Novack Machinery Corporation manufactures equipment to a very high standard of quality; however, it must still provide a warranty for each unit sold, and there are instances where the machines do require repair after they have been put into use. The company started in business in 2014, and as the controller, you are trying to determine whether to use the expense or the revenue approach to measure the warranty obligation. You would like to show the company president how this choice would affect the financial statements for 2014, and advise him of the better choice, keeping in mind that the revenue approach is consistent with IFRS, and there are plans to take the company public in a few years.
You have determined that sales for the year were 1,000 units, with a selling price of $3,000 each. The warranty is for two years, and the estimated warranty cost averages $200 per machine. Actual costs of servicing warranties for the year were $105,000. You have done some research and determined that if the revenue approach were to be used, the portion of revenue allocated to the warranty portion of the sale would be $350. Because the costs of servicing warranties are not incurred evenly, warranty revenues are recognized based on the proportion of costs incurred out of the total estimated costs.
Instructions
(a) For both the expense and the revenue approach, prepare the necessary journal entries to record all of the transactions described, and determine the warranty liability and expense amounts for 2014.
(b) What are the advantages and disadvantages of the two choices? What do you think is the best choice in this situation? Why?