1. In my opinion, using the partial recognition approach (as did Circuit City) to account for extended warranty and service contracts is the most consistent with the actual sales transaction involving products extended warranty contracts. This approach is the most consistent for four reasons as we can see with Circuit City Stores, Inc. First, pricing of the sale of an extended warranty is an integral part of pricing of related products. As we can see with Circuit City the joint sale of products and warranties was indeed an integral part of their corporate strategy and by selling extended warranties and service contracts to a portion of their customers, Circuit City could price their products more competitively. [p2] A second reason why the partial revenue approach is more appropriate is because the sale of such warranties and contracts almost all the time accompany the purchase of a related product (as with Circuit City). A third reason, Circuit City could see that the profit margin on selling extended warranties was high in comparison to the profit margin of selling just the product itself as in the following example about Circuit City’s warranties. Example: Sales price of warranty- $100 Actual cost of warranty- $20 Profit = $80
Lastly, similar to the previous reason, the estimated costs to be incurred to render services or repairs under the warranty could be estimated with a high degree of reliability. As in the above example, Circuit City was very confident that the actual costs incurred on an extended warranty was just 20% of the entire cost of the warranty, therefore providing an 80% profit margin for the sale of the warranty. [p2]
2. This is an important issue for Circuit City Stores, Inc. because if they were required to adopt a new approach that the FASB would require, would mean hat the true yearly profits would not be correct because total profit from the sale of and extended warranty or service could not be recorded or recognized for two years or longer, depending on how long the warranty was good for. Furthermore, this is an important issue because it could have negative impacts on the equity of Circuit City’s shareholders.
3. Additionally, this would show that for the next two years until the first extended warranties would expire, Circuit City would not be as profitable because warranties could not be recorded as income on their income statement and furthermore, Circuit City’s deferred revenue would not be recorded on their Statement of Cash Flows for about two years. This would show that Circuit City was not as profitable for two years. Without being able to show this revenue, this may affect their ability to acquire additional funding if needed, this may also affect how much debt Circuit City could repay each year and also, their ability to sell stock at a premium may be more difficult as people would think that Circuit City is not as profitable of a company.
4. For Mike Chalifoux this is an important issue and he first needs to make sure that his understanding and knowledge of Circuit City’s accounting policies for warranties and services is correct and know the pros and cons of any other alternative available. If the FASB is heading towards implementing a different way to record income from warranties, Mike Chalifoux can contact the FASB and explain Circuit City’s reasoning for using the current method and request that the FASB look into alternative methods. Finally, if the FASB is going to implement this new method and Circuit City will have to change, Mike Chalifoux needs to consider how this will affect Circuit City’s corporate strategy and policy and be prepared to change their strategy and policy to accommodate the new method from the FASB so that Circuit City can continue to be a competitor in the retail electronics market.