Question

Presented below is the current liabilities section and related note of Mohican Company

Mohican Company (dollars in thousands) Current Year Prior Year Current liabilities Current portion of long-term debt \( 15,000 \) 10,000 Short-term debt 2,668 405 Accounts payable 29,495 42,427 Accrued warranty 16,843 16,741 Accrued marketing programs 17,512 16,585 Other accrued liabilities 35,653 33,290 Accrued and deferred income taxes 16,206 17,348 Total current liabilities \(133,377 \)136,796

Notes to Consolidated Financial Statements Note 1 (in part): Summary of Significant Accounting Policies and Related Data Accrued Warranty The company provides an accrual for future warranty costs based upon the relationship of prior years’ sales to actual warranty costs.

Instructions

Answer the following questions.

1. What is the difference between the cash basis and the accrual basis of accounting for warranty costs?
2. Under what circumstance, if any, would it be appropriate for Mohican Company to recognize deferred revenue on warranty contracts?
3. If Mohican Company recognized deferred revenue on warranty contracts, how would it recognize this revenue in subsequent periods?

Short answer

1. Warranty cost is charged as an expense on a cash basis, but warranty cost is provided under the accrual approach in the year of sale.
2. Revenue is generated from the sale of extended warranties, which are deferred and generally recognized straight-line throughout the contract.
3. Generally, deferred revenue on warranty contracts is recognized using straight-line techniques.

Step-by-step solution

Meaning of Current Liabilities

Financial commitments made by a company that must be paid off within a year are known as current liabilities. When a trade locks in an exchange that raises the possibility of future cash flow issues or other financial asset outflows, such exchange creates a liability.

(a) Difference between the cash basis and the accrual basis of accounting for warranty costs

Warranty costs are charged under the cash basis as they are incurred, or more specifically, they are charged throughout the time the seller or manufacturer complies with the warranty. No obligation to pay future expenses associated with warranties is recorded, nor are the costs of fulfilling outstanding warranties necessarily charged to the period in which the sale is recorded.

The accrual approach must be applied when it is likely that consumers will file warranty claims for sold items or services and when it is possible to estimate the expenses associated reasonably. The year of the sale or the year the productive activity occurs is when a provision for warranty costs is made under the accrual approach.

(b) Explain whether Mohican Company would be appropriate to recognize deferred revenue on warranty contracts.

The sales warranty procedure is utilized when the warranty is sold independently from the item. Sales of the amplified warranty create revenue, which is deferred and ordinarily perceived on a straight-line basis throughout the contract. Due to the warranty seller's commitment to providing services for the term of the contract, revenue is postponed.

(c) Explaining how Mohican would recognize deferred revenue in subsequent periods

The standard procedure is to recognize deferred income on warranty contracts using the straight-line method. Revenue should be recognized throughout the contract period in proportion to the costs anticipated in providing the contracted services if historical information suggests that costs incurred do not follow a straight-line approach. Only expenses (mostly commissions) that fluctuate and are directly tied to contract acquisition should be postponed and amortized. The expenses that would have been incurred even if there had been no contract acquisition, such as staff wages, advertising costs, and general and administrative costs, should be expensed when they are incurred.