Answer 1. I believe that Approach No. 1 (full revenue recognition) is the most consistent with the actual substance of sales transactions involving equipment and extended warranties. Circuit City matches up almost perfectly with the five criteria in Exhibit 2. They incur 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.
With all of this in place, it would be unnecessary to use Approach No. 2 (deferral of revenue). Circuit City warranties are not comparable to insurance contracts as stated in Exhibit 3, because unlike the insurance contracts, Circuit City warranties are paid up front, and in full, and buyers cannot cancel their warranty or renegotiate the terms after their warranty has expired.
Circuit City also has enough experience and data to show that warranty expenses are very predictable and hardly deviate from their expectations. It is almost like selling another product, where the cost and profit are known well in advance. I would steer clear of Approach No. 3 (partial revenue recognition) as Circuit City warranties do not match up with most criteria necessary for this approach. I.e. only 40-70% of customers buy warranties, and this depends on the products. Also, roughly only 5% of total net sales come from warranties, making them far from an integral part of pricing the related product.
Answer 2 and 3. This issue is important due to the effect these different methods have on the financial