Accounting for Advanced Accruals
6.6.1 Illustration of accounting for warranties
Assume that a business called Nice Tools trades in building equipment. The following ending balances appear on the balance sheet for 20X7:
Cash - $400
Inventory - $600
Contributed Capital - $500
Retained Earnings - $500
The following transaction occurred in the accounting period 20X8:
- Merchandise costing $200 was sold for $700 cash.
- $100 warranty obligation to the customer from Event No. 1 was recognized.
- The customer returned some goods purchased in Event No. 1. The goods were damaged and required repairing (the customer claimed warranty). Warranty claim in the amount of $80 was settled.
Let's see how these transactions affect the accounting equation.
Event No. 1. The sale of goods results in two entries. The first one records revenue recognition. Cash and Sale Revenue increase by $700. The second entry is posted to recognize cost of goods sold. Inventory decreases and Cost of Goods Sold increases by $200:
Illustration 6-19: Effect of revenue and cost of goods sold recognition in the horizontal model
| Event No. |
Assets |
= |
Liab. |
+ |
Equity |
Rev. |
- |
Exp. |
= |
Net Inc. |
Cash Flow |
|||
| Cash |
+ |
Inven. |
||||||||||||
| 1a |
700 |
+ |
n/a |
= |
n/a |
+ |
700 |
700 |
- |
n/a |
= |
700 |
700 |
OA |
| 1b |
n/a |
+ |
(200) |
= |
n/a |
+ |
(200) |
n/a |
- |
(200) |
= |
(200) |
n/a |
|
Event No. 2. As mentioned before, the amount and timing of warranties are not known beforehand. Thus, until actual warranties are claimed by customers, Nice Tools' management needs to estimate future possible warranty obligations. Let's assume that in our example management estimated this obligation to be $100. The entry to record warranty acts to increase liabilities (Warranties Payable) and decrease equity (by increasing Warranty Expense). Recognition of the estimated warranty obligation causes the warranty expense to be recorded. Such accounting for warranties is in line with the matching principle because both revenues (sale of equipment) and related expenses (future warranty obligation related to the equipment) are recorded in the same period:
Illustration 6-20: Effect of warranty expense in the horizontal model
| Assets |
= |
Liab. |
+ |
Equity |
Rev. |
- |
Exp. |
= |
Net Inc. |
Cash Flow |
|
| n/a |
= |
100 |
+ |
(100) |
n/a |
- |
(100) |
= |
(100) |
n/a |
|
Event No. 3. As regards payment of warranty to the customer, note that the payment does not trigger an expense recognition. Warranty expense was already recorded when we increased liabilities (Warranties Payable) and decreased equity (by increasing Warranty Expense) in the previous transaction. In this transaction, we are decreasing assets (Cash) and liabilities (Warranties Payable):
Illustration 6-21: Effect of actual warranty claim in the horizontal model
| Assets |
= |
Liab. |
+ |
Equity |
Rev. |
- |
Exp. |
= |
Net Inc. |
Cash Flow |
|
| (80) |
= |
(80) |
+ |
n/a |
n/a |
- |
n/a |
= |
n/a |
(80) |
OA |
6.6.2 Journal entries and T-accounts for illustration of warranties accounting
General journal and ledger T-accounts are shown below.
Illustration 6-22: Journal entries for illustration of warranties accounting
| Event No |
Account titles |
Debit |
Credit |
| 1a |
Cash |
700 |
|
|
|
Sales Revenue |
|
700 |
| 1b |
Cost of Goods Sold |
200 |
|
|
|
Inventory |
|
200 |
| 2 |
Warranties Expense |
100 |
|
|
|
Warranties Payable |
|
100 |
| 3 |
Warranties Payable |
80 |
|
|
|
Cash |
|
80 |
| Closing |
Sales Revenue |
700 |
|
| entry |
Cost of Goods Sold |
|
200 |
|
|
Warranties Expense |
|
100 |
|
|
Retained Earrings |
|
400 |
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