Assume that Carmen Moustafa has asked you to use the data presented in this case to compute an independent estimation of the accrued product warranty liability as of December 31, 2001. Since this figure will be an estimate, she wants you to prepare working paper to indicate exactly how the estimation was derived. Also, indicate whether or not the $45,465 figure reported for Accrued Product Warranty is reasonable. (Hint: Remember the matching and the periodicity accounting principles)

During the last part of January 2002, Carmen Moustafa, senior auditor for the CPA firm of EM & M, was in the process of finishing the substantive testing for the Sunset Electronics Company audit engagement. Sunset Electronics is a retailer of consumer durable musical electronics that has six stores in different areas and specializes mainly in selling the TOSHEDA Brand with other less known brands. Carmen Moustafa hoped to complete fieldwork by February 9 in order to have the final audit report delivered to the client by the February 22 deadline. The examination had moved into its final phases, and Carmen Moustafa, along with the other members of the audit team, were now accumulating evidence relating to the weeks subsequent to the end of the client's fiscal year. They had already performed the following testing procedures in the period since December 31, 2001: 1. Confirmations were returned to the auditors by each of the banks that dealt with Sunset Electronics during the year (see Exhibit 2-3). These documents disclosed year-end balances and the terms for all accounts and loans. The confirmations also requested the banks to furnish information on certain types of contingent liabilities such as discounted notes receivable. Upon receipt of each confirmation, Paul Rubens- a new staff auditor hired by the firm and performs audit procedures under supervision of Carmen and the engagement manager- reconciled the reported balances to Sunset Electronics' December 31, 2001, records to ensure their agreement. In addition, Carmen Moustafa verified that the terms of each loan were consistent with the accounting records of the company. She also made certain that all loans were being appropriately disclosed within the financial statements. 2. Cut-off statements were received from each bank for all of Sunset Electronics' checking accounts. These statements covered the period from January 1, 2002, through January 10, 2002. Rubens verified that all canceled checks and deposits returned by the bank agreed with the year-end reconciliations prepared by Sunset Electronics employees. 3. Another EM & M auditor, Art Heyman, established the validity of the year-end inventory and sales cut-off. Using the bills of lading prepared between December 28, 2001, and January 2, 2002. Heyman located the corresponding sales invoices to determine the appropriate date for recognizing each sale. This information was then compared with the actual recording of the transaction in Sunset Electronics Sales Journal. Heyman also traced the receiving reports for the same period to the purchase invoice to ascertain the date on which the legal title changed hands for each incoming shipment. These dates were then reconciled to the Inventory Purchases Journal to ensure that all purchases were recorded in the correct time period. The results of the inventory count and comparison with the records showed the following: a) The company's count was adjusted from 59 to 60 for one item (stereo systems). Several items did not belong to Sunset Electronics. They had beenreturned for repairs or adjustment. A properly completed \"Repair Order\" were available signed by the customer and the company's representative. These items did not appear to have a value over $1000. 4-. Wallace Andrews, the audit manager for the Sunset Electronics engagement, read the minutes of a board of directors meeting held on [anuary 1?, 2002. The directors had met primarily to discuss two matters: the expansion of the warehouse facility and damage to Store Two caused by an electrical re on [anuary 5, 2002. At this meeting, Basher Omar, president of Sunset Electronics, stated that the construction was progressing as expected and should be completed during March at a cost of approximately $220,000. He also reported that an electrical malfunction in Store Two had started a small re on the evening of [anuary 5. Actual re damage was limited but water and heavy smoke had caused over 540,000 in inve ntorylosses. Basher Omar indicated that the company's insurance would cover between 60% and 30% of this amount. As a nal action in the meeting, the board of directors declared a cash dividend of $3,000 to be paid to shareholders on [anuary 31 ,2002. The company is a privately owned company in which Mr. Basher Omar owns 30% of the shares and is the company's CEO. Carmen Moustafa began to review a portion of the invoices received by Sunset Electronics during the month of .[anuary 2002. She also intended to analyze the company's cash disbursements for this same period. Both procedures were designed to detect any liabilities that were unrecorded by the client as of December 31 , 2001. Carmen Moustafa performed an extensive search for contingent losses. She talked with Sunset Electronics' management about the possible existence of such losses, read correspondence as well as invoices received from the law rm of Benzinger and Dawkins [the outside legal counsel employed by Sunset Electronics), and reviewed all bank conrmations along with the company's current contracts. None of these procedures indicated the presence of any type of contingent loss as of December 31, 2001. A letter was then mailed to Benzinger and Dawkins stating that the management of Sunset Electronics did not believe any material contingencies existed. On February 2, 2002, EM 8.: M received a response stating that the law rm did not differ with the evaluation of contingencies made by the Sunset Electronics management. A related parties inquiry letter was sent to the Basher Omar Construction and Development Company owned by Mr. and Mrs. Basher Omar. This letter asked about the extent and nature of dealings with Sunset Electronics, as well as all amounts due to, or om, that company. Basher Omar's reply stated that this development company will construct and lease the Store Seven to Sunset, but nothing more [See Exhibit 2-2). Carmen Moustafa performed a nal analytical review. This review is in addition to the one done during the preliminary stages of the audit. The purpose of the earlier analytical review was to help identify critical or problem areas for further substantive testing. The purpose of this nal analytical review is to ensure that nothing unusual has occurred during the latter stages of the audit. If unusual fluctuations occur. then the auditor must investigate further. One issue still concerned Carmen Moustafa. She had recently reviewed the year- end adjustment entries prepared by Sunset Electronics. Most of these entries were quite routine: depreciation expense. payroll liability. interest expense accrual. etc. One entry though did catch her attention: a debit to Other Miscellaneous Expenses and a credit to Accrued Product Warranty for 545,465. When questioned. Mark Hayes. the controller. stated that this adjusting entry was made annually to recognize the company's obligation for future repairs on products that had been sold under warranty during the past year. He indicated that the former auditors. Kamal and Associates. had suggested some years ago that Sunset Electronics accrue 0.?96 of its annual sales as product warranty. Since that time. a similar adjusting entry had been made each year. Hayes stated that 2001 sales of $6.49 5.000 required an accrual of 1545.465 based on the 03% rate. in further discussion with Hayes. Carmen Moustafa discovered that Sunset Electronics offers a six- month warranty on all merchandise. If any item malfunctions within that time. Sunset Electronics will repair it at no- cost to the customer. The services of several local repair shops are used for this purpose. When asked about the cost, Hayes responded. N[t usually runs about $4.000 per month. The Brand Name of TOSHEDA. which the company sells its products are good: repairs are not that common.\" Carmen Moustafa immediately went to Mr. Mahmoud Moustafa. the audit partner on the engagement. for guidance. Estimating the potential liability of a six-month product warranty on $6.5 million in sales was an obvious audit concern. Mahmoud agreed that additional evidence was needed to corroborate the accrued liability balance reported at December 31. 2001. He asked Carmen Moustafa to prepare a two-year history of repairs so that a determination could be made of the client's potential liability. Carmen Moustafa requested this data from Hayes and received the following: MONTH 2000 SALES FOR MONTH REPAIR EXPENSE FOR MONTH January $532,000 $3,03 February 316,000 3,018 March 359,000 4,691 April 479,000 4,439 May 486,000 3,005 June 414,000 3,049 July 371,000 2,866 August 460,000 2,648 September 442,000 4,116 October 533,000 3,804 November 586,000 3,542 December 800,000 3,730 MONTH SALES FOR MONTH REPAIR EXPENSE FOR MONTH 2001 January $610,500 $4,313 February 381,000 4,750 March 346,000 3,973 April 557,000 4,439 May 590,000 4,818 June 409,000 4,449 July 422,000 4,075 August 550,000 3,542 September 511,000 4,181 October 602,500 5,206 November 642,000 4,830 December 874,000 4,741 In addition to the data presented above , Hayes was able to break down the repair expense for each month by the age of the item being repaired. This information is contained in Exhibit 2-1.W 2:1. Sunset Electronics Company SUMMARY OF PRODUCT WARRANTY EXPENSE [Prepared byClient} Ianuary, 20111] through December, 20111 HO NTH Sales for Month 2 Month Old Sales 3 Month old Sam ' 555 4- Month Old Sales STD MO NTH Returns During Month: Current Month Sales 1 Month Old Sales 2 Month Old Sales 3 Month Old Sale: 4- Month Old Sales 5 Month Old Sale: 6 Month Old Sales 211 4-4-5 4-5? 251 Total $3,005 - 3 3,049 32,366 $2,643 \"This row represents actual returns during the month for goods that were sold during the month Listed. For example, the $445 Listed under January 2000I "i Month Old Saies, " were items sold in December of 1999 and returned in JanuaryI of 2000. September October November December MONTH 2000 2000 2000 2000 Sales for Month $442,000 $533,000 $586,000 $800,000 Returns During Month: Current Month Sales 210 292 469 505 1 Month Old Sales 497 559 583 563 2 Month Old Sales 569 462 629 666 3 Month Old Sales 797 541 639 664 4 Month Old Sales 1,029 735 512 604 5 Month Old Sales 812 698 490 456 6 Month Old Sales 202 517 220 272 Total $4,116 $3,804 $3,542 $3,730 Exhibit 2-1 (continued) January February March April MONTH 2001 2001 2001 2001 Sales for Month $610,500 $381,000 $346,000 $557,000 ReturnsDuringMonth: Current MonthSales $323 $336 $234 $335 1 Month OldSales 948 969 366 351 2 Month OldSales 657 885 861 397 3 Month OldSales 917 845 1,074 915 4 Month OldSales 594 625 798 1,201 5 Month OldSales 675 699 500 657 6 Month OldSales 199 391 140 583 Total $4,313 $4,750 $3,973 $4,439 May June July August MONTH 2001 2001 2001 2001 Sales for Month $590,000 $409,000 $422,000 $5 50,000 ReturnsDuringMonth: From Current MonthSales $421 $368 $599 $251 1 Month OldSales 670 736 442 337 2 Month OldSales 410 766 684 516 3 Month OldSales 580 527 1,054 947 4 Month OldSales 1,023 549 292 718 5 Month OldSales 1,010 808 519 468 6 Month OldSales 704 695 485 305 Total $4,818 $4,449 $4,075 $3,542\fExhibit 2-2 RENTAL AGREEMENT The following shall constitute a legal agreement between Rogers Development Company ("Lessor") and the Sunset Electronics Company ("Lessee") as to the leasing of land and building ("Property") located at 910 Second Street in Williamsburg, Virginia. The agreements between the Lessor and the Lessee are as follows: (1) The lease shall run from December 1, 2001, through November 30, 2002. (2) The Lessee shall deliver to the Lessor a payment of $21,000 prior to the initial lease date as stated above. This payment shall give the Lessee sole privilege to use the Property for the period of time of the lease. (3) All utilities, property taxes, and maintenance costs associated with the Property for the period of the lease shall be the sole responsibility of the Lessee. (4) Any permanent improvements of the property shall be the sole responsibility of the Lessee subject to prior written approval of the Lessor. Any attachments to the Property shall become the property of the Lessor subject to the laws of the Commonwealth of Virginia. (5) The Lessee makes no guarantee as to the value of the Property at the end of the lease period but does guarantee to repair any physical damage to the Property. (6) The Lessor agrees to maintain adequate insurance coverage on the Property while the Lessee agrees to maintain adequate insurance coverage on the contents therein. LESSOR: OMAR DEVELOPMENT COMPANY BY: . LESSEE: SUNSET ELECTRONICS COMPANY BY