Problem

Reading and Interpreting Sears Holdings Corporation’s Notes—Revenue Recognition

The following excerpt is taken from page 64 of the Sears Holdings Corporation (parent company of Kmart and Sears) 10-K for
the fiscal year ended January 28, 2012: ‘‘Revenues from the sale of service contracts and the related direct acquisition costs are
deferred and amortized over the lives of the associated contracts, while the associated service costs are expensed as incurred.’’
Required
1. Assume that you buy a wide-screen television from Sears for $2,500, including a $180 service contract that will cover three
years. Why does Sears recognize the revenue associated with the service contract over its life even though cash is received at the
time of the sale?
2. How much revenue will Sears recognize from your purchase of the television and the service contract in Years 1, 2, and 3?
(Assume a straight-line approach.) What corresponding account can you look for in the financial statements to determine the
amount of service contract revenue that will be recognized in the future?

Step-by-step solution

1. Step 1 of 5
According to the revenue recognition concept, all the revenues should be recognized at the time the title of
goods is transferred to the buyer.
Comment

2. Step 2 of 5
1.
As per the accrual basis accounting system, the revenue earned but not yet received is considered as revenue of
the business for the current year. There is no role for cash; the service revenue should be recorded on the date
of its occurrence. Hence, the company recognized the revenue associated with the service contract over its life.
Comment

3. Step 3 of 5
2.
The following table shows the recognition of revenue and the service contract over the three years:

Year 3
Particulars Year 1 (S) Year 2 (S) Total ($)
($)

Sales Revenue 2.320(1) 0 0 2,320

Service Contract Revenue 60(2) 60(2) 60(2) 180

Total Revenue 2.38 60 60 2.5

Service contract is unearned revenue and is treated as a liability in the balance sheet. Unearned revenue refers
to the revenue that is received in advance for a service during a particular period but has not been performed,
and thus not recorded in the books of accounts. This revenue is recognized in the future years.
Comment

4. Step 4 of 5
Working Notes:
Calculate the sales revenue earned in year :
Purchase price = $2,500
Service contract = $180
Comment

5. Step 5 of 5
Calculate the service contract revenue for each three years:
Service contract = $180 Number of years = 3