You are auditing the estimated liability for warranty expense of an automobile manufacturer for the year ended December 31, 2003. The automobiles carry a five-year or 50,000 mile warranty (whichever comes first) covering labor and parts on major components. This warranty policy has been in effect since October 1, 1998. Previously, the warranty was for three years or 36,000 miles.

Required:

a. Should you be most concerned about the potential overstatement or understatement of this liability? Explain your answer.

b. What alternative approaches might you use to verify the reasonableness of this estimate? Which approach do you believe will be most effective and efficient?

c. What audit procedures would you perform to verify the reasonableness of this estimated liability?