Warranty Liability Using Service Contracts

1. Chapter 6 Illustrated Solution: Exercise 6-20 Warranty Liability Using Service Contracts

2. 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.

3. 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.

4. 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

5. Sales–Even Flow Assumption 2001 Contracts: $60  300 = $18,000 First year 40% = 20% in 2001 + 20% in 2002

6. 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

7. 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

8. 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

9. Revenue Computations by Year } } }

10. Revenue Computations by Year } } } } } }

11. Revenue Computations by Year } } } } } }

12. 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.

13. 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.

14. 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

15. End of Problem