1. The board is concerned with the frequent variances in the amount of warranty expense that was initially recognised compared to the actual cost of warranty the company paid/incurred to fix/replace the faulty products. Therefore, at the most recent board meeting it was agreed to stop recognising the warranty expense before the warranty cost is actually incurred. Instead expense will be recognised when we actually pay for these warranty repairs/replacements. This way we won’t have to deal with all these variances.
Letter of advice
Re: Accounting Issues: Year Ending 30 June 2017
From: Maria ([email protected])
To: Con Pewter ([email protected])
The warranty expenditure is the cost, which your business anticipates incurring or which has already been incurred for the purpose of repair of goods that you have sold. The total amount of warranty expenditure is limited by the period of warranty, which your business typically allows. Following the expiry of the product warranty period your business will no longer incur a warranty liability (Gigler et al. 2014). Your business should identify the warranty expenditure during the same period with the sales of the product. If it is probable that an expenditure will occur and your business can make an estimate of the amount of expenses. This will ultimately give rise to matching principles where all the expenditure relating to sales is identified in the same reporting period with the revenue from the sale transaction.
It is suggested that the historical percentage of the warranty expenditure to sales should be recognised for identical types of goods for which the warranty is presently being determined by your business (Wahlen, Baginski and Bradshaw 2014). Hence, your business must implement the same percentage of the sales for the current accounting period in order to derive the accrued warranty expenditure. This amount can be adjusted to the account for the unusual factors associated with the goods that were sold. Your business should accrue the warranty expenditure with the debit in the warranty expenditure account and a credit to the warranty liable account. This will result in impairing the income statement by the full amount of warranty expenditure when sales are recorded even if there are no warranty claims incurred during that period (Chen et al. 2015).
As the part of IASB and AASB, revenue from the contracts with customers is proposed that your business must assess whether the objective of the warranty provided covers either the quality assurance or an insurance warranty. If your business provides quality assurance warranty to protect the customers from the defaults that existed as the part of production and will not lead to any separate performance would represent a fulfilment of the obligation of the original performance obligation. An insurance warranty helps in protecting against the future events and therefore may enable your business for separate performance (Thapa 2015). In addition to this, it is viewed that revenue for your business would be ultimately deferred since distinguishing between the variable expenses and variance would not lead your business any cost benefit. It is acknowledged that concerns expressed by you over the operational expenditure were more suitable than revenue deferral.
Keeping the principles of AASB in mind it is recommended that a separate warranty obligation should be established since there would be no kind of revenue deferred. Instead, it will help in identifying the warranty obligation along with the warranty expenditure during the transfer of goods. It is further suggested that warranty arrangement must meet the above stated criteria as the separate warranty obligation, which would conversely be considered as the distinct obligation for performance and may result in deferral of revenue (Frias?Aceituno et al. 2014). The IASB and AASB has laid down a step by step proposal where the customer has the opportunity of purchasing the product warranty separately this would result in separate obligation for performance and will lead to revenue deferral for your business. If the warranty renders a service to the customers and may represent a distinct performance obligation or whether the warranty represents a distinct warranty obligation then your business incurs cost accrual expenditure. According to the AASB 111 Construction Contracts standard your business should only record the warranty expenditure given the time when the product is sold and the warranty liability can be estimated by your business.
According to the AASB 111 Construction Contracts, when the liability for warranty is both probable and can be estimated the accountant will have the opportunity during the period of sales liability and the expenditure for the future warranty work (Weickgenannt 2014). This kind of matching of warranty expenditure with the related sales revenue is considered as reasonable since this will help in reducing the variances. Given that your business can reasonably estimate the sum of warranty claims, which is likely to arise under the business policy, framed, your business must accrue the warranty expenditure, which will help in reflecting the cost of the anticipated claims. This will further help in addressing the variance and it accrual must take place during the same reporting period under which the related product sales are recorded by your business. By undertaking the proposed accounting method the financial statement of your business is most likely to represent an accurate cost of each product associated with sales (Smith, Reid and Hsu 2016). It will reflect a true scenario of profitability associated with the sales.
Given that the management decides to change the period covered by warranty, this will ultimately change the warranty expenditure not only for the sales took place in the current period, but also for the sales in earlier periods whose warranty will be ultimately extended in the current period. If your business decides that the cost of warranty to claims were to be identified during the company processes, the expenses might not be identified for several months following the associated sales and this will give rise to variance (Sawyer 2015). If your business does not possess information from which to generate a warranty estimate for using an accrual basis of accounting it is recommended that your business must use the industry information concerning warranty claims. It is suggested that if your business faces an insignificant amount of expenses you must develop an actual cost of warranty claims and must calculate the relationship amid the cost incurred and the related amount of revenue or units sold by your business.
According to AASB 118 recognition and measurement of revenue represents the matching principles that states the revenue of the company must be matching with the expenditure. Accounting requires a use of estimates and warranty expenditure is similar to such expenditure. If the your company anticipates the period of claim to be extended for more than one year it is recommended that your business should split the accrued warranty expenditure in a short term liability for such claims and long term liability for claims that is expected to last more than year. In accordance with AASB 118 recognition and measurement of revenue this will further help in addressing the variances of warranty expenditure (Armstrong et al. 2015).This kind of information can be implemented in the current sales level and this will help in forming the justification of the amount of accrued warranty expenditure.
According to AASB 102 Inventory represents the number and the value of stock items forming the part of business possession. The revenue for your business relatively comprises of the finished goods, which is ready for sale and the raw materials that is waiting to undergo in the production process. It is recommended that the value for inventory for your business should be computed accurately because it accounts for huge amount of share of current assets and forms an important element in the determination of profits and losses generated by your business (Brief 2013). However, discrepancies might arise between the values of inventory that is captured in records along with the value of actual inventory count. It is recommended that your business must set up an inventory adjustment so that it can correct the differences to avoid the circumstances of overstatement or understatement of the income statement.
Your business may face the risk of inventory fluctuations where the overstated inventory records represents that more stock items are in the store than the actual stock count. An understated inventory may represents that there is less amount of merchandise available in the store than the actual count of stock. Such kind of differences generally arises from the circumstances when your business might have omitted the items in the store receipts or might have failed to keep reconciliation in the movement of raw materials and finished goods from one point to another (Young and Cohen 2013). An overstated inventory generally lowers down the cost of goods sold for your business.
According to AASB 102, the availability of excess amount of inventory in your store could ultimately lead to higher instances of closing stock and lesser amount of cost of goods sold. Therefore, it is recommended that the your business must make an adjustment entry in order to remove the extra amount of stock and this may reduce the amount of closing stock and increase the cost of goods sold. It is recommended that your business must not record a lower amount of inventory by reducing the closing stock effectively increasing the cost of goods sold (Nobes 2014). When an adjustment entry is made in order to make an addition of the omitted stock this will ultimately increase the amount of closing stock and will reduce the cost of goods sold. Fluctuation in the cost of goods sold creates a direct impact on the business income statement. For instance, your business may have to subtract the cost of goods sold from the sales to derive the gross profit. This represents an overstated inventory and inflates the gross profit and vice versa. An increase in the cost of goods sold due to the downward adjustment of the overstated inventory would ultimately reduce the gross profit of the organisation (Cohen, Krishnamoorthy and Wright 2014).
Consequently, a reduction in the cost of goods sold because of the upward movement of an understated inventory may increase the gross profits. Furthermore, recording the net sales cost of doing the business typically forms the part of typical income statement. Hence, it will reflect the total amount of revenue, which the company has brought in from the sales after subtracting the value of goods returned from the store and allowances. Allowance reflects the price reduction or rebates that are offered to the customers in order to persuade them to keep an item instead of returning them. The net sales figure of your business must include the subtractions amount of sales returned by the supplier. It is recommended for your business that it must keep the stocks that are obsolete and will lead to low turnover slow down sales. Therefore, it is recommended that the company must consider the demand levels in order to avoid the overstocking and under stocking.
Sufficient inventory management forms the essential part of your business in maximising the operational efficiency along with the profitability. The bottom line of the business is the net income since net income simply reflects the profit with the entire amount of income statement flowing towards the number of units sold by your business (Zhang and Andrew 2014). It is suggested that your business must record the net amount received from the revenue by subtracting the expenditure or any kind of gains or losses incurred during the business process. Therefore, keeping the records of your business forms the most important factor in controlling the profitability of your business. Hence, the process adopted by your business in sourcing and managing the inventory can create an impact on the difference of profit levels of your income statements.
It is suggested that your business should provide the revenue recognition as the meaningful and consistent measurement of business performance. Your business is currently incurs a recurring revenue which forms obligatory to match the revenue and the cost incurred to derive the revenue in the same accounting period (Whittington 2014). The revenue recognition principles form the cornerstone of accrual accounting together with the matching principles. They will help in recognising the accounting period in which the revenues and expenses for your business will be identified. According to the principle, revenues are identified when they are realised or realizable and are earned irrespective of when the cash is received. According to the IFRS approach, there are five criteria of identifying the critical event for identifying the revenue of sale of goods. An allowance account should be created in order to match the principles of expenses to the revenue earned. Hence, it is recommended for your business to record the sales revenue since the amount of revenues and expenditure should be able to reasonably measurable.
Maria ([email protected])
McKenzie and Associates.com.au
Level 6, 510 King William Street, Melbourne VIC 3000
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