Question 5

Rob Thomas, the controller of MatchBox 20 (Match), has a disease (in other words, he is unwell) and wont be able to report for work today. In his absence, you (the assistant controller) must prepare some adjusting journal entries and respond to questions raised by the CEO of Match, Mr. Yale. It is March 8, 2008, and you are working on the financial statements of Match for its year ended December 31, 2007.

The following information is available from Thomass files:

• Match offers a 1-year warranty on its main product, the tone-deff hearing aid. Sales were 2,500,000 units in 2007. Matchs estimates are that 2% of the units sold will be returned for repairs within the warranty period (up from 1.5% from the prior year). Repairs are estimated at $20.00 per unit returned.
• During 2007, 70,000 units were turned in for repairs, and Match spent $1,295,000 repairing them.
• You note that the general ledger has a balance in its warranty expense account of 1.295 million, and also has a balance of $600,000 in its accrued warranty liability account (unadjusted from the balance on its 2006 financial statements).
• In 2006, a customer injured himself when he wired his hearing aid to a 10,000-watt stereo system. In January 2007, his lawyer filed for a suit against Match claiming that they did not adequately warn their customers against such activities; he is seeking damages from hearing loss of $15 million.
  • In-house counsel for Match considers the lawsuit to be frivolous and expects it to be dismissed.
• In March 2007, Match was named as a defendant in a patent infringement suit. In-house counsel believes that it is probable that Match will need to pay damages and estimates that Match will need to pay between $1 million and $1.5 million to settle the suit.
• Match has current liabilities of $39 million (which includes any estimated warranty liability)
• In January 20, 2008, Match issued $60 million in long-term debt. It used $10 million of these proceeds to refinance part of the current liabilities above. In addition, Match paid off $2 million of its current liabilities using excess cash on January 10, 2008.

The CEO, Yale, would like to minimize Matchs disclosure of current liabilities as much as possible. He reasons that the $60 million of new long-term debt is more than sufficient to cover the $39 million of current liabilities, so he would like to see the entire $39 shown as long-term debt on its 2007 balance sheet. At the very least (according to Yale), the $12 million paid off already should be reclassified as long-term.

Yale also thinks that Thomas must have made a mistake because the balance of $600,000 has remained in accrued warranty liability from last year, and he would like to know what adjustment will be needed to the 2006 financial statements because of the increase in the estimate of defective units from 1.5 to 2% in 2007. Presumably, he reasons, the balance in the liability should go up. He is also unsure as to why Match doesnt just report the actual expenditures for warranty repairs, which are known and verifiable, instead of using estimated numbers that could turn out to be wrong in the future.

Required: show any journal entries that might be required from the above information (hint: recall that the warranty period is only one year).