Case
Autor: anshu mali • October 19, 2016 • Case Study • 347 Words (2 Pages) • 522 Views
Page 1 of 2
Accounting for Extended Warranty Contracts
Example
Stereo | Contract | Total | |
Revenue | 1000 | 100 | 1100 |
Cost | 900 | 20 | 920 |
Profit | 100 | 80 | 180 |
Methods
- Full revenue recognition: Recognize full revenue and cost on the date of sale. Hence full profit of $180 will be recognized. If during the service term of 2 years, the service cost exceeds or falls short of $20, adjustment will be made on a later date.
- Deferred Revenue Recognition: Sale of stereo and sale of service contracts are two separate heads. Though the service contract has been sold today but the services associated with the contract have not been rendered hence should be deferred and recognized over 2-year period using some systematic allocation method.
- Partial Revenue Recognition: A part of the combined transaction will be recognized at the time of sale, with the remainder deferred and recognized over the contract period. The cost associated with the extended warranty will be recognized as incurred.
Q1. Partial revenue Recognition.
Reason:
- All 4 points mentioned in the case
- 54% of customers buy warranty.
- Extended warranty relates to the product sold by circuit city
- Profit margin is 400% which is unusually high
- Cost estimate to a high degree of reliability
Partial recognition also allows provisioning for estimated cost of servicing which is deferred and hence lowers the risk of inflated cost if any.
Q4. Mike Chalifax should shift to deferral method, make an
Q3. The effects on the financial statement of city circuit may be as follows
- The income derived from sale for warranty is a major part of net income and if taken out will have drastic effect on the eps. A lower EPS might disappoint the shareholders.
- Profitability Measures will take a Hit
- Roe will go down
- Test on investment utilization (Asset turnover, equity turnover, etc) will go down
Q2. Importance to circuit city
- Income will go down which might have a negative impact on the shareholders
- There was a huge profit margin in selling the warranty and if they had to do the third party reselling, it might shrink the margin on profit.
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