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Chapter 6. Illustrated Solution: Exercise 6-20. Warranty Liability Using Service Contracts. Background – Warranties. Warranties Obligate the seller to bear repair costs for a specified time period. Create an expense and estimated liability at the time of sale.

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Chapter 6

Illustrated Solution: Exercise 6-20

Warranty Liability

Using

Service Contracts


Background warranties
Background–Warranties

  • Warranties

    • Obligate the seller to bear repair costs for a specified time period.

    • Create an expense and estimated liability at the time of sale.

    • All estimated expenses are matched against revenues in the period when the item is sold.

    • No revenues or expenses are shown in future years.


Background warranty service contracts
Background–Warranty Service Contracts

  • Warranty Service Contracts

    • Customer pays fixed rate in advance for all repairs and/or maintenance for a specified time period. Services they are not entitled to under standard warranty.

    • Upon receipt, this payment creates a liability (unearned revenue) for the service provider.

    • Liability is reduced over the life of the service contract as revenue is earned.

    • Contract was priced originally so that revenues will exceed expenses (estimated) which will allow the provider to show a profit on the service contracts.


Calendar years and warranty life years
Calendar Years and Warranty Life Years

Warranty terms often cross multiple reporting periods.

Example:

Two-year warranty beginning June 1.

Calendar Year 1: 7 months

Calendar Year 2: 12 months

Calendar Year 3: 5 months


Sales even flow assumption
Sales–Even Flow Assumption

2001 Contracts: $60  300 = $18,000

First year 40% = 20% in 2001 + 20% in 2002


Sales even flow assumption1
Sales–Even Flow Assumption

2001 Contracts: $60  300 = $18,000

First year 40% = 20% in 2001 + 20% in 2002

Jan 1 (12 months) and Dec 31 (0 months)

= 6 month average


Sales even flow assumption2
Sales–Even Flow Assumption

2001 Contracts: $60  300 = $18,000

First year 40% = 20% in 2001 + 20% in 2002

Jan 1 (12 months) and Dec 31 (0 months)

= 6 month average

Feb 1 (11 months) and Dec 1(1 month)

= 6 month average


Sales even flow assumption3
Sales–Even Flow Assumption

2001 Contracts: $60  300 = $18,000

First year 40% = 20% in 2001 + 20% in 2002

Jan 1 (12 months) and Dec 31 (0 months)

= 6 month average

Feb 1 (11 months) and Dec 1(1 month)

= 6 month average

Second year 36% = 18% in 2002 and 18% in 2003

Third year 24% = 12% in 2003 and 12% in 2004





2001 journal entries
2001 Journal Entries

Cash ………………………………………………………. 18,000

Unearned Revenue From Service Contracts ……. 18,000

To record cash received from sale of

service contracts: 300  $60 = $18,000.

Unearned Revenue From Service Contracts ………. 3,600

Revenue From Service Contracts …………………. 3,600

To record estimated revenue earned

from service contracts:

(1/2  .40)  $18,000 = $3,600.

Cost of Servicing Television Contracts ……………… 3,350

Cash, Inventory, etc. ………………………………… 3,350

To record repairs actually made during

the year.


2002 journal entries
2002 Journal Entries

Cash ………………………………………………………. 21,000

Unearned Revenue From Service Contracts ……. 21,000

To record cash received from sale of

service contracts: 350  $60 = $21,000.

Unearned Revenue From Service Contracts ………. 11,040

Revenue From Service Contracts …………………. 11,040

To record estimated revenue earned

from service contracts.


2002 profit on service contracts
2002 Profit on Service Contracts

Total revenue from service contracts in 2002 …………………… $ 11,040

Total actual expenses relating to service contracts …………… 9,630

Profit from service contracts in 2002 ……………………………… $ 1,410



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