Describe the impact the three proposed accounting methods (full revenue recognition, deferral of revenue, and partial revenue recognition) would have on the company’s financial statements: 1) at the time of the sale, and 2) in future periods. Full revenue recognition: I believe this is the most consistent with actual substance of sales transactions involving equipment and extended warranties. Circuit City matches up almost perfectly with the five criteria in Exhibit 2 in the case study. They incurred the selling costs, they have a service network in place and warranty expenses are forecasted with a great deal of accuracy.
Very few customers go above the allocated cost of the service warranty, thus Circuit City does not employ a deductible. After a warranty is purchased, Circuit City’s cost and profit can be expensed with a reasonable degree of accuracy. The uncertainty is so low, it’s almost as if the warranties were like any other physical product, and can be treated as such under Approach No. 1. Deferral of revenue: Two distinctly separate transactions should be accounted for separately. In this case the revenue is recognized at the time of sales while the cost associated with the warranty is accounted for separately.
The contract revenue is deferred and recognized as revenue over the number of years of the warranty period. Proponents believe that it is inappropriate to recognize revenue at the point of sale because none of the services associated with the contract has been rendered and therefore the revenue had not been earned. This is fully explained in approach 2. The impact of full revenue recognition at the time of sales on the company’s financial statement will be negative. This is because the share equity on the balance sheet becomes significant.
... the risk of false revenue recognition due to either channel stuffing or the sale of equipment (meant to ... and thus assume a representative cost mix that is proportional to total revenues. Hence, we use the ... with a corresponding reduction in accounts receivable. The cost of goods sold is reduced by $470mn, ... ’s intangible assets are subject to different costs as its tangible assets, and therefore have ...
Partial Revenue Recognition: is where a company in this case circuit city store recognizes a portion of the total revenue at the time of sales with the remainder defers and recognizes over the contract period. The cost under the extended warranty contract is recognized as it occurs. This treatment would be allowable for financial reporting in only very limited circumstances. In the case of partially deferred, since the profit together with sales is recognized at the time of sales but only a portion of the warranty is deferred, the impact on the financial statement of the company is likely to be positive since it is only a portion that has
been deferred. The profit which is added to the sale will be seen on the financial statement hence the increment on revenue. 2. In your opinion, which of the three approaches to accounting for extended warranty and service contracts is most consistent with the actual substance of a sales transaction involving equipment and an extended warranty contract? Explain your selection and your reasoning fully. In my opinion, the most consistent approach to accounting for extended warranty and service contracts with the actual substance of a sales transaction involving equipment and an extended warranty is the fully deferred warranty.
This is because it is in line with accrual method of accounting procedure and accepted by AICPA body. The proponents believe that it is inappropriate to recognize revenue at the point of sale because none of the service associated with the contract had been rendered and therefore the revenue had not been earned Circuit City should go with the Approach 3: Partial Revenue Recognition. At the beginning of the article, it shows that Circuit City believed that the revenue from sales of extended warranty contracts would most closely matched costs under the Partial Revenue Recognition method.
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Michael Chalifoux didn’t feel right about the FASB proposal because is not going to favor the shareholders. Partial Revenue Recognition would be the only choice left for Circuit City, and it would help them better than other methods. What will be the effects on Circuit City Stores financial statements (income statement, balance sheet, and statement of cash flows) if the FASB requires them to change the accounting for extended warranty contracts and product maintenance contracts?
If the FASB requires them to change the accounting for extend warranty contracts and product maintenance contracts, there income in the Income Statement will be reduce and that being said the company will debit cash and credit deferred revenue at the time of sale. Looking at the case, for example if they sold the two years contract, they will record the sale as deferral revenue in the first year. As a result of that, the actual revenue is understated in the Income Statement. As we all know, deferred revenue is a liability of the company.
In this case, if Circuit City decided to record their sales in the first year as deferred revenue, then their liability will be increase in the Balance Sheet. Since Income Statement does not include deferral revenue, the actual income reported is decreased. The net income in Statement of Cash Flow will decrease and deferral revenue in operating activities will increase. These changes will hurt Circuit City since most of the revenue they make comes from selling products. However, as they sell those extended warranty and service contracts to a substantial portion of equipment customers, they