Problem 9-5 Warranties
Bombeck Company sells a product for $1500. When the customer buys it, Bombeck provides a one-year warranty Bombeck sold 120 products during 2010. Based on analysis of past warranty records, Bombeck estimates that repairs will average 3% of total sales.
Required:
1. Prepare a journal entry to record the estimated liability.
2. Assume that during 2010, products under warranty must be repaired using repair parts from inventory costing 4950. Prepare the journal entry to record the repairs of products.
Problem 9-10 Contingent Liabilities
Several independent items are listed for which the outcome of events is unknown at year end.
a. A company offers a two year warranty on sales of new computers. It believes that 4% of the computers will require repairs.
b. A company is involved in a trademark infringement suit. The company's legal experts believe that an award of $500,000 in the company's favor will be made.
c. A company is involved in an environmental cleanup lawsuit. The company's legal counsel believes that the outcome may be unfavorable but has not been able to estimate the costs of the possible loss.
d. A soap manufacturer has included a coupon offer in the Sunday newspaper supplements. The manufacturer estimates that 25% of the 50c coupons will be redeemed.
e. A company has been sued by the federal government for price fixing. The company's legal counsel believes that there will be an unfavorable verdict and has made an estimate of the probable loss.
Required:
1. Identify which of the items (a) through (e) should be recorded at year-end
2. Identify which of the items (a) through (e) should not be recorded but should be disclosed in the year-end financial statements.
To answer the first question, let's start with problem 9-5 on warranties.
1. Prepare a journal entry to record the estimated liability:
To record the estimated liability for warranties, we need to calculate the estimated repairs amount based on the estimated percentage of sales.
Step 1: Calculate the estimated repairs amount:
Sales amount * Estimated repair percentage = Estimated repairs amount
$1500 * 3% = $45
Step 2: Prepare the journal entry:
The estimated liability for warranties is recorded as an expense and a liability in the financial statements. The journal entry to record the estimated liability would be as follows:
Debit: Warranty Expense - $45
Credit: Estimated Warranty Liability - $45
This entry recognizes the estimated cost of repairs associated with the warranties sold.
2. Prepare the journal entry to record the repairs of products:
To record the repairs of products under warranty, we need to account for the cost of repair parts used from inventory.
Step 1: Calculate the cost of repair parts used:
Cost of repair parts used = Cost of repair parts from inventory
Step 2: Prepare the journal entry:
The repairs of products under warranty are recorded as an expense and a reduction in inventory. The journal entry to record the repairs would be as follows:
Debit: Warranty Expense - Cost of repair parts used
Credit: Inventory - Cost of repair parts used
This entry reflects the cost of repair parts used and reduces the value of inventory.
Now let's move on to problem 9-10 on contingent liabilities.
1. Identify which of the items (a) through (e) should be recorded at year-end:
In this problem, we need to determine if each item should be recorded as a liability in the year-end financial statements.
a. The warranty on sales of new computers (4% repair rate) should be recorded because it is a probable future outflow of resources.
b. The expected award of $500,000 in favor of the company in the trademark infringement suit should be recorded because it is a probable gain.
c. The environmental cleanup lawsuit with uncertain costs should not be recorded at year-end but should be disclosed in the financial statements because the outcome is uncertain and an estimate cannot be made.
d. The coupon redemption estimate of 25% should not be recorded at year-end but should be disclosed in the financial statements because it is a potential future expense.
e. The unfavorable verdict in the price fixing lawsuit with an estimated probable loss should be recorded as a liability because it is a probable future outflow of resources.
2. Identify which of the items (a) through (e) should be disclosed but not recorded at year-end:
As mentioned above, items c and d (the environmental cleanup lawsuit and the coupon redemption estimate) should be disclosed in the year-end financial statements but not recorded as liabilities.
Remember, contingent liabilities are potential future obligations or gains that depend on uncertain events. They should be evaluated for recognition (recording as a liability) and, if not recognized, should be disclosed in the financial statements.