Discounting warranty obligations. GAAP require long-term monetary liabilities to appear at the present value of the future cash flows discounted at the market rate of interest appropriate to the monetary items at the time the firm initially recorded them. The Accounting Principles Board Opinion No. 21 specifically excludes from presentvalue valuation those obligations that arise from warranties. The Opinion requires that warranties, being nonmonetary liabilities, be stated at the estimated cost of providing warranty goods and services in the future.

Assume that the estimated future costs of a three-year warranty plan on products sold during Year 1 are as follows:

Actual costs coincided with expectations as to both timing and amount.

a. Prepare the journal entries for each of the years 1 through 4 for this warranty plan following current GAAP.

b. Now assume that GAAP allow these liabilities to appear at their present value. Prepare the journal entries for each of the years 1 through 4 for this warranty plan, assuming that the firm states warranty liability at the present value of the future costs discounted at 10 percent. To simplify the calculations, assume that the firm incurs all warranty costs on December 31 of each year.

c. What theoretical arguments can you offer for the valuation basis in part \(\mathbf{b}\) ?

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Year of Expected Expenditure 2 3 4 Total Expected Cost $ 500,000 600,000 900,000 $2,000,000