Question

Question 1:

Pleasant Co. is considering issuing bonds for the expansion of its business overseas. Is it more advantageous for Pleasant Co. to offer customers the option to purchase additional service contracts or to provide warranties on all products sold considering its upcoming bond issuance?

Suggested approach to answer this question:

1. Write out the journal entries for Assurance-typed warranties and Service-typed warranties and think of the balance sheet impact of each.
2. Think about how the balance sheet impact would impact the selling price of bonds. Remember that investors look at liquidity ratios when determining the risk of a bond issuance

Answer 1

Here Pleasant Co. is considering issuing bonds to finance its expansion overseas. In this case it would be more advantageous for pleasant co. to offer customers warranties on all products sold at no additional cost. This would be a better   choice considering the fact that the company has additional funds due to the bonds issue and it wants to grow it’s business overseas, offering free warranties will help it attract more customers and increase sales further enabling it's expansion.

Journal entry for assurance typed warranty:

Dr. Warranty expense

    To Accrued warranty liability

The impact of this on the balance sheet is the greatest as it reduces profit and creates a liability for future warranty repairs

Journal entry for service typed warranty:

Dr. Cash

   To Unearned Warranty Revenue

In this case we receive cash and we create an equal liability for the unearned warranty revenue, under this method any expenses for repairs are deducted from this liability ledger and the remaining amount after expiry of warranty is booked as warranty income, also if the expense is greater than the initial amount received, then warranty expense is booked for the expense in excess of balance in unearned warranty liability ledger.

The balance sheet impact of assurance typed warranty would be an increase in the company’s current liabilities and decrease in profit. This would result in a decrease in the bond price as the company has increased it’s liabilities. Also the current ratio would be lower because of the increase in current liabilities due to future warranty expenses.