Describe the impact the three proposed accounting methods would have on the companys financial statements at the point of sale and in future periods.

The three proposed accounting methods discussed were full revenue recognition, deferral of revenue, and partial revenue recognition.

Full revenue recognition would look most positively for Circuit Citys earnings in the same quarter that the sale of the warranty was realized, but in future periods, there would have to be expenditures to provide services for the warranty which would affect income statement accounts and reduce net income; on the balance sheet there would be a decrease in current assets required to fulfill services. Full revenue recognition would also combine both the warranty sale and product sale into one transaction.

Deferral of revenue means that the revenue from the original sale of the product is split between two distinct transactionsrevenue for the warranty and revenue for the product itself. Revenue for the product is recognized at the point of sale, but the warranty revenue is deferred until appropriate costs arise in costs incurred from providing services for the warranty. What also happens in the case of deferred revenue for warranties is that the costs are systematically allocated throughout the period of the warranty, but none of the revenue for the warranty is recognized immediately at the point of sale. While expenditures and credits to assets take place in the maintenance of the warranty contract, revenue is also recognized in the same period through allocations such that the expenditures do not have as significant of an effect on net income as in the first case.

Partially recognized revenue would realize a small portion of revenue for the warranty at the point of sale and the remainder would be allocated throughout the rest of the warranty period. This resembles deferral in terms of the prospective allocation of revenue over the warrantys period of time but the key distinction is that revenue is also partially recognized up front at the point of sale. This results in higher net income at the point of sale than the second method, but also similar to the second method are the gradual releases of liabilities over the period of the warranty.

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?In our opinion, the deferral of revenue approach appears to be most consistent with the actual substance of a sales transaction involving equipment and an extended warranty contract. Method two coincides with the matching principle the best as the costs are recognized with revenue. This method ensures the correct allocation of revenue and costs, treating each sale that of the product and warranty as two separate transactions. The revenue and expenses of the product are recognized at the time of the sale when the revenue is earned and the title of the product is transferred; then the warranties revenue is deferred to be allocated over the life of the warranty, when costs are expected. This is consistent with the matching principle. Also considering the fact that each customer does not have to buy the warranty shows how it should be treated as a separate transaction with the revenue matching the costs over the period of the warranty. The warranty transaction should be dealt with in accordance with FASB Statement No.60, these services of the warranty are ensured by circuit city to be provided as events occur, with that the expenses will be incurred overt the warranty period and with that revenue recognized. This treatment of warranty transactions as a separate transaction makes the deferral of revenue approach the most logical for circuit city.

What will be the effects on Circuit City Stores financial statements if FASB requires them to change the accounting for extended warranty contracts and product maintenance contracts?If FASB requires Circuit City Stores to use deferral of revenue for extended warranty contracts and product maintenance contracts, the income will be reduced in the income statement because the company debits cash and credits deferred revenue at the time of sale. An example would be if the company sold the two year contract. The company will record the sale as deferred revenue for the first year which will cause the actual revenue to be understated in the Income Statement. Essentially this is because less recognized revenue would reduce income. The income statement doesnt include deferred revenue so the actual income reported is lowered. Deferred revenue remains to be a liability of the company and if the company records all its sales as deferred revenue in the first year, the liabilities in the balance sheet will be increased. Finally, the net income in the Statement of Cash Flow will decrease and deferred revenue in operating activities will increase. However, the final amount of net cash provided by the operating activities will remain the same.

Why is this issue important to Circuit City Stores, Inc.?

Mike Califoux was very concerned about switching from a partial recognition method to a deferral method because it would negatively affect shareholders immediately; the revenue recognized from the sale of warranty would not happen until costs were incurred. Very few customers actually end up using the extended warranty services, so that would mean that at best, the revenue would be recognized systematically over a long period of time even when expenditures are not being incurred instead of immediately upfront; this would decrease net income which would then decrease the amount of retained earnings available to distribute to shareholders or reinvest into expansion of current operations. Circuit City was also a very large company at the time and Califoux would have to consider how these changes would affect corporate strategy and policy if the standard changed, and investors may view this as a risk in losing their value from a decreasing share price.

FASB CODIFICATIONS605-20-25Recognition Separately Priced Extended Warranty and Product Maintenance Contracts (25-2, 25-3, 25-4, 25-6)605-25-55Implementation Guidance and Illustrations (55-10, 55-11, 55-12)

4Chin, Haug, MooreCircuit City Case