[Anonymous]

East Corp. manufactures stereo systems that carry a 2- year warranty aganist defects. Based on the past experience, warranty costs are estimated at 4% of sales for the warranty period. During the year, stereo systems sales total $3 million, and warranty costs of $67,500 were incurred. In its income statement for the year ended December 31, East should report warranty expense of

A. $120,000

B. $52,500

C. $60,000

D. $67, 500

Answer (A) is correct. Warranty expense equals 4% of sales for the period,or $120,000 ($3,000,000*4%)

I am a little confused here since we know the actual for the year can’t we use $67,500 and accrue $52,500 since its a 2 year warranty contract. What I dont understand is why use the est. when we know the actual number.

[See Pee A]

It seems that we use the estimated expense ratio rather than actual costs because actual expenses can be managed /manipulated more easily. An auditor can comfortably say whether a warranty percentage is reasonable but it would be much more difficult to asses actual expenses every year. Plus, it provides better matching and less.volatility.

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[Anonymous]

As per GAAP you must book the entire warranty expense immediately at the time of sale. This is because when you book full revenue, you should match it with the estimated full expense in the same period.

Suppose,as you said, if we incurred and paid $ 67,000 during the year and accrued the balance of $52,500 that also is considered as an expense as follows:

Dr. Warranty Expense $120,000

Cr. Cash $67,500

Cr. Warranty Liability $52,500

Hence, we still show a full amount as an expense in the Income Statement i.e $120,000

[Author]

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