 Hello and welcome to the session in which you would look at a CPA exam simulation or an exercise that deals with warranties. Warranties are liabilities. They occur when a company makes a sale and they offer a warranty on that sale. As a result, the company will be responsible for servicing the client. And as a result, because you have an obligation, you have a liability. So in this session, I will work the simulation to show you how you would approach such a problem on the exam day. Let's take a look at this example. Eagle machinery managed to sell 600 units of the AutoMaster product each for $7,000. Throughout the year, the year of sale, Eagle incurred expenses and mounting to $25,000 to service the two-year warranties that were provided along with each AutoMaster. So when they make the sale, they also offer a two-year warranty. It comes with the sale. All sales were made on cash basis. What we need to do is to prepare the journal entries, assume Eagle estimate the total cost of servicing the warranty in the second year will be $125,000. So let me clarify one thing here. The total cost of the warranty for two years after the year of sale will be $125,000. So what we're going to do, we're going to go ahead and journalize the entries for the sale as well as for the warranty expense and estimating the warranty. Let's go ahead and get started if you want to try to work this example before we resolve it. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true false questions, as well as exercises. Go ahead, start your free trial today. Okay, first we start with sales. We're going to debit cash for $4.2 million. We sold 600 units at $7,000 each. We said it's for cash, therefore we debit cash. Now if it was on credit, we debit a count receivable, then we credit sales revenue $4.2 million. For simplicity, I'm going to keep the cost of goods sold out, but if we had cost of goods sold, we would debit cost of goods sold and we would credit inventory, say for example, $2 million if that was giving, but that's not giving for simplicity. Now in the year of the sale, so here we go, in the year of the sale, let's say year of the sale is year one, in the year of the sale, the company incurred $25,000 in warranty expense. In other words, they service the product and they incurred the $25,000. We're going to debit warranty expense $25,000 and we're going to credit either cash, parts, inventory, payroll, whatever we incurred, we're going to assume we gave them $25,000 to replace the defected item. That's done. At the end of the year, what we are told, we are told that the total warranty expense for this product for the next two years, so what we do is this. Let's assume we made the sale here, so the warranty, it's for two years. Therefore, we're going to say this is part, so this is the two years basically, all the blue year two and year three, and we estimate for the total should be $125,000. Now bear in mind, bear in mind, we already incurred $25,000. So what's left, what we are responsible for, based on our estimate, is $100,000 of warranties. Therefore, what we have to do at the end of year one, at the end of year one, we have to book an expense of $100,000 and credit warranty liability, warranty obligation of $100,000. Now, here's what else you need to know about this. Now you have a warranty liability of $100,000. This warranty liability, as I was showing you earlier, it spans over two years. Therefore, of this warranty liability of $100,000, here's what you need to know. $50,000 of it will be current liability, and $50,000 of it will be long-term liability. Because remember, the first $50,000, I got to show you the time frame again, year one, year two, and year three. Remember, when we're standing here, we're going to be covering year one, we're going to be over a year. We're going to assume the operating cycle is a year. So we're going to be going over year two and year three. Therefore, $50,000 is current, and the remaining is non-current. Now we're going to change the scenario a little bit. We're going to prepare the journal entries, assuming the warranties are not an integral part of the sale. In other words, we made the sale, but part of the sale, we, part of the price, we sold a service type warranty. And here we're going to assume, we're going to assume that the total, of the total sales, of the total sales, remember the total sales was $4.2 million, $200,000 relates to the sale warranty contract. In other words, the product itself is $4 million, but we added $200,000 for the warranty, warranty, for the warranty, which is called the service type warranty. A service type warranty is different than the manufacturing warranty. In the first example, and you have to understand this, the first one was a manufacturing warranty. What is a manufacturing warranty? Or simply put, it's called the warranty. In other words, the company stands behind their product. And as a result, you don't have to pay anything. We will stand behind our product two years from the, from the, from the time of the sale. Now what we are saying is this, if you want us to stand two years behind the product, well, you have to pay an additional $200,000. Now how do we book this entry if that's the case? Well, we're going to debit cash, $4.2 million. And basically, we cannot now assume, like I have it here just to kind of show you how we get to the, to the $4.2 million, but really the unit cost is no longer $7,000. It's a little bit less than $7,000 specifically because the sale itself, just want to show you, the sale itself is $4 million. So the $4 million is spread out over $600 unit. So the, the price of the unit really is $6,666.66. Okay. Why? Because the $200,000, the sales revenue is only $4 million. And the $200,000, it's an unearned warranty revenue, which is to record, which is to record the service type warranty. Again, this actual selling price of the unit here changed. Why? Because we're assuming of the $4.2 million, $200,000 is unearned warranty revenue. I just showed you this kind of to make it simple, but in reality it's not. Now at the end of year one, so after we make the sale, what we do is we're going to recognize revenue from the service type warranty on a straight line basis. What does that mean? Remember we made the sale here year one, then for the next two years, year two and year three, every year we are going to record $100,000 of their revenue. Therefore year one and year two will debit unearned warranty revenue, $100,000 credit warranty revenue, $100,000. And we hope and pray that the customer never comes back for any expense. So the customer don't come back for any, any expense in the sense that any expense that we have to repair the item and basically what we did is we booked this $200,000 of unearned revenue, then we turn it into revenue and we kept the whole thing. The whole thing is $200,000, the whole thing. This way they don't come back for any work. So this is the difference between a service type warranty versus a manufacturing warranty. I do have other exercises, other exercises, other multiple choice. You got to go to Farhat Luxures to see them, make sure you do so because you want to understand this topic inside out. For example, in this topic, I ignored if the customer comes back, how do you handle this? But I do have other examples that cover that. Go to Farhat Luxures, work additional MCQs through false look at additional exercises that's going to help you understand this warranty, manufacturing warranty obligation or a service type warranty. Whatever you are studying for your CPA exam or you are an accounting student or you are studying for the CMA exam, invest in yourself, invest in your career. Good luck, study hard and stay safe.