 and welcome to the session in which we will work an exercise or a CPA simulation that deals with warranty expense. How does warranty expense work? Let's assume you go into Best Buy or Staples and you want to buy a smart TV. Let's assume this is the smart TV that you are purchasing. What comes with this smart TV, a warranty, okay? You don't have to pay for this warranty. There's no money you have to pay for it. Basically it comes with a TV just because you purchased it. The manufacturer of this TV would say, okay, we will warranty this TV for two years. That's fine. Then Best Buy will offer you or the store that you're buying from an extended warranty. Here you have to pay. Here you have to pay money for that extended warranty. So you have to know the difference between how to account for a manufacturing warranty, which you don't pay any money in for an extended warranty. In this example, we will work in extended warranty. In the prior example, I did a regular or manufacturing warranty. 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 gonna 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. No obligation, no credit card required. So let's go ahead and see how we will complete the journal entries and what the company will have to report for the extended warranty. Starting with the example, Adam Company sells tablets at an average price of $1,000. And Adam offers to each customer a separate three-year warranty. Notice this is a separate three-year warranty contract. So this doesn't come with the tablet itself. Adam sell it separately and Adam charges $200 for that warranty. The warranty will cover any replacement of defective parts and any labor costs needed to replace or repair that tablet. During 20X1, the company sold 300 tablets and 50% of customers opt to purchase the warranty. It's estimates that the three-year warranty cost $10 for parts and $40 for labor for each unit. That's the estimate for Adam. Adam accounts for the warranty separately. What we're gonna do now, we're gonna prepare the journal entries for the sale and we're gonna prepare the journal entries for the warranties. Starting for the sales. Well, we sold $1,300 tablets for $1,000 each. The total sales revenue is $300,000. Also we sold $150 contract each for $200. The unearned warranty revenue is $30,000. So all in all, Adam would receive $330,000 in cash, $300,000 for the sales revenue and $30,000 is reported as unearned warranty revenue, which is a liability. So that's the journal entry for the sale of the tablets and the sale of the extended warranty contract. Now, how would Adam report this information on the financial statements? Obviously the sales revenue will go on the income statement. How about the unearned warranty revenue? The unearned warranty revenue, 10,000 of it is reported under current liabilities and 20,000 is reported under long-term liabilities. So simply put, the warranty which is the unearned revenue is $30,000, 10,000 of it is current, 20,000 of it is long-term. Now let's assume in 20x2, Adam company actually incurred 3,000 worth of parts and 4,000 in labor from the warranty. So now the customers came back and they had their tablet repaired. So this is how much Adam incurred, 3,000 for parts, 4,000 in labor. What do we do here? Well, since we incurred 3,000 of parts, we're gonna credit inventory 3,000, our labor cost is 4,000 and we debit a warranty expense in total of 7,000. So this is what actually happens. Now this is what I want you to notice here. For the extended warranty, we did not prepare the expense in the year of the sale. So simply put, we did not estimate the expense. Why? Because the expense will have to match the revenue because we did not account for any revenue in 20x1, no warranty revenue in 20x1 to report any expense. So what happened is we waited until the customer came back and actually needed the work. This is when we report the expense. Now is this the only thing we have to do in 20x2? Not at all. In 20x2, we also have to start to record the revenue from the unearned warranty revenue. How much revenue we would recognize? Well, we are not told how to recognize it. Therefore we're gonna recognize it using the straight line method. Well, 30,000 divided by three, we're gonna recognize 10,000 of warranty revenue for 20x2. So this is all 20x2. Simply put, we recognized 10,000 of the revenue. We reduced our unearned revenue by 10,000. And simply put, what happened is this. This 10,000 of current liability turned into actual revenue. Now what would you report in 20x2 as far as liabilities? In 20x2, now you still have 10,000 of unearned warranty revenue that's current liabilities and 10,000 of unearned warranty revenues as long-term liabilities. What would you do in 20x3? Let's assume none of the customers came back in 20x3. 20x3, you had no issues, no person came back. You don't need this entry, but you will need this entry, debit unearned warranty revenue, credit revenue. And by the end of 20x3, you no longer have long-term liabilities. All what you have is current liability, which is for the unearned revenue. And hopefully no one will come back. You would recognize the revenue and all said and done, you would recognize the $30,000 of unearned revenue. Now, if you do incur expenses in 20x3 and 20x4, you have to record those warranty expenses. I'm just giving you the example where it's pretty straightforward. What should you do now? Well, the first thing you have to know is how warranties are accounted for. Remember, we have a manufacturing warranty and an extended warranty. Be aware of the difference between the two because an extended warranty is the customer pace for that. It's treated a little bit differently from an accounting perspective. What should you do next? Go to FARHAT lectures and look at MCQs, true, false, additional exercises, where it's gonna help you understand this concept better. Good luck, study hard, stay safe. I'm always here for you.