Crazy Computers intends to create a Captive Insurance Company. This company will be part of the CC group, engaging primarily in reinsurance of warranty contracts. Third-Party Insurance Companies for whom CC sells the contracts in question will have the option to reinsure with the new CIC.CC sells the warranty contracts on behalf of a third-party company. In case of any warranty claims, the third company responds and meets the obligation. Crazy Computers is in effect a sales agent of a third-party company.
The proposal to increase profit margins involves the creation of CC’s Captive Insurance Company. This is an effort to earn the reinsurance revenue spent by third-party insurers. The result would be increased profit margins for CC Group. Under the first arrangement, CC earns a net income of $80 for each extended warranty sold (Bragg 70). However, under the new arrangement, CC stands to earn $165 for each contract sold. This will arise after CC pays its sales agents and the Third Party Insurer.
Currently, CC recognizes the $80 as revenue immediately after the contract is sold since it is neither the insurer nor the reinsurer. According to ASC 605-45, this is correct. The question is whether CC should continue with its current accounting policies after establishing a Captive Insurance Company. In the case of reinsurance, the revenue would be split between commission and reinsurance fees. The commission is $80, while the reinsurance fee is $85.
Option One-The recognition of Commission Revenue at The Point of Sale
CC can opt to proceed as usual, and therefore recognize the total revenue from the sale of the extended warranties at the point of sale. If this is done, CC will transfer $165 to the statement of income immediately after it sells the contract. This is a great improvement from the previous $80. Therefore, this is Management’s most desirable option. It will reflect positively in the financial statements and achieve the aim of increasing profit margins.
The company can pursue this option because the revenue in question, $165, will have been earned through the sale of the extended warranty contract. Since customers pay cash for such warranties, the revenue is realized immediately after the contract is sold. There is no question about its realizability. Concerning the earnings, management could argue that servicing the warranty is the responsibility of the Third-party Insurance Company. The reason is they service the warranties as customers raise claims. The only job CC needs to perform to earn the commission is the sale of the contracts.
This option fails to consider the effect of reinsuring the very contracts by the proposed CIC. It seeks to maintain the status quo when there have been significant changes. In case the Third Party Insurance Company runs into financial trouble and needs to claim from the reinsurer, CIC will be liable. Therefore, it is evident that this option fails to recognize the substance of the new arrangement. It is an attempt at window dressing. The true nature of the transaction will be concealed from users of the financial statements. This could lead to wrong decisions.
Option Two- Failure to Recognize the Commission Revenue at the Point of Sale
Anybody proposing the adoption of the first option is correct in claiming that the commission revenue has been earned and realized at the point of sale. However, if Crazy Computers owns the Captive Insurance Company, which reinsures the Third Party Insurance Company, it has additional obligations. CC can no longer consider itself as an agent. The company has further financial obligations to the TPI in regards to the warranty contracts.
The standard accounting setters FASB place additional responsibility on such a company. If the company stands to gain revenue from reinsuring, then it should be prepared to bear the burden of the cost associated with this. According to FASB guidance in ASC 605-20-25-3, Crazy Computers is required to defer the total revenue obtained from the transaction involving the warranty contracts. Total revenue refers to both the commission on sale and reinsurance premium.
This total revenue should be apportioned in line with the costs incurred to earn it. This amortization requires subjective judgment, which should be based on empirical calculations. It is management’s responsibility to ascertain the actuarial variables necessary to make such a judgment. The first option was concerned with the legal position of CC. This option is concerned with the substance of the transaction concerning CC Group.
Therefore, the correct accounting treatment if Crazy Computers decides to create a Captive Insurance Company is the second option. CC should not recognize the money received for the sale of extended warranties as revenue at the point of sale. The major reason is that the transaction will be complete only when the CIC performs its obligation to the TIP. This can be ascertained by checking the terms of their contract. In addition, recognizing revenue at the point of sale is against ASC 605-20-25-3. The Accounting Standard Codification guides enable entities to recognize the substance of such transactions.
ASC 605-20, Revenue Recognition: Services (ASC 605-20-25-3)
This is the first relevant standard in this case study. It addresses the question of revenue recognition in service firms in America. Revenue is a critical item in the statement of income hence the extensive guidance. ASC 605-20-25-3 is a codification of the standard concerned with revenue. It provides further guidance to accounting practitioners. It also clarifies any issues that the standard has left unclear. In particular, ASC 605 deals with revenue recognition under warranties.
The standard describes several types of warranties. The standard warranty is issued with the purchase of a product. The seller promises to provide the buyer with the after-sale service of a warranty for a certain period. The revenue recognition for this type of warranty is deferred since the entity has some obligation to the customer. The entity can recognize the warranty fees when the period of performance lapses. Before then, the entity is entitled to amortize the revenue in a manner that best reflects the cost incurred on the warranties. Entities use historical data related to warranties to compute an estimate for this cost.
A separately priced warranty is not part of the product purchased. It is usually designed to follow the standard warranty when it expires. It is issued by the selling entity or a third-party entity. The customer is not obligated to purchase this warranty. They can purchase it or fail to purchase it. If they do, the revenue should be recognized similarly to standard warranties over the contract’s life. Separately priced warranties are also referred to as extended warranties. The problem arises when one party sells the warranty but another party is responsible for the performance of the contract.
This is the situation facing Crazy Computers. The company sells extended warranties on its computers on behalf of Third Party Insurers. Crazy Computers discharges its obligations by selling the extended warranty to the customer. It earns a commission of $80 for this service. From the gross revenue, CC pays $10 to its sales agents for their services. The remaining $110 is transferred to the Third Party Insurer. This insurer bears the obligation of servicing the warranty if the need arises. The margins on Crazy Computers’ sales have been declining and management is seeking a way to increase them. The latest proposal is the creation of a Captive Insurance Company to reinsure the extended warranties sold by CC.
ASC 605-20-25-3 defines extended warranties. They are contracts to provide warranty coverage above the standard warranty. It also defines separately priced contracts. In such a contract, customers pay for the product, then the extended warranty. The two are priced separately. In Crazy Computer’s case, customers pay for the computers and then purchase an extended warranty to be provided by third parties (Mackenzie and Coetsse 43).
The Codification guides entities in situations like CC. They are required to defer such income until they fulfill their contractual obligations to customers. This enables them to comply with the requirement that revenue must be earned before it is recognized. In the current case, Crazy Computers earns its commission revenue as soon as it makes the sale of the extended warranty. This is all that is expected of CC in regards to these contracts.
In the second proposed scenario, CC sells the contracts and reinsures the Third Party Insurance Company. This extends its obligations beyond just the point of sale. Legally, Crazy Computers completes its obligations at the point of sale, and then TPIC takes over to satisfy the warranties (Mackenzie and Coetsse 43). During this period, CIC also must reinsure the activities of TPIC in case anything goes wrong. Therefore, theoretically, CC Group’s obligations end only when the reinsured warranty contracts expire. This is the true point at which revenue is both earned and realized.
ASC 944, Financial Service — Insurance (ASC 944-605-25-12)
This standard is applicable in the second scenario. It would be relevant to Crazy Computers if they decided to set up the wholly-owned CIC to reinsure the extended warranty contracts. It guides the reinsurance of short-term insurance contracts. It also deals with long-term reinsurance contracts. If Crazy Computers decides to set up the CIC, they need to decide whether it will reinsure 6-month or 30-day contracts. This will determine the accounting treatment to be used.
ASC 944-605-25-12 requires reinsurance firms to defer the revenue recognition until the earning process is complete. This process will be complete when the reinsurance firm discharges its obligation to the Third Party Insurance Company. It is difficult to separate the CIC from CC since CC owns it wholly. This means it controls CIC’s operations and is responsible for its obligations. Therefore, if CIC does not recognize the revenue from the extended warranty contracts until later, then it follows that CC should also defer its revenue recognition. This provides the users of financial statements with the true picture of the situation at CC (Shamrock54).
If CC creates the CIC and continues with its current accounting treatment of the commissions, it will be contravening both ASC 944-605-25-12 and ASC 605-20-25-3. However, ASC 944 is relevant mostly to the operations of the Captive Insurance Company. It offers detailed guidance on revenue recognition. The commission is related to CIC since CC owns the subsidiary wholly. If CC did not own the reinsurance company, then its commissions would not be pegged on the reinsurance firm’s activities.
FASB Concepts Statement No. 5, Recognition and Measurement in Financial Statements of Business Enterprises (ASC 450-10-05)
This concept statement defines revenue and provides the criteria for revenue recognition. It is at the core of CC’s issue. If the managers at Crazy Computers understand, what revenue is and when it should be recognized, then they would easily resolve the issue at hand. Revenue is earned when the entity has discharged most of its obligations to the third party. This varies in different businesses. In the case of CIC, revenue would be earned when CIC compensates TPIC for any losses related to the extended warranty contracts or the term of the contract ends (Shamrock54).
ASC 450-10-05 stipulates that revenue can be earned, but it is not realizable. Realizable revenue is that which the entity has access to and can obtain. This is not an issue for Crazy Computers given the fact that customers pay cash for the extended warranty. The revenue is realized at the point of sale but earned at a future date. When the criteria of earning and realizability are met, CIC and CC can recognize the revenue from the extended warranty contracts (Bragg 70).
Bragg, Steve. Wiley Revenue Recognition: Rules and Scenarios, London: Wiley, 2010. Print.
Mackenzie, Bruce, and Danny Coetsse. Interpretation and Application of International Financial Reporting Standards, Chicago: Wiley, 2012. Print.
Shamrock, Steve. IFRS and US GAAP: A Comprehensive Comparison, London: Wiley, 2012. Print.