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Chapter 8: Problem 17

A firm has sold one million units of a product that has a one-year warranty. Management estimates that about \(5 \%\) of the units will require repairs, and the costs per repair will average about \(\$ 12 .\) What dollar amount of liability would you recognize in this case?

Short Answer

Expert verified
The firm should recognize a liability of \$600,000 for the product warranties.

Step by step solution

01

Calculate the number of units expected to be repaired.

Taking into consideration that 5% of the total units sold would require repairs, we need to find 5% of one million. This can be carried out by multiplying one million by \(0.05 \) (which is the decimal equivalent of 5%). Hence, \(1,000,000 * 0.05 = 50,000 \) units.
02

Calculate the total cost of repairs

Next, by knowing that each repair would cost around $12, we multiply the number of units that are likely going to be repaired (50,000 units) by the cost of individual repairs. This can be done like so: \(50,000 * 12 = \$600,000 \)
03

Recognize the liability

The amount calculated in Dealing with budgeting, costs and financial glossaries, the business would need to recognize a liability of \$600,000. This amount represents the expected cost to honor the warranties on the sold products.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Financial Accounting
Financial accounting is the process of recording, summarizing, and reporting a company's financial transactions through financial statements like the balance sheet and income statement. These records provide a comprehensive view of a company's financial health.

The purpose of financial accounting is to give managers and stakeholders accurate information about a company's financial position. This helps them make informed business decisions.
  • Recording involves documenting each transaction at the time it occurs.
  • Summarizing means organizing the records into a coherent format.
  • Reporting involves creating financial statements that summarize the business's activities and financial condition.
In the context of warranty liabilities, financial accounting ensures that potential costs associated with product repairs are accurately reflected in the financial statements.
Liability Recognition
Liability recognition involves identifying and recording a company's obligations or debts. Liabilities can arise from various sources, including loans, unpaid bills, and future expenses like product repairs under warranties. These need to be recorded in the accounting records to reflect the financial obligations accurately.

In our example, the liability recognized involves the estimated cost to repair sold products under warranty. Recognizing this liability involves:
  • Estimating the number of repairs needed (here, 5% of a million units).
  • Calculating the total repair cost (50,000 repairs at $12 each).
  • Recording this amount ($600,000) as a liability on the balance sheet.
This ensures transparency and accurate representation of future obligations in the company's financial records.
Cost Estimation
Cost estimation in financial accounting is the process of approximating the cost of a business obligation or project. Proper estimation is crucial for budgeting and financial planning. It involves analyzing historical data, using statistical methods, or consulting industry standards to predict future costs.

In the exercise, the cost estimation involves calculating the likely expenses from the product warranty repairs by:
  • Determining the percentage of products anticipated to need repairs (5% of 1,000,000).
  • Assessing the average cost per repair ($12).
  • Multiplying these factors to find the total estimated cost ($600,000).
Such estimates help in preparing financially for potential expenses and maintaining the company's fiscal health.
Repair Costs
Repair costs are the expenses incurred to restore a product to its original or functioning condition. These costs are significant when businesses offer warranties, as they can substantially impact financial statements.

Understanding repair costs involves:
  • Identifying the average cost of each repair ($12 in the given exercise).
  • Multiplying this by the number of units expected to be repaired to determine total costs (5% of one million units, or 50,000 repairs).
This brings us to the total repair cost of $600,000, which is classified as a liability. These costs must be accurately recorded to ensure clarity in financial obligations and avoid unexpected financial strain.

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Most popular questions from this chapter

At the balance sheet date, an airline's passengers have accumulated 20 million frequent flyer miles, which could be exchanged for about 1,000 "free" domestic round-trip tickets. Similar tickets are sold at an average price of \(\$ 600,\) and the company incurs an incremental cost of about \(\$ 200\) for each passenger carried. Management believes that about \(75 \%\) of these tickets will ultimately be issued. What dollar amount of liability would you recognize in this case?

The annual report of the Jolly Gold Giant, an international food processing and food service firm, included a liability for accrued restructuring costs of \(\$ 179.3\) million. Footnotes contain the following explanation: In \(1999,\) restructuring charges of \(\$ 88.3\) million on a pre-tax basis were reflected in operating income to facilitate the consolidation of functions, staff reductions, organizational reform, and plant modernization and closures. In \(2000,\) restructuring charges of \(\$ 192.3\) million on a pre-tax basis were reflected in operating income. The major components of the restructuring plan related to employee severance and relocation costs ( \(\$ 99\) million) and facilities consolidation and closure costs \((\$ 73\) million). Upon completion of all the projects in \(2002,\) the total headcount reduction will be achieved. a. Why do firms accrue restructuring costs before such costs are actually incurred? Do such costs satisfy the definition of liabilities that was presented in Chapter \(3,\) "The Balance sheet," of this text? b. Based on the footnote information, Jolly Gold Giant has recognized restructuring costs of \(\$ 280.6\) million \((\$ 88.3 \text { in } 1999 \text { plus } \$ 192.3 \text { in } 2000\) equals \(\$ 280.6\). How will these charges affect the amounts of income reported by the firm in future years? How would these charges influence your comparison of the firm's profit trend beyond \(2000 ?\)

Use the accounting equation to show the effects of each of the following transactions on the firm's balance sheet: 1\. Received subscription orders and cash of \(\$ 360,000,\) representing 160,000 magazines. 2\. Mailed 30,000 magazines (ignore any inventory effects). 3\. Borrowed \(\$ 100,000\) at \(6 \%\) annual interest for one year. 4\. Mailed 30,000 magazines (ignore any inventory effects). 5\. Mailed 70,000 magazines (ignore any inventory effects). 6\. Accrued interest on the loan for six months. (Set up an interest payable account.) 7\. Accrued interest on the loan for the following six months. 8\. Repaid the loan, plus accrued interest. 9\. Discuss the implications and meaning of the remaining subscriptions. Where will they appear on the firm's balance sheet? What aspects of these subscriptions will most concern the firm's managers?

a. Discuss the differences between current and long-term liabilities. b. Identify three types of each. c. Indicate how such current liabilities reduce a firm's need for cash. d. Discuss how noncurrent liabilities are used as a source of capital.

Use the accounting equation to show the effects of each of the following transactions on the firm's balance sheet: 1\. Borrowed \(\$ 20,000\) cash from First Bank and signed an interest-bearing \(120-\) day note \((12 \% \text { annual interest rate })\) on October 1. 2\. On November 1 , borrowed cash from Interwest Bank. Signed a note with a face value of \(\$ 18,000\) and a maturity of 90 days. The bank discounted the note at a \(10 \%\) annual interest rate and issued the net proceeds to the firm. 3\. At December 31 (year-end), record the following adjustments: \(\cdot\)Accrued interest on the note in transaction 1 \(\cdot\)Interest incurred on the note in transaction 2. 4\. Paid the note in transaction 1 plus interest at maturity. 5\. Paid the note in transaction 2 at maturity.
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