Warranties…When to “expense”? General Principle

Warranties…When to “expense”? General Principle

According to GAAP, the entire estimated warranty expense must be recorded in the period the sale is made, NOT in the period when the actual warranty cost is paid. (Matching principle is being followed.)

A warranty liability is recorded along with the expense. This liability is REDUCED whenever cash is paid to service a product still under warranty.

(Accrual Accounting—NOT Cash Basis Accounting—impacting the Income Statement & Balance Sheet)

Illustration of Warranty Accounting

We are going to do the example for Cell-it on the following slides

Transaction AnalysisTransaction Analysis

The following selected events occurred at Cell-It. (Perpetual inventory method is used.)

1. On 1/1/04 sold merchandise for $5,000 cash that

had originally cost $4,000. These goods were sold with a two-year warranty.2. On 1/1/04 Estimated that $100 of warranty cost

will be incurred over the next two years on the goods sold in #1.

3. During 2005 a customer returned for repair, goods

still under warranty. The cost of the repair was $30 cash.

Transactions Posted to T-accounts Transactions Posted to T-accounts 1. In 2004, sold for $5000 cash (1A), units costing $4000 (1B).

Cash

Bal. X 30 (3) (1A) 5,000

Inventory

Bal. X 4,000 (1B)

Warranty Payable

(3) 30 100 (2)

Sales Revenue

5,000 (1A)

Cost of Goods Sold

(1B) 4,000

Warranty Expense

(2) 100

2. At time of sale in 2004, estimated $100 warranty cost over two years. 3. During 2005, paid $30 cash to repair units sold in 2004.

Entries (not shown here) to close Sales, Cost of Goods Sold, and Warranty Expense to Retained Earnings would have been made at the end of 2004.

Notes Payable & Interest Example

Exercise #8-14A (page 387): “Regular” Single Payment Note “Discounted Note” (“non-interest

bearing”)

Link to Excel Spreadsheet—among files downloaded at beginning of course!‘Avi’ file for Notes Payable (Ex.8-14A is available)

Accounts Receivable Ratios Accounts Receivable Ratios (Do NOT (Do NOT follow method used on pages 373 & 374 follow method used on pages 373 & 374

in textbook)in textbook)

Average Collection Period for Accounts Receivable = “On the average”, how many days go by between the date on which a sale on credit is made and the time the cash is collected from the customer!

AVERAGE COLLECTION PERIOD CALCULATION

From Balance Sheet: Accounts Receivable 12/31/2005 = $50,000

From Income Statement for Year 2003: Sales Revenue (all ‘on account’) = $500,000

Calculate the “Average Collection Period”

$50,000 Accts. Receivable = 36.5 Days

$1,370 Average Daily Sales

($500,000 / 365 days)

What is the “Accounts Receivable Turnover” Ratio?

If the average collection period is 36.5 days, how many times would the receivable ‘turn over’ (i.e., be collected) during a year?Answer = 10 times (365 days/36.5 days)Which is more understandable? On the average, it takes 36.5 days from

date of credit sale to collect your cash Your accounts receivable “turned over” 10

times a year

Length of Operating CycleLength of Operating Cycle

Avg. days to sell inventory 60.8 days

+ Avg. days to collect receivables 36.5 days

Length of Operating Cycle 97.3 days

Remember that a company’s operating cycle is the time it takes to convert inventory to cash by selling the inventory and then collecting the receivable.

So, an Operating Cycle could be:

Interesting to compare to creditor terms for Accounts Payable (What if creditors demanded to be paid in 30 Days?)

Class Assignment Questions

Questions 2, 4, 10, 17, 20, and 27 (Page 381 in textbook)

Chapter 8

The End