrual approach
b. Expense as incurred approach

4. Accrual Approach
It has the soundest theoretical support because it properly matches cost with revenue.

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Learning Resource 1, Liabilities Lesson 3, Warranty Liability

The estimated warranty cost is recorded as follows:

Warranty expense xx
Estimated warranty liability xx

When actual warranty cost is subsequently incurred and paid, it is recorded as:

Estimated warranty liability xx

Cash xx

Any difference between estimate and actual cost is a change in estimate; thus, treated
currently or prospectively, if necessary.

If the actual cost exceeds the estimate, the difference is charged to warranty expense
as follows:

Warranty expense xx
Estimated warranty liability xx

If the actual cost is less than the estimate, the difference is an adjustment to warranty
expense as follows:

Estimated warranty liability xx

Warranty expense` xx

5. Expense as Incurred Approach

This is the approach of expensing warranty cost only when actually incurred.

This approach is justified on the basis of expediency when warranty cost is not very
substantial or when the warranty period is relatively short.

6. Sale of Warranty
a. A warranty is sometimes sold separately from the product sold.
b. When the products are sold, the customers are entitled to the usual manufacturer’s
warranty during a certain period.
c. The seller may offer an “extended warranty” on the product sold but with additional
cost. In this case, the sale of the product with usual warranty is recorded separately
from the sale of the extended warranty.
d. 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.
e. If costs are expected to be incurred in performing services under the extended
warranty contract, revenue is recognized in proportion to the costs to be incurred
annually.

Activity 2
Application Exercises

You are provided with exercises that will demonstrate the application of the accounting
principles discussed for warranty liability; and, thereby come up with an appropriate analysis
to be able to solve the exercises correctly and accurately.

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Learning Resource 1, Liabilities Lesson 3, Warranty Liability

Exercise L3.1
An entity sells 500 units of television sets at P18,000 each for cash. Each TV set is under
warranty for one year.

The entity has estimated from past experience that warranty cost will probably average P600
per unit and that only 60% of the units sold will be returned for repair.

The entity incurs P90,000 for repairs during the year.

Required:
Prepare journal entries to record the sales, to set up the estimated liability on the warranty,
and to record payment of the actual cost:

Solution to Exercise L3.1

1. To record sales:
Cash 9,000,000
Sales 9,000,000

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

Warranty expense 180,000
Estimated warranty liability 180,000

Estimated sets to be returned (60% x 500) 300 sets

Multiply by estimated warranty cost per set 600
Estimated warranty cost 180,000

3. To record the payment of the actual cost:

Estimated warranty liability 90,000
Cash 90,000

 The statement of financial position at the end of the year would report estimated warranty liability
of P90,000 as a current liability.
 The income statement for the year woud show warranty expense of P180,000.
 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.
Therefore, the warranty cost expected to be incurred within one year is classified as current and the
balance as noncurrent.

Exercise L3.2
An entity sells air conditioning units that a 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 2,500,000 3,000,000
Actual warranty repairs 70,000 150,000

Required:
Prepare journal entries for 2020 and 2021 using the expense as incurred approach.

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Learning Resource 1, Liabilities Lesson 3, Warranty Liability

Solution to L3.2
Journal Entries – 2020
1. To record the sales:
Cash 2,500,000
Sales 2,500,000

2. To record the warranty expense:

Warranty expense 350,000
Estimated warranty liability 350,000
(14% x 2,500,000)

Note: The total warranty expense each year is 14% to be incurred over a 2-year
warranty period.

3. To record the actual warranty repairs:

Estimated warranty liability 70,000
Cash 70,000

Journal Entries – 2021

1. To record the sales:
Cash 3,000,000
Sales 3,000,000

2. To record the warranty expense:

Warranty expense 420,000
Estimated warranty liability 420,000
(14% x 3,000,000)

3. To record the actual warranty repairs:

Estimated warranty liability 150,000
Cash 150,000

At this time – December 31, 2021 - end of the accounting period, the estimated warranty
liability is

Warranty expense:
2020 350,000
2021 420,000 770,000

Actual warranty repairs:

2020 70,000
2021 150,000 220,000
Estimated warranty liability – December 31, 2021 550,000

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.

Hence, 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.

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Learning Resource 1, Liabilities Lesson 3, Warranty Liability

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 (1,250,000 x 4%) 50,000
First contract year of July 1, 2020 sales (1,250,000 x 4% x 6/12) 25,000

2021
First contract year of July 1, 2020 sales (1,250,000 x 4% x 6/12) 25,000
Second contract year of January 1, 2020 sales (1,250,000 x 10%) 125,000
Second contract year of July 1, 2020 sales (1,250,000 x 10% x 6/12) 62,500

2022
Second contract year of July 1, 2020 sales (1,250,000 x 10% x 6/12) 62,500

Total warranty expense for 2020 350,000

Warranty expense related to 2021 sales

2021
First contract year of January 1, 2021 sales (1,500,000 x 4%) 60,000
First contract year of January 1, 2021 sales (1,500,000 x 4% x 6/12) 30,000

2022
First contract year of July 1, 2021 sales (1,500,000 x 4% x 6/12) 30,000
Second contract year of January 1, 2021 sales (1,500,000 x 10%) 150,000
Second contract year of July 1, 2021 sales (1,500,000 x 10% x 6/12) 75,000

2023
Second contract year of July 1, 2021 sales (1,500,000 x 10% x 6/12) 75,000

Total warranty expense for 2021 420,000

The warranty costs after December 31, 2021 represent the estimated warranty liability on December
31, 2021.

2020 sales still under warranty after December 31, 2020:

Second contract year of July 1, 2020 sales (1,250,000 x 10% x 6/12) 62,500

2021 sales still under warranty after December 31, 2021:

First contract year of July 1, 2021 sales (1,500,000 x 4% x 6/12) 30,000
Second contract year of January 1, 2021 sales (1,500,000 x 10%) 150,000
Second contract year of July 1, 2021 sales (75,000 + 75,000) 150,000

Estimated warranty liability – December 31, 2021 392,500

Estimated liability per book 550,000
Decrease in warranty liability (157,500)

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

Estimated warranty liability 157,500

Warranty expense 157,500

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Learning Resource 1, Liabilities Lesson 3, Warranty Liability

Exercise L3.3
An entity sold a product for P6,000,000. The regular warranty period for the product is two
years. The entity sold an additional warranty of two years at a cost of P120,000.

Required: Journal entries to record the sales, and the amortization of the unearned warranty
revenue.

Solution to Exercise L3.3

1. To record the sales:
Cash 6,120,000
Sales 6,000,000
Unearned warranty revenue 120,000

The extended warranty contract starts only after the expiration of the regular two-year warranty
period.

2. If the costs are incurred evenly, the unearned warranty revenue is amortized at the end of the
third year, as follows:

Unearned warranty revenue 60,000

Warranty revenue (120,000/ 2 years) 60,000

Activity 3
Evaluation Exercises

General Instructions: You are required to provide solutions/answers to the following

exercises. Supporting computations which are presented in good form shall be part of all
solutions. Answers/solutions to these exercises are to be submitted to the Professor through
her e-mail address or may be sent to her office/home, whichever is convenient. Please take
note of the deadline of submission which will be communicated to all concerned students.

Answers/solutions to these evaluation exercises are withheld by the professor for control
purposes; however, such are available upon request.

A. Theoretical Exercises

Choose the correct answer by writing the corresponding letter-answer and a convincing
justification it is indeed the correct answer. However, an explanation shall be made as well
to the other possible answers which were not chosen. Briefly explain or provide justifiable
reason/s via applicable appropriate accounting principles discussed in Activity 1.

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. Expense when paid.
b. Expensed when warranty claims are certain.

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c. Expensed based on estimate in year of sale.

d. Expensed when incurred.

3. Which of the following best describes the expense 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
d. Expensed when incurred

4. What is the classification of the estimated warranty liability in a three-year warranty?

a. Noncurrent c. Partly current and partly noncurrent
b. Current d. No need for disclosure

5. Which of the following is a characteristic of the accrual of warranty but not the sale of
warranty?
a. Warranty liability c. Unearned warranty revenue
b. Warranty expense d. Warranty revenue

B. Practical Exercises

Solve the following problems with supporting computations presented in good form:

1. Sunday Company sells color television sets with a two-year repair warranty. The sale
price for each set is P15,000. The average repair cost per set a 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:
a. Prepare journal entries in connection with the warranty using the “expense as
incurred” approach.
b. Prepare journal entries in connection with the warranty using the “accrual” approach.
c. Determine the estimated warranty liability on December 31, 2021.
d. Analyze the estimated warranty liability account to ascertain whether actual warranty
costs approximate the estimate. The sales and warranty repairs are made evenly
during the year.
e. Prepare journal entry to correct the estimated warranty liability on December 31,
2021.

2. In 2020, Monday Company began selling a new calculator that carried a two-year
warranty against defects. The entity projected the estimated warranty cost as a percent
of sales.

First year warranty 4%

Second year warranty 10%

Sales and actual warranty repairs were:

2020 2021
Sales 5,000,000 9,000,000
Actual warranty repairs 200,000 560,000

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Learning Resource 1, Liabilities Lesson 3, Warranty Liability

Required:
a. Prepare journal entries in connection with the warranty using the expense as incurred
approach.
b. Prepare journal entries in connection with the warranty using the accrual approach.
c. Determine the estimated warranty liability on December 31, 2021.
d. Analyze the estimated warranty liability account to ascertain if adjustment is
necessary. The sales and warranty repairs are made evenly during the year.
e. Prepare the adjustment to correct the estimated warranty liability on December 31,
2021.

3. Tuesday Company sells an electric timer that carries a 90-day unconditional warranty
against product failure. The warranty costs of known failures have already been reflected
in the records.

Based on a reliable statistical analysis, 2% of units sold will require an average cost of
P150 per unit.

October November December

Units sold 32,000 28,000 40,000
Known product failures from
sales of:
October 160 320 160
November 80 280
December 180

Required:
Prepare a journal entry to record the estimated liability for warranty on December 31.

4. Wednesday Company sells televisions at an average price of P9,000 and also offers a
separate three-year warranty contract for P900 that requires the entity to perform
periodic services and replace defective parts.

During 2020, the entity sold 300 television sets and 270 extended warranty contracts for
cash.

The entity estimated the three-year warranty cost as P200 for parts and P400 for labor
and accounts for the sale of warranty separately.

The sale occurred on December 31, 2020. The entity recognized income from the sale
of warranty on a straight line basis.

In 2021, the entity incurred actual cost relative to the warranty of P20,000 for parts and
P40,000 for labor.

Required:
a. Prepare journal entries in 2020 and 2021.
b. How is the unearned revenue from warranty contracts presented on December 31,
2021?

*****

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