Approaches to accounting for extended warranty

Circuit City Stores, Inc.
Circuit City Case Study
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.
Approach one is to view the cost of the stereo and the warrantee as a single transaction. The profit from the stereo and the contract is calculated a single ‘item’ while the cost deducted is comprised of the cost of the stereo and the estimated cost of the service agreement. Adjustments are made later on if the service agreement is more or less costly to the company. Approach two views both stereo and warranty as separate items, and counts the completion of the service agreement only as a profit and/or loss after the service is performed. After all, the agreement has not been fulfilled at the point of purchase. Additionally, there is no way to know how much the service agreement will really cost, if there are problems with the stereo. This way, no adjustments need to be made regarding the item’s profitability if the service contract is accounted for after the agreement has been fulfilled.
The third approach, as deployed by Circuit City, is to count the transaction basically as a unit, but to defer some costs until the end of the contract period, if a reliable estimation can be made as to how much fulfilling the contract will cost the company. In support of this strategy, Mike Chalifoux maintains that few customers take advantage of the service, and they must still pay a small fee that offsets the costs of the service if costly repairs are required, thus no deferral of revenue is necessary. Effectively, most customers drop the warrantee in the drawer, and forget about it, and a net profit is earned by the company. This is one reason that so many consumer advisory groups suggest that customers do not buy such warrantees. The certainty of the revenue is another point in Chalifoux’s favor. According to the Journal of Accountancy, “The profit margin on the extended warranty contract is unusually high in comparison to the profit margin on the product. Estimated costs to be incurred on the extended warranty contract are nominal in relation to the combined price and can be estimated with a high degree of reliability.” Additionally, these accounts cannot usually be canceled, further adding to the certitude of profit.
2. What should Mike Chalifoux do?
Mike should present a statement to the FASB demonstrating the following
1. Extended warrantee services are a reliably included ‘item’ with the purchase of a stereo, thus viewing the transaction as a unit is entirely appropriate. There are no sales of service contracts that are not connected to the product.
2. The requests for service are reliably minimal, thus resulting in a minimal unexpected drain upon company finances.
3. Consumers must pay a small fee that makes up for any unexpected costs incurred by Circuit City in fulfilling the service contract.
4. The profit margin on the contracts is both reliable and high.
5. Chalifoux could also submit evidence that there are few complaints or recalls regarding the products, and thus relatively few expectations that costly replacements will be required.
References
Profit on extended margin. (1990, August 1). The Journal of Accountancy.
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