Question

MULTIPLE CHOICE: Choose the best answer and place it on the line alongside each question. - 1. According to the matching principle, warranty costs related to items sold should be reported as an According expense in the same accounting period as: the sales revenue is reported as income; B. the warranty repairs are made; the warranty period expires; cash is received from customers. C. Use the following to answer questions 2 and 3. Road Runner Company, which began operations in early 2020, sells merchandise with a one year warranty. In 2020, sales were 2,500 units. It is estimated that warranty repairs will average $10 per unit sold. In 2020, Road Runner spent $7,500 making repairs under warranty. Total warranty expense reported by Road Runner on its year end December 31, 2020 income statement is: A. $7,500 $25,000 $17,500 D. $0 C The warranty payable liability reported by Road Runner on its year end December 31, 2020 balance sheet is: A. $7,500 $17,500 $0 D. When a contingent liability is probable and can be estimated it should be: ignored; disclosed in the notes to the financial statements; reported as a liability on the balance sheet and an expense on the income statement; reported on the balance sheet as a contra fixed asset.

Answer 1

1. A. Sales revenue reported as income

According to matching principle expenses related to corresponding income should be reported as expense in the same year in which the corresponding incomes are reported. Therefore, warranty costs related to items sold should be reported as expense in the same year as sales revenue recognised as income.

2. B. $25000

Total warranty expense for 2020 = units sold in 2020 × estimated warranty cost per unit.

= 2500 × $10

= $25000

As expense is recognized based on number of units sold in the year, it is $25000 and not $7500.

3. C. $17500

Warranty payable liability reported in the balance sheet of 2020 = total warranty payable liability recognized in 2020 - amount spent for making repairs under warranty.

= $25000 - $7500

= $17500

4. C. Reported as liability in balance sheet and an expense in income statement

Liability is recorded when the future economic benefits outflow is probable (that means more certain) and it can be measured reliably. So, when these two conditions are satisfied contingent liability turns to be liability. So it is recorded as liability in balance sheet and as expense in income statement. It is recognized as expense in income statement because future economic benefits outflows.