Question

Question: Dusty Johnson is the accounting and finance manager for a manufacturer. At year-end, he must determine how to account for the company’s contingencies. His manager, Tom Pretti, objects to Johnson’s proposal to recognize an expense and a liability for warranty service on units of a new product introduced in the fourth quarter. Pretti comments, “There’s no way we can estimate this warranty cost. We don’t owe anyone anything until a product fails and it is returned. Let’s report an expense if and when we do any warranty work.”

Required

Prepare a one-page memorandum for Johnson to send to Pretti defending his proposal.

Short answer

Answer

Date: XX/XX/XXXX

To: Pretti

From: Dusty Johnson

Subject: Reporting estimated warranty expenses and liability

This memorandum is in response to your objection to recognizing expense and liability relating to the service warranty. To comply with the matching principle, we must report estimated warranty liability and expense on the balance sheet. According to the principle, the business entity must record the expenses related to the sale in the period in which the revenue relating to sales is recorded. If such expenses arise in another period and we record them in another period, it will violate the principle.

Step-by-step solution

Definition of Warranty Expenses

All those sacrifices made by the business entity to maintain and repair the goods sold to the customer are known as warranty expenses.

Memorandum for Johnson

According to the matching principle, the business entity must report warranty expenses and liability as the product is sold. The business entity must report expenses related to sales when the revenue of the respective sales is recorded.