Massarra’s Photos sells memory cards for digital cameras on the Internet, by catalog, and in numerous retail stores. The items are sold with a 90-day money-back guarantee. The customer can return any item within 90 days of purchase for replacement if it fails to work. At the end of each year, Massarra’s records an accrual for warranty expense related to the potential claims at the end of the year. In your review of the warranty expense account, you note that sales for the last six months of year were $10,800,000. Sales for the fourth quarter totaled $6,400,000. The gross margin for this business is 45%.
a. If 1% of sales are returned, what is your estimate of warranty expense at year-end?
b. How would you determine whether management’s estimate that 1% of all sales were returned is accurate?
c. Propose an audit adjustment if the correct return rate is 1.25%.