Question

Problem 3

A car dealership also owns a workshop that it uses for servicing cars under warranty. In preparing its financial statements, the car dealership needs to ascertain the provision of a one year warranty that it would be required to provide at year-end. The entity's past experience with warranty claims is as follows:

• 70% of cars sold in a year have zero defects.

• 18% of cars sold in a year have normal defects.

• 12% of cars sold in a year have significant defects.

  The cost of rectifying a "normal defect" in a car is $3,000. The cost of rectifying a "significant defect" in a car is $8,000. A total of 800 cars were sold in the year ended December 31, 20x5.

  Required -

1. a) Compute the amount of "provision for warranty" needed at December 31, 20x5.

2. b) Assume that the car dealership also provides their customers with a two year warranty that starts after the end of regular warranty period. The cost of an extended warranty is $3,200 and 300 of the customers who purchased a car in 20x5 also purchased the extended warranty. Management believes that the percentage of work done on the extended warranties is 35% in the first year and 65% in the second year. Prepare all journal entries with regards to the extended warranty for the years 20x5 – 20x8. Assume that all sales of cars took place on December 31, 20x5.

Answer 1

a) Provision for Warranty needed at December 31, 20x5
Particulars	%	Equivalent No.s	Cost per Vehicle	Amount
Zero Defects	70%	560	0	0
Normal Defects	18%	144	3000	432000
Significant Defects	12%	96	8000	768000
Total Amount of Provision for Warranty				$                1,200,000.00
b) Journal Entries for Extended Warranty
On December 31, 20x5
Cash/Bank A/c            Dr	$       960,000.00
To Unearned Revenue		$        960,000.00
In 20x7
Unearned Revenue    Dr	$       336,000.00
To Extended Warranty Fees		$        336,000.00
In 20x8
Unearned Revenue    Dr	$       624,000.00
To Extended Warranty Fees		$        624,000.00
Working:
Revenue from Extended Warranty = 3200 x 300 = 960,000.00
Revenue to be recognised at the end of First year of extended warranty = 35% of 960,000= 336,000.00
Revenue to be recognised at the end of Second year of extended warranty = 65% of 960,000= 624,000.00