many retail stores offer service contracts in connection with goods sold. Unlike warranties, service contracts are priced and sold separately, so its is possible to identify the revenue associated with them. As a result, proceeds from the sale of a service contract are systematically allocated over the period of the contract. In this case, actual repair costs are simply recorded as they occur in expenses.
One problem with the allocation of revenue, however, is that a straight-line approach isn't justified, since the amount of repairs and replacements will normally increase as products get older, so more of the revenue is earned later in the contract period.
For example, assume a 4year service contract is being sold to a customer. Rather than expect that 25% of servicing will take place in each year, it might be more reasonable to expect a steady increase over time so that 10% of total service is rendered in the 1st year of the contract, 20% in the 2nd year, 30% in the 3rd year, and 40% in the 4th year. Although there will even be a difference between the first 6months and the lst 6months of the year. Lets assume that the pace of repairs within each year is even. if 100 dollars of contracts are sold in 20x1 throughout the year, the entry for the collection of contract money is:
- Cash 100
- Deferred Revenue 100
At the end of the year, revenue for the time that has elapsed on the average contract is:
- Deferred Revenue 5
- Service Revenue 5
Notice that only 5% not 10% has been earned by the end of 20x1. This is because the service contracts were sold throughout the year, not all on 1/1/x1, so the average contract is only 1/2 a year.