 Hello and welcome to this session in which we'll discuss accounting for warranties or guarantees. In this session, the warranty and guarantees are used interchangeably. So what is a guarantee? Well, when you purchase something, a car, a TV, a stereo, whatever you are buying, a piece of furniture, the seller or the manufacturer offer you a guarantee. In other words, if something happened to that product, if it doesn't meet certain specification, if it breaks within a certain period of time, we will make you whole. That's what a guarantee is. So it's a promise that the product meets certain specification and the contract. Otherwise, we will make you whole. We would replace it, fix it, whatever we have to do. Now, why is this topic important for revenue recognition? Well, here's why. Because companies might make sales in year one and gives warranty and that warranty could run through year two and year three. Simply put, here's what's going to happen. The company will make a sale here in year one. Then they will offer you a guarantee. If anything happened within the next two years, during this period, we will make you whole. Well, that's fine. Now, from an accounting perspective, here's what's going to happen. If we make the sale in year one, this is when the sale took place, and let's assume the customer came back, nothing happened in year one, and the customer came back in year two and asked for a repair, asked for the product to be replaced, asked for a part to be replaced. What's going to happen is this. If we don't do anything about those guarantees or warranties in year one, here's what's going to happen. The sale took place in year one, the expense will take place in year two. Well, this is a violation of the matching principle. If you made a sale in year one, all the related expenses to that sale should be recorded in year one. And this is why we need to learn about accounting for warranties to match the expenses to the sale in the same year. So what we have to do is we have to estimate what would our guarantee and warranty be and book the warranty in year one. And this is what we need to learn in this session. So this is why this is part of the revenue recognition, because you need to know when you book a sale. And if there's a warranty, you need to book the related expense for that sale in the same period. Don't worry, we'll work an example. We have two types of warranties that we need to be familiar with. One is assurance type. And this warranty is sometime called manufacturer warranty. And that's included in the price of the products. When you buy the product, they will tell you, look, this product comes with two year or three year warranty. You don't have to pay for the extra cost. Usually when you buy a card, they give you like three year plus a certain mileage or whichever comes first. But this is what's called assurance type. So there is no payment here. You don't pay for this warranty. This is the warranty that we are discussing here. Basically the promise that the product will work as expected. Then we have another type of warranty called service type warranty. Service type warranty is when the seller asks you to buy additional warranty beyond, for example, if this is two year, they would say, okay, if you pay an additional $200 or some amount, we will give you another three years of additional warranty on this product. So two plus five, now you're up to five years if you did buy this service warranty. So the service warranty, it's an additional protection beyond the assurance warranty. Bear in mind this is paid for separately. So if you want a service type warranty, and believe me, phone companies, Best Buy or electronics, they would love to sell you those service type warranties. In my opinion, if I have a year or two on a product, that's good enough. If something's going to happen, it's going to happen early on, also a car. So this is what a service type warranty is. And for this warranty, we're going to record a separate performance obligation. So this warranty is separate than what we discussed minutes ago where we have to account for the revenue and the expense in the same period. This is a separate contract. So the service type warranty will be a separate contract and obviously will work an example explaining this service type warranty. Before we look at the example, I would like to remind you whether you are a student or a CPA candidate to take a look at my website, farhatlectures.com. I don't replace your CPA review course. I don't replace your accounting courses. My job, my goal is to be a useful addition to be a supplemental material to your CPA review course, to your accounting courses. My motto is saving CPA candidate and accounting students one at a time by providing new lectures, resources, multiple choice, through false that are aligned with your courses. Everything is broken down by chapter. This is a partial list of my courses. My CPA material is aligned with your Becker, Roger, Wiley, Gleam, Myles. So it's very easy to follow between your CPA review course and my courses. I give you access to the original 1500 previously released AI CPA questions, almost 1500 questions in their original format plus detailed solution. 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, Reddit. And right now I started a CPA exam group on GroupMe. So please join us so we can discuss CPA with other candidates. So let's take a look at this example. Adam Electronics sold 10 flat screen TV on November 1st, year X1 for a total price of 4000. The cost for Adam Electronics is 1500. The assurance type, the assurance warranty for the product is two years with an estimated cost of 600. So we sold the TVs and we said, okay, if anything happened for the next two years, we will guarantee your TV. We think our cost for that warranty is $600. We are going to incur $600. Now, in addition to the assurance type, Adam sold extended warranties related to six flat screen TVs for additional three years for a price of $300. So what happened is we sold the TVs, gave them more assurance warranty for two years. We think it's going to cost us $600. In addition, six customers, six of the 10, we're going to assume each individual bought one flat screen TV, six customer bought the extended warranty, and in total they paid $300. So it appears to be $50 per extended warranty. Here's what's going to happen. We're going to debit cash $4,300. Why $4,300? $4,000 is the sale and $300 is for the extended warranty. Therefore, we're going to credit sales $4,000 for the TVs. We're going to credit unearned warranty revenue $300. Now, please make sure to make to make a T account for this unearned warranty revenue because eventually unearned revenue will have to be turned into revenue and we're going to see when. So just make a note of it for now. Also, we're going to have to debit cost of goods sold and credit inventory for $1,500 to account for the cost that Adam incurred to purchase those TVs. Are we done yet? No. What we have to do now since we have an assurance warranty involved, we have to record the expense and the liability for that assurance liability because we don't know when the customer comes back for service, but we have to record the expense in the same period that the sale takes place. Therefore, we debit warranty expense $600, credit warranty liability $600. And this is a good illustration, whether it's for inventory or warranty, good illustration of the matching principle. We make the sale on November 1st and all the expenses related to that sale cost of goods sold and warranty expense are recorded in that same date. Now, some companies don't book this expense and liability till the end of the year. Some textbook, they don't book this expense and liability till the end of the year or the end of the period. I book it this way to show you the matching concept that on the same date that you made the sale, that you made the sale, there was an expense related to that sale and you record the expense in the same period. I'm going to tell you what I mean by some companies don't book it till the end of the period. Now, we have a warranty liability with the balance of $600. We're starting with. On December 5th, it doesn't matter when, X1 in the same year, Adam incurred labor cost of 75 and part cost of 25 related to the assurance warranty. What does that mean? It means one or two customers, let's say one customer came back, they needed some parts replaced. It was $25 and we assigned an employee to work on it. The employee cost us $75. Now, what do we have to do? Now, we have to start to reduce our liability. We're going to debit liability $100 because we already recorded the expense. So this is when the customer comes back. There is no expense. Why? Because we booked the expense when the transaction took place and we credit salary and wages table for 75, credit inventory parts for 25. And this was in December, I said December 5th. It doesn't matter when, but it's December 20 X1. So it's in the same period. So here's what companies would do or some textbook would do. What some textbook would do, they will not, so let me first show you the warranty liability. So what's going to happen is after we booked this entry, our warranty liability is $500. Here's what some textbook and some CPA review courses would do. What they would do is they will not book this entry first. So they will not book this entry first. What they do is when the customer comes back in the same period, they debit warranty expense 100. They will credit salaries and wages table 75 inventory 75. Then on December 31st of that year, which is at the end of the period, we're going to assume December 31st is the end of the period. What they would do on December 31st, they will debit warranty expense 500 and they will credit warranty liability 500. So what happened is you will end up with only 500 and warranty liability because you would, you expense this, you expense 100 on December, I said December the 5th and the remainder is the 500 is booked. So basically the warranty liability would look something like this, which is the same thing as the same balance 500. But I like to book the entry the same date, the same day of the sale. So it's a great illustration for what we call the matching principle and accounting. Now let's move on for future periods. Now we have a warranty liability, now a balance of 500. On March 15, X2, which is year two now, Adam incurred labor cost of 300 related to the assurance warranty. Something, some malfunction happened. We had to send an employee to the customer and they fixed, and they fixed a flat screen TV. What entry do we make on March 15th? We're going to debit warranty liability 300 credit salaries and wages table 300. Notice no expense. We are not expensing anything because everything was expensed in the same accounting period. Matter of fact, the same day that the sale took place. Now our balance in the warranty liability is 200. And this is how we will account for future cost and hopefully we will not incur more than 200 of additional warranty for the next, you know, till November 1st, till November 1st, 20X3. Hopefully we don't incur more than an additional $200. If that's the case, then we'll start to account for expenses. We start to account for additional expenses. Now that's the assurance type warranty. Remember what I told you earlier, you also have a service type warranty and that service type warranty kicks in November 1st, 20X3. So November 1st, 20X3D service type warranty will kick in and remember we have a balance of $300 of unearned revenue. Then what's going to happen is this, starting from November 1st, 20X3 till November 1st, 20X4, we're going to earn $100 of this unearned revenue. Why? Because now we are servicing the client. This unearned warranty revenue, this service type warranty now kicks in. Therefore, what's going to happen? We're going to make this entry November 1st, 20X4, November 1st, 20X5, November 1st, 20X6 and by doing so for the next three years, we would earn the revenue. The unearned revenue will go down to zero and we'll have this additional warranty revenue. So this is how basically, this is how it works. This is how it works, but right now for one year, the balance is $100. What should you do now to learn more about this important topic, assurance accounting for guarantees or accounting for warranties, go to farhatlectures.com. Don't hesitate. Work MCQs. Work through faults. Look at exercises. Reinforce the concepts. Look at additional resources and exercises that's going to help you understand this concept. The CPA exam is an important part of your career. Your accounting courses are the foundation for your professional journey. Don't shortchange yourself. Invest. Good luck. Study hard and of course, stay safe.