 Hello and welcome to this session in which we will discuss guarantee and warranty cost. What is the main idea? Well, what is a warranty? Let's talk about a warranty or a guarantee. Basically, it's a promise made by a seller when you buy something to a buyer to make the buyer good in case of deficiency of quantity, quality or performance in the product. Simply put, when you buy an item, you want to have some assurance, some type of assurance that this item is going to work the way you would expect. Now, to encourage you to buy this item, either the retailer or the manufacturer, they will provide you some sort of a warranty. Well, that's fine. So what is complicated when it comes to guarantee and warranty? Why do we have to treat it in a separate recording? Why is that important? The importance of it, it becomes part of the matching principle. What does that mean? Let me give you an idea how it works. Let's assume in year one, a retailer make a sale in year one and they sell, they sold something for $10,000 plus warranty plus they warranty this item, whatever that item is, a machine. Now, what's going to happen is this, the machine may never breaks. So what's going to happen is if the machine never breaks, you never actually incurred any cost. But what happened is this? If you don't record, if you don't take care of the warranty, what happened if the warranty cost took place in year two or in year three? Simply put, you make a sale in year one. This is when the sale took place. The expense, if you wait, it took place in year two or it took place in year three. This is a violation of the matching principle. Why? Because the expense should follow the revenue. So if the revenue took place in year one, the expense should also take place in year one. And that's why we have to know how to book and when to book guarantee and warranty cost. But we also have to differentiate between two types of warranties. What we have, assurance type warranty, that's one type of warranty that we have to talk about. And that's a free warranty. What is an assurance type warranty? An assurance type warranty, think of it as the manufacturer warranty. It's basically when you buy a car, they'll give you, for example, when usually when it's a new car, a warranty for a year or two or three years that the product meets agreed upon specification. So basically that's given to you, it's free. This warranty, this type of warranty should be expensed in the period the goods are provided or the services is performed. And this is where the matching principle matters. They gave you the warranty. Then they have to expense any potential. This is basically a part of contingent liabilities that we talked about earlier. What we have to do, we have to estimate how much we are going to incur in warranties and guarantee cost. And companies know that based on their historical sales, if it's a new product, they can estimate. So what they have to do is as soon as they make the sale, they have to debit warranty expense and credit liability, warranty liability. And obviously, we will work an example illustrating this type of warranty, which is assurance type warranty. The second type of warranty, which is different, it's a service type warranty. Here you actually purchase this warranty as extra. And if you wanted to buy a TV or a car or any type of refrigerator, a microwave, what they do, maybe a warranty comes with it, assurance type. Then they ask you, would you like to buy an additional warranty? That additional warranty is called service type warranty. This warranty, it's provided additional service beyond the assurance type warranty. For example, you have a warranty assurance type that covers the first two years, year one and year two. Then what you do, they will offer you, well, guess what? We can cover you for year three, year four and year five, but you have to pay a certain amount for that. This is the service type warranty. Here it's a separate performance obligation, simply put, they're selling you something separately from the sale itself. So what we do, when the merchandiser receive the cash, they will debit the cash and they will credit unearned warranty revenue, some sort of unearned revenue. Why? Because we're going to recognize this revenue later on on a straight line basis when the warranty took place. When does the warranty took place in our example? Year three, year four and year five. So this is how it works, the difference between assurance type versus service type warranty. Now, the best way to illustrate this concept is actually to work an example. Before we look at an example, let me remind you whether you are an accounting student or a CPA candidate to check out my website, farhatlectures.com. I don't replace your CPA review course. 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If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation like this recording. Share it with other connect with me on Instagram, Facebook, Twitter and Reddit. So let's take a look at this example to see how we do accounting for warranty cost. Aaron purchased an automobile from Express Auto EA for $40,000 on January 1st, year one. EA estimated the assurance type warranty cost on the automobile to be $900. What does that mean? It means EA based on their experience and this is for three years. This is the assurance is for three years. Based on their experience, they assume based on this car model, it's going to cost them $900. Simply put, Adam's going to come back and they're going to incur on average for every car $900 in this type of assurance cost. Something will break down. They're going to have to come back and fix it for Adam. Adam also purchased a 600 service type warranty. So in addition to the warranty that the dealer provide, Adam purchased an additional service type warranty for an additional three years or 36,000 miles. Express Auto incurs warranty related to the assurance type warranty of 150 in the same year, year one, 300 in year two and 400 in year three. This is for the assurance type. Remember, it covers Adam for three years, but Adam wanted to have an additional three years so he purchased the additional three years. So let's go ahead and journalize the entries and see how it works. First EA received from Adam $40,600, $40,000 for the sale and $600 for the service type warranty and they will credit unearned warranty revenue. This is for the service type warranty and the sale is $40,000. On the same date, here's what we're going to do. We're going to book our warranty expense and warranty payable. Some companies don't do that until the end of the year. The way I'm going to work this example, I'm going to book this entry now. So I'm going to debit warranty expense, credit warranty liability. So I'm going to debit the warranty expense, credit warranty liability, everything on January 2, 2001 or 2000 X1. Why am I emphasizing this point? Because in your textbook, what they might have did, they might have only booked this entry, then took care of this warranty, this 150, then they booked the adjustment. I prefer to book the adjustment simply put, now I have a liability that is worth $6,900 warranty liability that's worth $900 and another liability that's worth $600 would worry about that later. So this liability $900. So Adam came back the same year and we did some work for Adam, I don't know, we gave them some parts, gave them cash to go fix it somewhere or we incurred some payroll of 150. Therefore, we debit warranty, liability. So we're starting to reduce the warranty and we credit whatever we used. If we gave them cash, parts or a cruel, it does not matter. What matter is this is not an expense anymore. When Adam comes back in year one, it's not an expense. Let's go to year two. And this is throughout year one. Year two, Adam came back and we incurred an additional $300 in warranty cost. So simply put, this is the warranty liability. We started at 900 and year one, we reduced it by 150 and year two, we reduced it by 300. In year three, we incurred an additional $400. Adam came back for more work. Therefore, if we notice that's $708.50. So what's going to happen is we still have $50 remaining liability. Now we can reverse this or we can close it against warranty expense because this is an estimate. We're not going to be accurate. But what's going to happen is most likely we have a warranty for another car and we might have a debit of 50. So those two would cancel each other. So you're not going to be accurate. Sometimes you're going to be underestimate your warranty. Sometimes you're going to overestimate your warranty. But that's estimate. That's the point of estimate. You are not going to be accurate. You can either, if you don't have any more warranties and if you overestimated, well, you're going to book the expense. If you underestimated, you will close the expense to some sort of other gain or reduce your expenses for that year. Now we talked about the warranty liability. What about the service type warranty? The service type warranty, remember, it's going to kick in three years after the assurance type is done. So what's going to happen starting in year, starting in year four, five and six, we're going to debit an unearned warranty revenue, $200 credit warranty revenue, $200 to account for that warranty that we earned when we make the sale, but we did not really earn it as revenue until it kicks in, until the time at service. Now warranty cost is an important concept, whether it's an intermediate accounting course or the CPA exam. What I advise you to do, go to my website and work additional multiple choice questions to strengthen your knowledge. At the end of this recording, I'm going to remind you again to invest in yourself. Your accounting career is important. Your CPA exam is important. Put it behind you. Move on. My resources works along your CPA review course. Don't shortchange yourself. The CPA exam is worth it. Good luck, study hard, and of course, stay safe.