warranty liability using service contracts

6-1

Warranty LiabilityUsing

Service Contracts

Chapter 6Illustrated Solution: Exercise 6-20Illustrated Solution: Exercise 6-20

6-2

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–WarrantiesBackground–Warranties

6-3

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.

Background–Warranty Service ContractsBackground–Warranty Service Contracts

6-4

Warranty terms often cross multiple reporting periods.

Example:Two-year warranty beginning June 1.

Calendar Year 1: 7 monthsCalendar Year 2: 12 monthsCalendar Year 3: 5 months

Calendar Years and Warranty Life YearsCalendar Years and Warranty Life Years

6-5

Sales–Even Flow AssumptionSales–Even Flow Assumption

2001 Contracts: $60 300 = $18,000

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

6-6

Sales–Even Flow AssumptionSales–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

6-7

Sales–Even Flow AssumptionSales–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

6-8

Sales–Even Flow AssumptionSales–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

6-9

Revenue Computations by YearRevenue Computations by Year

Calendar Year

2001 Contracts

$60 x 300 = $18,000

2001

$3,600

40%2002 3,600

3,240

36%2003 3,240

2,160

24%2004 2,160

2005

Totals $18,000

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6-10

Revenue Computations by YearRevenue Computations by Year

Calendar Year

2001 Contracts 2002 Contracts

$60 x 300 = $18,000 $60 x 350 = $21,000

2001

$3,600

40%2002 3,600

3,240

36%

$4,200

40%2003 3,240 4,200

2,160

24%

3,780

36%2004 2,160 3,780

2,520

24%2005 2,520

Totals $18,000 $21,000

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6-11

Revenue Computations by YearRevenue Computations by Year

Calendar Year

2001 Contracts 2002 Contracts Calendar Year Totals$60 x 300 = $18,000 $60 x 350 = $21,000

2001

$3,600$3,600

40%2002 3,600

$11,0403,240

36%

$4,200

40%2003 3,240 4,200

$13,3802,160

24%

3,780

36%2004 2,160 3,780

$8,4602,520

24%2005 2,520

$2,520

Totals $18,000 $21,000 $39,000

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6-12

2001 Journal Entries2001 Journal Entries

Cash ………………………………………………………. 18,000Unearned 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…………………. 3,600To record estimated revenue earned from service contracts:(1/2 .40) $18,000 = $3,600.

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

Cash, Inventory, etc.………………………………… 3,350To record repairs actually made during the year.

6-13

2002 Journal Entries2002 Journal Entries

Cash ………………………………………………………. 21,000Unearned 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…………………. 11,040To record estimated revenue earned from service contracts.

6-14

2002 Profit on Service Contracts2002 Profit on Service Contracts

Total revenue from service contracts in 2002…………………… $ 11,040Total actual expenses relating to service contracts …………… 9,630Profit from service contracts in 2002……………………………… $ 1,410

6-15

End of ProblemEnd of Problem