Question

Totally “Honest” Dave and Co. is a very successful seller of used home appliances. All washing
machines come with a four year warranty allowing for the complete repair or replacement of the
appliance. The Company uses a warranty servicing firm to service the payment of specific
warranty obligations, with amounts for the year due on December 31. Honest Dave has
traditionally observed that warranty expenses will be 1.3% in the first year following the sale,
2.7% in the second year, and 4.7% in the third year, and 7.8% in the fourth year. Honest Dave
had sales of $782.74 million in 2016 and had a balance in the Estimated Warranty Liability
account of $7 million. On December 31, 2016, Honest Dave received a bill from the warranty
servicing firm for $13 million. Looking through the detail, Honest Dave sees that $5 million are
for sales prior to 2016. The firm’s normal discount rate, calculated as its weighted-average cost
of capital, is 5%. Calculate the adjusting entry for warranties for 2016.

Answer 1

Based on the information provided, let us first determine the warranty expense to be accounted for in the current year.

The computation is shown as under:

Year	Warranty %	Warranty expense ($ million)	Present value factor @ 5%	PV of Warranty expense
1	1.3	10.17562 (782.74 * 1.3%)	0.9524	9.69
2	2.7	21.13398	0.9070	19.17
3	4.7	36.78878	0.7462	27.45
4	7.8	61.05372	0.3101	18.93
				75.24

Therefore, the warranty expense to be accounted for and additional liability to be created in 2016 is $75.24 million.
This will be done via the following entry:

Warranty expense a/c ….Dr	75.24
To Warranty Liability a/c		75.24
(Being estimated warranty expense recorded for the year and liability created for the same)

After passing the above entry, the warranty liability account will reflect the following balance:
Opening balance = 7 million
Additional created = 75.24 million
Therefore, balance = 82.24 million (before adjusting actual expense incurred)

The bill received from warranty servicing firm is of 13 million

The entry for the warranty expense for the previous year would have already been passed in the previous year. Therefore, there is no adjustment required to be made for the same in the current year.
The only adjustment to be made is to reverse the outstanding warranty liability.

Therefore, the entry to adjust the liability is as follows:

Warranty Liability a/c …..Dr	13
To warranty servicing firm a/c		13
(Being liability reduced as actual expense is incurred and due to the service vendor.)

Alternatively, The above entries can be clubbed and a single adjusting entry can be passed as follows:

Warranty expense a/c ….Dr	75.24
To Warranty Liability a/c		62.24
To warranty servicing firm a/c		13
(Being warranty expense for the year being recorded, and the liability adjusted with the amount due to service vendor)

After passing the above entries, the warranty liability account will show the following net balance:

Opening balance = 7 million
(+) Additional created = 75.24 million
(-) Bill received from warranty servicing firm = 13 million
Therefore, closing balance = 69.24 million