Danny’s Lawn Equipment sells high-quality lawn mowers and offers a 3-year warranty on all new lawn mowers sold. In 2017, Danny sold \(300,000 of new specialty mowers for golf greens for which Danny’s service department does not have the equipment to do the service. Danny has entered into an agreement with Mower Mavens to provide all warranty service on the special mowers sold in 2017. Danny wishes to measure the fair value of the agreement to determine the warranty liability for sales made in 2017. The controller for Danny’s Lawn Equipment estimates the following expected warranty cash outflows associated with the mowers sold in 2017.

Cash Flow Probability Year Estimate Assessment 2018 \)2,500 20% 4,000 60% 5,000 20% 2019 \(3,000 30% 5,000 50% 6,000 20% 2020 \)4,000 30% 6,000 40% 7,000 30%

Instructions Using expected cash flow and present value techniques determine the value of the warranty liability for the 2017 sales. Use an annual discount rate of 5%. Assume all cash flows occur at the end of the year.

Step by step solution

01

Computation of discounted cash flow of each year

Year	Expected cash flow		PV factor	Discounted cash flow
2018	2,500*20%+4,000*60%+5,000*20%	3,900	0.95238	3,714.282
2019	3,000*30%+5,000*50%+6,000*20%	4,600	0.90703	4,172.338
2020	4,000*30%+6,000*40%+7,000*30%	5,100	0.86384	4,405.584

02

Calculation of Warranty liability

$\begin{array}{rcl}\mathrm{Value}\mathrm{of}\mathrm{warranty}\mathrm{liability}& =& \mathrm{Sum}\mathrm{of}\mathrm{discounted}\mathrm{cash}\mathrm{flow}\mathrm{each}\mathrm{year}\\ & =& 3,714.282+4,172.338+4,405.584\\ & =& \$12,292\end{array}$

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