Homebake Inc. is a growing company in the consumer small appliance industry. After months of research and testing, Homebake introduced its new home breadmaker in retail stores in September 20X5, just in time for the Christmas season. The breadmaker had many more features than other similar models on the market, but it sold for the same price as the unit offered by the company’s main competitor. Consumers were demanding products that would allow them to make preservative-free, fresh bread in their homes, and Homebake was anticipating that sales of its breadmaker would be high. The breadmaker came with a two-year warranty on all parts and labour and an unconditional guarantee that allowed consumers to return the product for a full refund if not completely satisfied.

In October 20X5, the company began to receive returns and complaints from some of the consumers who had purchased the product. Although the breadmaker had been tested thoroughly and all mechanical parts were performing satisfactorily, some consumers were having trouble removing the freshly baked bread from the breadpan. It seemed that the non-stick coating would allow for easy removal of the bread for a week or two, depending on the frequency of use, and then would suddenly stop working. Consumers were having to use spatulas and knives to remove the fresh, soft bread from the pan, often scarring the coating and making it even less effective, and ruining the bread in the process.

Research into the problem showed that although the breadpans themselves were manu¬ factured by Homebake, the non-stick coating was applied by three independent suppliers. One of the suppliers had used a substandard coating mixture on the breadpans that it fin¬ ished for Homebake. Homebake knew it would have to immediately remedy the problem and provide those consumers who complained with a new breadpan made by one of the other suppliers; otherwise, the consumers would return their breadmaker for a full refund.
Unfortunately, the breadpans could not be identified by supplier, and Homebake had no way of knowing how many of the substandard pans had been sold or were sitting on shelves in retailers’ stores waiting for the Christmas rush.
The company set up a toll-free line that consumers or retailers could call for a replace¬ ment pan. When consumers or retailers called, highly trained customer service representa¬ tives explained the problem and reassured the callers that a replacement pan would be sent out immediately by courier. They reminded callers of the Homebake breadmaker’s unique features and urged them not to return the product. They also told consumers about how much good feedback the company had received from other Homebake breadmaker owners who were using the good breadpans. Finally, they promised to send out free bread mixes and coupons with the breadpans and reminded callers that the pan would be delivered in less than three days. The company felt that there would be few breadmakers returned when consumers and retailers were treated with this kind of respect and courtesy.
It is now 6 January 20X6. You are employed as controller for Homebake. You are in the process of preparing year-end financial statements when the president of the company calls you into her office. You are glad for the meeting, for you were just considering what should be done about the potential warranty liability from the sale of breadmakers. A rea¬ sonable estimate and accrual of normal returns and warranty costs has been made from past experience with other similar products and from the experience of other manufactur¬ ers with this product. However, the breadpan failure is unique, and you have not yet deter¬ mined how to account for the expenses relating to it.
From your data, you have learned that the breadmakers, which sell for \($199.99\) in retail stores, cost Homebake \($75\) to manufacture and are sold to retailers for \($125\). The cost of sending out a second breadpan, including shipping and the free mixes and coupons, is \($20\). Over 3,600,000 original breadpans have been shipped, and approximately one-third are estimated to be faulty. By 31 December 20X5, only 100,000 replacement breadpans had been shipped, since many of the breadmakers were purchased as Christmas gifts and had not yet been used.
When you arrive at the president’s office, you learn that the breadpan liability is the focus of the meeting. The president is wondering how the returns will be accounted for in the year-end statements. Her comments to you are:
“I was thinking about the problem with the breadpans. I think the best way to deal with this is to expense all the costs of shipping new pans as we incur them. I know this is not our normal accounting procedure, but this is not a normal situation. We will be suing the supplier of the faulty pans, and more than likely we will recover all of the costs we have incurred. But there is no way this case will make it through the courts until sometime next year. If we recognize only the costs incurred to the year-end, then next year when we have the settlement from the lawsuit, we can put the settlement against the costs of shipping the new breadpans and there will be no impact on our profitability picture. You know that we are a small company, and this project is going to allow us to grow and expand to be a much bigger company. But we can’t do that if we don’t have the confidence of our banker and the general public. We need to show a good bottom line this year, so we can survive next year.”
You leave the president’s office feeling as if she used the meeting more to convince you of her ideas than to listen to your expertise. You are not convinced that the cash basis will provide the proper valuation of the liability for product replacement. However, the president did not seem very open to any other way of accounting for the costs of the faulty breadpans.

The president has asked you to jot down some rough figures for the next meeting, which is in two days. Your plan is to present both her approach and what you think would be more acceptable under GAAP, since Homebake requires audited statements for share¬ holders and bankers.
Required:
Respond to the president’s request.