Question

Accounting, Analysis, and Principles (Note: For any part of this problem requiring an interest or discount rate, use 10%.) YellowCard Company manufactures accessories for iPods. It had the following selected transactions during 2017.

1. YellowCard provides a 2-year warranty on its docking stations, which it began selling in 2017. During 2017, YellowCard spent \(6,000 servicing warranty claims. At year-end, YellowCard estimates that an additional \)45,000 will be spent in the future to service warranties related to 2017 sales.

2. YellowCard has a \(200,000 loan outstanding from First Trust Corp. The loan is set to mature on February 28, 2018. For several years, First Trust has agreed to extend the loan, as long as YellowCard makes all its quarterly interest payments (interest is due on the last days of each February, May, August, and November) and maintains an acid-test ratio (also called “quick ratio”) of at least 1.25. First Trust has provided YellowCard a “commitment letter” indicating that First Trust will extend the loan another 12 months, providing YellowCard makes the interest payment due on March 31.

3. During 2016, YellowCard constructed a small manufacturing facility specifically to manufacture one particular accessory. YellowCard paid the construction contractor \)5,000,000 cash (which was the total contract price) and placed the facility into service on January 1, 2017. Because of technological change, YellowCard anticipates that the manufacturing facility will be useful for no more than 10 years. The local government where the facility is located required that, at the end of the 10-year period, YellowCard remediate the facility so that it can be used as a community center. YellowCard estimates the cost of remediation to be \(500,000.

Accounting

Prepare all 2017 journal entries relating to (a) YellowCard’s warranties, (b) YellowCard’s loan from First Trust Corp., and (c) the new manufacturing facility YellowCard opened on January 1, 2017.

Analysis

Describe how the transactions above affect ratios that might be used to assess YellowCard’s liquidity. How important is the commitment letter that YellowCard has from First Trust Corp. to these ratios?

Principles

YellowCard is contemplating offering an extended warranty. If customers pay an additional \)50 at the time of product purchase, YellowCard would extend the warranty an additional two years. Would the extended warranty meet the definition of a liability under current generally accepted accounting principles? Briefly explain.

Short answer

1. Total balance on the credit and debit side of the journal is $5,797,941
2. As current obligations, the warranty payable and the interest payable will, all else being equal, reduce both the current and acid-test ratios.
3. Yellowcard would currently be required to offer repair services to its clients due to the earlier sales of its goods.

Step-by-step solution

Meaning of Journal Entry

A journal entry is a record offinancial transactions kept in the books of accounts of an organization with debit and credit columns of each transaction in a proper format.

Determining the accounting components

Date	Particulars	Debit ($)	Credit ($)
(1)
2017	Warranty expense	6,000
	Cash		6,000
	Warranty expense	39,000
	Warranty payable		39,000
(2)
2/28/2017	Interest expense $\left(\$5,000\times \frac{2}{3}\right)$	3,333
	Interest payable $\left(\$5,000\times \frac{1}{3}\right)$	1,667
	Cash $\left(\$200,000\times 10\%\times \frac{3}{12}\right)$		5,000
05/31/2017	Interest expense	5,000
	Cash $\left(\$200,000\times 10\%\times \frac{3}{12}\right)$		5,000
08/31/2017	Interest expense	5,000
	Cash$\left(\$200,000\times 10\%\times \frac{3}{12}\right)$		5,000
11/30/2017	Interest expense	5,000
	Cash $\left(\$200,000\times 10\%\times \frac{3}{12}\right)$		5,000
11/30/2017	Interest expense	1,667
	Interest payable $\left(\$5,000\times \frac{1}{3}\right)$		1,667
(3)
01/01/2017	Plant assets	5,000,000
	Cash		5,000,000
01/01/2017	Plant assets	192,770
	Asset Retirement Obligation $\left(\$500,000\times 0.38554\right)$		192,770
12/31/2017	Depreciation expense	519,227
	Accumulated depreciation- Plant asset $\frac{\left(\$5,000,000+\$192,770\right)}{\mathbf{10}}$		519,227
12/31/2017	Interest expense	19,277
	Asset retirement obligation $\left(\$192,770\times 10\%\right)$		19,277
		$5,797,941	$5,797,941

Explaining the analysis part

Since the warranty payable and the interest payable are current liabilities, they will, all else being equal, reduce both the current and acid-test ratios. The $200,000 loan can be categorized as a noncurrent liability due to the commitment letter from First Trust Corp. Without it, Yellowcard is probably unable to show that it can refinance the obligation over the long run. This would necessitate classifying the $200,000 loan as current debt, significantly lowering Yellowcard's current and acid-test ratios. The asset retirement obligation won't impact the current and acid-test ratios because it can be categorized as a noncurrent liability.

Explaining the Principles component

Agreeing to FASB Concepts Explanation No. 6, Liabilities are likely future losses of financial picks up resulting from a particular entity's present commitments to exchange resources or perform services to other entities within the future due to past exchanges or events. Due to previous product sales, Yellowcard would already be required to supply repair services to its clients concerning the unused warranty plan. In this manner, despite the reality that users pay upfront, Yellowcard is still committed to offering services in the future. As a result, the payments ought to be recorded by the corporation as unmerited income up until the point at which it is now not required to embrace repairs.

In other words, the expense warranty method is reflected in the current accounting. A sales-type warranty would account for the new plan, deferring a portion of the original sales price until the company incurs actual expenditures or the warranty expires.