From the 2011 Wiley FAR – Module 12

Cobb Company sells appliance service contracts agreeing to repair appliances for a two-year period. Cobb's past experience is that, of the total dollars spent for repairs on service contracts, 40% is incurred evenly during the first contract year and 60% evenly during the second contract year. Receipts from service contract sales for 2 years ended Dec 31, 2011, are as follows:

2010 $500,000
2011 $600,000

Receipts from contracts are credited to unearned service contract revenue. Assume that all contract sales are made evenly during the year. What amount should Cobb report as unearned service contract revenue at Dec 31, 2011?

Wiley’s answer: $630,000

All contract sales are made evenly during the year. Therefore, the 2010 contracts range from one year expired (if sold on 12/31/10) to two years expired (if sold on 1/1/10), for an average of one and one-half years expired [(2+1/2]. Similarly, the 2011 contracts range from zero years expired to one year expired, for an average of one-half year expired [(0+1)/2]. The average unearned portion of the 2010 contracts is one-half year (two years minus one and one-half years), the last half of the second contract year. The amount of unearned revenue related to 2010 contract is computed as following:

$500,000 x 60% x ˝ = $150,000

The average unearned portion of the 2011 contracts is one and one-half years (two years minus one-half year), the last half of the first contract year and all of the second contract year. The amount of unearned revenue related to the 2011 contract is computed as follows:

2011

$600,000 x 40% x ˝ = $120,000

$600,000 x 60%=$360,000

=$480,000

Therefore, the total unearned revenue is $630,000 ($150,000+$480,000).

I’m confused by Wiley’s explanation. Someone please clarify?

It took me a while to understand this, too.  Does this make it easier?

2010	500000		1/2	60%	150000
2011	600000		1/2	40%	120000
2011	600000		1	60%	360000
					630000

If this were real life, I just wouldn't estimate this way - it seems ridiculous.

Hey Gailxadri,

I understand your way a little better and the concept of earned and unearned revenue but I'm still stuck on Wiley's "the 2010 contracts range from one year expired (if sold on 12/31/10) to two years expired (if sold on 1/1/10). Similarly, the 2011 contracts range from zero years expired to one year expired"

Please explain.

OK, see if this makes sense using the way they are trying to explain it:

for 2010 Contracts:

Our balance sheet date is 12/31/11.  This means that it has been 2 years since the 1st 2010 contract on 1/1/10 and one year since the last 2010 contract on 12/31/10.

The average then is 1.5.   Which is the number that are finished or "expired" of 2 years.  So you only have 1/2 a year left of liability and that is the second year at 60%.

for 2011 contracts:

It has been one year since the first 2011 contract on 1/1/11; and zero years since the last on 12/31/11.

The average then is .5.   Which means that half a year of 2 years has expired, so you have a liability of 1-1/2 years.

.5 x 40% and 1 x 60%.

Gailxadri,

Thanks, I get it now!, you stated it more clearly than Wiley's explanation.

Are you take "FAR" tomorrow if so Good Luck!!

Thanks again for help on this problem!