 Hello and welcome to this session in which you would look at a CPA simulation or a CPA exercise that deal with warranty expense or warranty liability. This topic is covered on the CPA exam as well as an intermediate accounting or financial accounting course. Now, if you are an accounting student or especially a CPA candidate studying for the CPA exam, I strongly suggest you check out my website, farhatlectures.com, what I have resources that's going to help you pass your CPA exam. No, I don't replace your Becker, Rager, Glyme or Wiley. What I can do is I can be a useful addition. I can be that additional supplemental material that's going to add 10 to 15 points on your exam. How? Well, the way I explain the material is different than a CPA review course. The CPA review course only reviews the material with you. They don't explain it. That's not their job. The job is to review it. They assume you have already learned it. I don't assume anything. 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Connect with me on Instagram and Facebook. So let's take a look at the problem itself. Adam Corporation introduced a new line of commercial drones in 2021 that carry two year warranty against manufacturers defect. Based on their experience with previous product introduction, warranty costs are expected to approximate 1% of sales. Sales and actual expenditure for the first year of selling are as follows sales 5.9 million actual warranty expenditure 37,750. And they're asking us three questions about this. The first question as does this situation represent a loss contingency? Simply put, we sold some drones 5.9 million worth of drones. It's a new product. We expect 1% of it to be subject to warranty cost. Do we have a lost contingency? Do we have a potential liability? Do we have a warranty liability? And the answer is yes. Why? We are already told in the problem that we expect this to be 1%. Now, how did we come up with this 1%? Usually companies estimate based on prior experience, based on industry data or just simply guessing. But definitely there should be a lost contingency based on the information that's giving. Therefore, the answer is yes. It does represent a lost contingency. Question two, prepare the journal entries that summarizes sales of the drones and any aspects of the warranty that could be recorded during 2021. Simply put, journalize these entries. Well, here we go. We made sales of 5.9 million. That's pretty straightforward. We're going to debit account receivable 5.9 million credit sales revenue 5.9 million. Is this all what we do? And the answer is no. Why not? We are told in the problem that we are expected to have a warranty cost of 1.1% of sales. Simply put, if we take 1% times 5.9 million, we're going to have a potential liability. Warranty liability of 59,000. Now we don't wait until this liability actually occurs the day of the sale. So let's assume today's date is November 22nd. Let's assume we made the sale on November 22nd. So it's one contract on the same date. What we do is we record the liability and the expense. So simply put, on November 22nd, we said we made the sale, but we have an expense to that expense is called warranty expense. And that expense, it's going to be projected, not projected accrued to be more specific, please strike out the word projected accrued. We're going to have to accrue warranty liability. So simply put, we make a sale, we debit expense 59,000 credit warranty, credit warranty liability 59,000. Why did we do so? We don't wait until the customers comes back for repair. We record the expense in the same period that the sale took place. So we don't wait until the actual warranty occurs. So that's why we have to match the expense with the sales revenue in the same accounting period. Now we are told to that actual expenditure were 37,750. So simply put, we are told in 2021, we actually incurred 37,750 of expenditure. So in other words, the customers came back and they wanted to either repair their drone, replace it, replace some product of it. Maybe our engineers, not engineers, our employees or maybe engineers to tweak something in it, reprogram it, whatever the reason is, it costs us 37,750. Well, now when the customer comes back for repair, what we have is warranty liability debited and cash credited. It seems here what we're saying here, we gave them cash. That's what it seems. But it doesn't have to be cash. We could credit cash. We can credit material. We can credit labor. Whatever we incurred here, it seems we gave them cash. It's like, okay, here's the cash, go fix it somewhere else, or it costs us that much in cash. I don't know, but the point is it costs us that much. Now notice for this entry, there is no expense. So when the customer comes back for actual warranty expenditure of 37,000, we did not record any expense. Why not? Well, why not is because on November 22nd, when we recorded the sale itself, we recorded the expense for this. Now, so far, I mean, we're below our estimate. Okay, so we estimated 59, and we only incurred expenses so far, not expenses. Actually, yeah, we incurred, in quote, expenses of 37,750. But again, we cannot call this 37,750 an expense because it was already called an expense. All we're doing now is we are satisfying our liability. And let's take a look at question three. What amount should Adam report as a liability on December 31st, 2021? So basically, it was just heading toward that place. So basically, here's what we have to do. Let's create a T account, call it warranty liability. And initially, on November 22nd, I just made up this date, today's date. We had 59,000 of warranty liability. Then, I don't know, this happened before the end of the year. We reduced our liabilities by 37,750. Well, simply put, they're asking us, what is our remaining liability? Our remaining liability is a credit of, if we take the difference, is 21,250. So on the exam, on the CPA exam, you could be asked, what was the expense for the year? The expense is 59,000. How much is your balance and your liability at the end of the year? 21,250. So notice you recorded on your income statement, 59,000, 59,000 of expenses, because they could ask you, what is the expense? But the liability at the end of the year is 21,250, because we satisfied some of it. We satisfied 37,750 of liability when we served that customer. When the customer came back and we served them, we reduced our liability. Now, at the end of this recording, again, I'm going to make this offer, I'm going to make this offer to you and tell you, look, if you're studying for your CPA exam, why don't you try my system for a month? That's all what it's going to take you, $30 to try it. Yes, it's going to be $30. Are you willing to take that chance? If the possibilities increase in your CPA score in passing the exam. I cannot be more convincing than that. All what I ask you is give it a try, check out my LinkedIn account, connect with me and check out what other people say about my lectures. Anyhow, study hard, good luck, and most importantly, stay safe.