APPLIED

AUDITING 2
AUDIT OF LIABILITIES
(Problem 7 11)

NAME: Del Rosario, Renz G.

SCHEDULE: 2:00 3:00 MWF/ 2:30 4:00 TTH
INSTRUCTOR: Mr. Raymund Cabidog, CPA
PROBLEM 7 11
Accounting for Warranties and Premiums
OLSON MUSIC EMPORIUM carries a wide variety of musical instruments,
sound reproduction equipment, recorded music, and sheet music. To promote
the sale of its products, Olson uses two promotion techniques premiums
and warranties.
PREMIUMS
The premium is offered on the recorded and sheet music. Customers receive
a coupon for each P10 spent on recorded music and sheet music. Customers
may exchange 200 coupons and P200 for a CD player. Olson pays P340 for
each CD player and estimates that 60% of the coupons given to customers
will be redeemed. A total of 6,500 CD players used in the premium program
were purchased during the year and there were 1,200,000 coupons
redeemed in 2014.
WARRANTIES
Musical instruments and sound reproduction equipment are sold with a one-
year warranty for replacement of parts and labor. The estimated warranty
cost, based on past experience, is 2% of sales. Replacement parts and labor
for warranty work totaled 1,640,000 during 2014.
Olson uses the accrual method to account for the warranty and premium
costs for financial reporting purposes. Olsons sales for 2014 totaled
P72,000,000 P54,000,000 from musical instruments and sound
reproduction equipment and 18,000,000 from recorded music and sheet
music. The balances in the accounts related to warranties and premiums on
January 1, 2014, were shown below:
Inventory of premium CD players
399,500
Estimated premium claims outstanding
448,000
Estimated liability from warranties
1,360,000
Based on the preceding information, determine the amounts that will be
shown on the 2014 financial statements for the following:
1. Warranty expense
A. P1,640,000 C. P800,000
B. P1,080,000 D. P360,000
2. Estimated liability from warranties
A. P1,920,000 C. P240,000
B. P1,080,000 D. P800,000
3. Premium expense
A. P1,836,000 C. P756,000
B. P840,000 D. P2,189,500
4. Inventory of premium CD players
A. P399,500 C. P2,210,000
B. P569,500 D. P 739,500
5. Estimated premium claims outstanding
A. P364,000 C. P756,000
B. P840,000 D. P672,000

SOLUTION 7 11
1. Sales of musical instruments and sound
reproduction equipment P54,000,0000
Estimated warranty cost x 2%
Warranty expense for 2014 P 1,080,000
Answer: B

2. Estimated liability from warranties, Jan. 1, 2014 P1,360,000

Add: 2014 warranty expense (see no. 1) 1,080,000
Total 2,440,000
Less: Actual warranty costs during 2014 1,640,000

Estimated liability from warranties, Dec. 31, 2014 P 800,000

Answer: D

3. Coupons issued (18,000,000/P10) 1,800,000

Multiply by estimated redemption rate x 60%
Estimated number of coupons to be redeemed 1,080,000
Divide by exchange rate (200 coupons for a CD player) 200
Estimated number of CD players to be issued 5,400
Multiply by net cost of a CD player (P340 P200) x 140
Premium expense for 2014 756,000
Answer: C

4. Inventory of premium CD players P399,500

Add: Premium CD players purchased
during 2014 (P340 x 6,500) 2,210,000
Total
2,609,500
Less: Premium CD players distributed to customers
during 2014 (1,200,000/200 = 6,000 x P340) 2,040,000
Inventory of premium CD players, Dec 31, 2014 P 569,500
Answer: B
5. Estimated premium claims outstanding, Jan. 1,2014 P448,000
Add: 2014 premium expense (see no. 3) 756,000
Total
1,204,000
Less: 2014 actual redemptions
(1,200,000/200 = 6,000 x P140) 840,000
Estimated premium claims outstanding, Dec 31, 2014 P 364,000
Answer: A
COMMENT:
Estimated liabilities are obligations which exist at the end of reporting period
although their amount is not definite. Examples include estimated liability for
premium, award points, warranties, gift certificates and bonus.
Under PAS 37, an estimated liability is considered as a provision which is
both probable and measurable.
PAS 37 Provisions, Contingent Liabilities and Contingent Assets outlines the
accounting for provisions (liabilities of uncertain timing or amount), together
with contingent assets (possible assets) and contingent liabilities (possible
obligations and present obligations that are not probable or not reliably
measurable). Provisions are measured at the best estimate (including risks
and uncertainties) of the expenditure required to settle the present
obligation, and reflects the present value of expenditures required to settle
the obligation where the time value of money is material.
Paragraph 11 of PAS 37 states that a provision can be distinguished from
other liabilities in the sense that there is uncertainty about the timing or
amount of the future expenditure required for settlement.
PAS 37, paragraph 14, provides that a provision shall be recognized as a
liability in the financial statements under the following conditions:
a. The entity has present obligation, legal or constructive, as a result of a
past event.
b. It is probable that an outflow of resources embodying economic
benefits would be required to settle the obligation.
c. The amount of the obligation can be measured reliably.
Premiums are articles of value of such toys, dishes, silverware, and other
goods and in some cases cash payments, given to customers as result of
past sales or sales promotion activities.
In order to stimulate the sale of their products, entities offer premiums to
customers in return for product labels, box tops, wrappers and coupons.
Accordingly, when the merchandise is sold, an accounting liability for the
future distribution of the premium arises and should be given accounting
recognition.
In warranties, the best estimate of the warranty cost is recognized as a
provision because in this case there is clear legal obligation arising from an
obligation event which is the sale of the product with warranty.
Accordingly, at the point of sale, a liability is incurred.
There are two approaches followed in accounting for the warranty cost,
namely accrual approach and expense as incurred approach.
Accrual approach Expense as incurred approach
 The accrual approach has the
soundest theoretical support
because it properly matches
cost with revenue. At the time
of sale a liability for warranty
cost arises and therefore
should be given accounting
recognition.
The expense as incurred
approach is the approach of
expensing warranty cost only
when actually incurred. This
approach is popularly in
practice because it is the one
recognized for income tax
purposes and frequently
justified on the basis of
expediency when warranty
cost is not very substantial or
when warranty period is
relatively short.