Context: Your accounting firm has just been hired to perform the audit of a small, privately-held company called AAA for the fiscal year ended October 30, 2015. You have been assigned to the engagement team for AAA. You and the audit engagement manager have already had an initial meeting with the controller of AAA. Some of the information you gathered at that meeting is provided below along with the specific instructions that the engagement manager gave you following this meeting.

Product Offering and the Tadpole Warranty

Among other things, AAA markets and sells a popular specialty-type kit for young and inquisitive elementary school children, called Watch Me Grow! AAA customers for this product are large toy and pet stores as well as high-volume discount retailers. Each Watch Me Grow! kit contains a small plastic aquarium-type tank, decorative gravel, two plastic plants, and a coupon that the buyer can redeem for a live tadpole. The end customer redeems the coupon by calling AAA 1-800 number and providing a unique coupon code. Upon receipt of this code and the customers shipping information, AAA ships a tadpole to the customer. AAA follows strict shipping procedures designed to protect the tadpoles while in-transit.

To address concerns that the tadpole may not arrive at its destination (the end customers location) in good physical condition, AAA provides a warranty on the tadpoles it ships. If a tadpole does not arrive at its destination in good physical condition (i.e., it meets its demise on the way to the customers residence), AAA will send a replacement tadpole free of charge. To receive a replacement tadpole, the customer must return the defective (dead) tadpole to AAA headquarters within seven days of its receipt. If the tadpole is not returned to AAA within the seven-day window, the warranty is voided and no replacement is sent. Provided AAA quality control inspector does not suspect foul play upon examination of the damaged (dead) tadpole, a replacement is sent to the customer free of charge. This process can be repeated as needed until the customer receives a viable tadpole. AAA has tracked customers warranty claims for some time and estimates that out of every 1,000 tadpoles it ships, approximately 40 must be replaced. AAA also has cost information that allows it to reasonable estimate the costs it incurs to develop a tadpole. AAA has not historically recorded a warranty accrual for tadpoles nor have they ever disclosed any information related to the warranty.

Issue: Whether an accrual for the warranty on the tadpoles extended to customers should be recorded and disclosed by AAA in its financial statements for the fiscal year ended September 30, 2015 and, if so, how.For this issue, the engagement manager has instructed you to include in your memorandum any journal entries necessary to illustrate the appropriate accounting for the warranty.Should you determine that journal entries are necessary, you are to include an explanation of the entries.