I just need the answers for the first question: a-b-c and d each question have to be one page or more.

Max-Value Stores, Inc.: Financial Reporting of Gift Cards 1 Abstract Max-Value Stores, Inc., a discount general merchandise operator, has initiated a program to sell its own gift cards and those of other retailers. The case provides an opportunity to apply your understanding of various financial reporting topics (revenue recognition, liability de-recognition, accounting changes, and deferred tax accounting) to gift card transactions for determining the applicable GAAP (Generally Accepted Accounting Principles) for the estimated amount of gift cards that are unlikely to be redeemed (i.e., gift card 'breakage'). You also have to evaluate the soundness of the proposals that the management of MVS has made during the process of its annual audit with respect to the timing and method of recognizing the breakage and its presentation in financial statements. The case provides an opportunity to examine several technical and conceptual accounting issues in a real-world setting, strengthen accounting research capabilities, understand implications of the choice of an accounting policy for performance measurement and for financial statement analysis, and develop advanced critical thinking and professional judgment skills. Case Company Overview Max-Value Stores, Inc. (MVS or the Company) is an operator of discount general merchandise stores in fifteen states primarily in the southeastern United States. The Company's stores generally serve low, middle and fixed-income families that reside in small to medium-sized towns. Founded in 1969 in North Carolina with a single store, MVS has achieved significant brand recognition in its target markets and has grown to over 400 company-owned and 40 franchised stores by 2009. The Company's strategy consists of meeting the general merchandise needs of its target customers by offering (a) a wider variety of quality merchandise and a more attractive price-tovalue relationship than the smaller variety/dollar stores, (b) a shopper-friendly format which is more convenient than larger sized discount merchandise stores and (c) customer-service which exceeds that of both. MVS offers basic merchandise of over 12,000 items, with a particular focus on about 700 high demand consumable items which are promised to be always on the shelves under its \"We Got It\" marketing program. It guarantees the quality of all the products 1 This case was developed by Professor Mahendra Gujarathi of Bentley University as the basis for class discussion. 1 sold and also offers extended service contracts on behalf of third parties on higher priced items such as appliances and electronic products. 2 Performance Foreseeing a weakening retail environment, in the second half of fiscal 2007 3 MVS started implementing a new strategy focusing on enhancing its brand, improving operational performance, eliminating underperforming assets and streamlining the cost structure. This has enabled MVS to deliver higher sales and earnings in fiscal 2008 at a time when many other retailers experienced a decline in sales. The financial analyst community is impressed with the past performance of MVS and has assigned a rating of Ab to the Company's bonds (an investment grade rating from Moody's) and a multiple of 18 to its current earnings, well above the multiples for national retailers such as Wal-Mart or Target. Analysts are optimistic that the Company's new strategy will further accelerate its revenue and earnings growth in the coming years. The 2008 consensus earnings estimate of analysts that follow MVS was $3.45 per share. The preliminary results for fiscal year 2008 (ending on 2/29/2009) indicate, however, that the Company would not meet analysts' consensus earnings estimate. Tough credit markets in 2008 also have made additional borrowings difficult and expensive for MVS. The senior management of the Company is particularly concerned that a debt covenant with one of its crucial lenders is likely to be violated if MVS is not able to maintain a current ratio of 1.40 or higher. If a violation occurs, the creditor would have the right to accelerate maturity of the debt or seize the collateralized assets. Executive Compensation Impressed with the past performance of its senior management, the Board of Directors of MVS has approved generous executive compensation packages (consisting of base salary, annual bonuses, and long-term incentives) to its senior management. An annual bonus of up to 100 percent of base salary is awarded based on the Board's evaluation of senior management's performance. While 40 percent of the bonus is based on Board's subjective evaluation, the remaining amount (60 percent) is based on meeting or exceeding specified targets. For the fiscal year 2008, the targets are (a) annual sales growth of 12 percent or above, (b) annual gross profit 2 MVS recognizes commissions on such contracts ratably over the term of the service contract. 3 The Company's fiscal year begins on March 1 and concludes at the end of February. Fiscal year 2007 ended on February 29, 2008. 2 of 24 percent or greater, and (c) EPS (Earnings Per Share) of $2.95 or higher. Senior management is entitled to a bonus of 20 percent of base salary for each target achieved. Gift Cards Initiative Among the several factors that have contributed to MVS's success in recent years is its notable gift card program. Presented below is pertinent information relating to the Company's sales of gift cards of other retailers, issuance of MVS's restricted gift cards during a special Thanksgiving 4 promotion, and sales of its own gift cards. Gift Cards of Other Retailers Starting in fiscal 2008, MVS began selling gift cards of several other regional and national retailers. MVS receives a commission of 15 percent of the value of the gift cards when they are swiped through a POS (Point of Sale) terminal of MVS. The sale of other retailers' gift cards by MVS is non-refundable and the cards can be redeemed only at the sales channels of the respective retailers. In fiscal 2008, MVS's management recorded $50 million as sales of gift cards of other retailers and $42.5 million as the cost of goods sold. Gift Cards Issued during the Special Thanksgiving Promotion As a special promotion around Thanksgiving Day in 2008, the Company announced that for one week, each customer who buys 'iPod Touch' at the regular price of $299 will receive a $40 MVS gift card. These restricted gift cards expire after six months. With approximately 500,000 iPods purchased at MVS during the week of Thanksgiving, the Company has issued $20 million of gift cards and has recorded them as a reduction in sales. 5 The $18 million of the gift cards redeemed by customers before the end of fiscal year 2008 have been recognized as sales. MVS's management estimates that it is unlikely that customers will redeem the remaining gift card amount ($2 million) and has proposed to recognize this amount as sales in 2008. MVS does not have any prior experience with running a special promotion like this. 4 Thanksgiving Day is a harvest festival in the U.S. aimed to give thanks for the harvest and express gratitude in general. While perhaps religious in origin, Thanksgiving is now primarily identified as a secular holiday on the fourth Thursday in November. In 2008, the Thanksgiving Day was on November 27. 5 The Company recognizes revenue when the customer takes possession of the merchandise. Although MVS uses separate accounts (such as gross sales, sales discounts, sales returns and sales allowances) to record individual transactions, net sales reported in the statement of operations represent aggregate sum of those accounts. 3 Gift Cards of Max-Value Stores The Company started selling MVS gift cards in its retail stores in 1998 and on the Web in 2000. The gift cards can be purchased for any amount between $5 and $500. The company's gift cards have been recognized by Consumer Affairs as a "top pick" for not having deceptive features such as expiration dates, dormancy fees, and post-purchase fees. The amount of the "gift" value is loaded and stored on the host database by swiping a magnetic striped card through a POS terminal. Customers can add to outstanding amounts on their existing gift cards in the Company stores or on its web site. Customers can choose from a variety of gift cards designs suitable for different occasions. MVS also allows customers to upload photographs to create their own cards. The gift cards may be used multiple times to pay for merchandise or services. Over one-half of the annual sale of gift cards occurs around the Christmas holiday season. Most customers use the gift cards to make purchases in January when clearance sales are more common. MVS records a gift card liability upon the sale of gift cards. At the time of redemption, it recognizes sales revenue in the amount of redemption and reduces the gift card liability. To date, MVS has not recognized any income for unredeemed gift cards. Instead, the cumulative amount of unredeemed gift cards is included in \"other current liabilities\" in the Company's statement of financial position. A footnote in the last year's financial statements stated: The Company has not recognized any revenue from gift card breakage since the inception of the program in 1998 and does not expect to record any breakage revenue until there is certainty regarding our ability to retain such amounts in light of current consumer protection and state escheatment (i.e. unclaimed property) laws. In fiscal 2008, after a review of past redemption patterns and relevant escheatment laws, the management of the Company concluded that it can estimate the extent of non-redemption 36 months after the sale of gift cards. The escheatment rules in the state of North Carolina do not require retailers headquartered in North Carolina to remit the value of unredeemed gift cards to the state, regardless of which state the gift cards were sold. Past experience with redemptions indicates that typically 75 percent of the value of gift cards purchased is redeemed by customers in the same fiscal year as that the gift cards were purchased. Another 12 percent is redeemed in the fiscal year after the year of purchase, and 3 percent in the following year. On average, 10 percent of the value of the gift cards is never redeemed. The most common reasons for non4 redemption include customers losing or misplacing the gift cards or forgetting to redeem the remaining value. Although it is possible to replace the remaining value on a lost, stolen or damaged card by presenting the original purchase receipt, most customers do not. The management of MVS has proposed that starting in fiscal 2008 the estimated breakage of 10 percent of the gift cards sold be recognized as sales in the year in which the gift cards are sold. In addition, the cumulative effect of previously unrecognized income from such breakage is proposed to be recognized as sales in the transition year (fiscal 2008). Presented below are the Company's yearly and cumulative sales of gift cards: Fiscal Year 2002 and before 2003 2004 2005 2006 2007 2008 Gift cards sold (amounts in thousands) During the year Cumulative total $30,484 $10,436 40,920 11,897 52,817 13,562 66,379 15,461 81,840 17,625 99,465 20,093* 119,558 * The $20 million restricted gift cards issued during the 2008 Thanksgiving Day promotion (described above are not included in this number. Taxation of Gift Card Breakage on MVS's Gift Cards MVS follows the accrual method of accounting for tax purposes. Although advance payments (such as interest and rent receipts) are generally taxed in the year of receipt, Reg. 1.451-5(c) specifies exceptions for inventoried goods. If a taxpayer receives an advance payment in a taxable year with respect to an agreement (such as a gift card), then all payments received that are not previously included in income in accordance with the taxpayer's accrual method of accounting, shall be included in the taxable income of the second taxable year following the year in which the payments were received. For instance, if gift cards sold are $100 in year 1, and redemptions in years 1, 2, 3 and 4 are $60, $15, $13, and $4, respectively, the taxable income from gift cards would be $60 in year 1 and $15 in year 2, the same as the income recognized under the accrual method. In year 3, which is the second year following the year in which the gift cards were sold, all of the remaining income of $25 would be taxable. 5 Financial Statements The Company's fiscal year begins on March 1 and concludes at the end of February. MVS's unaudited financial statements for the 2008 fiscal year ending on 2/28/2009 are provided in Exhibit 1. Unredeemed gift card liabilities, unearned revenues and deferred tax liabilities are included in other current liabilities, and deferred tax assets are included in other current assets in the statement of financial position. The financial statements are not final; only upon further evaluation and approval by the external auditing firm will they be filed with the Securities and Exchange Commission. The effects of management proposals are not reflected in the unaudited financial statements because the proposals are not yet evaluated by the auditors. Requirements (Approximate point values for each are indicated in parentheses.) (An Excel spreadsheet containing case data is available on BB site) Assume that you are an audit senior of the external audit firm engaged by MVS. The audit partner has asked you to provide an analysis of the Company's existing accounting policies pertaining to the gift card transactions (as reflected in the unaudited financial statements provided in Exhibit 1) and an evaluation of the management's proposals to recognize estimated gift card 'breakage' and estimated non-redemption of the restricted gift cards issued during the special Thanksgiving promotion. Your answers should provide a description of the accounting policies and an assessment of whether they comply with Generally Accepted Accounting Principles (GAAP). Explain your rationale and support your position with citations from the applicable authoritative pronouncements using the FASB Accounting Standards Codification, and other relevant resources, if an authoritative pronouncement is unavailable. Specifically, address the following issues. 1. Analysis of the Existing Accounting Policies for the Gift Card Transactions (33 Points) a. Gift Cards of Other Retailers (10 points) i. Is it appropriate for MVS to record $50 million as sales and $42.5 million as cost of goods sold for the gift cards of other retailers that it sold during fiscal 2008? Why? 6 ii. b. What is a plausible motivation for management to report sales and cost of goods sold separately rather than reporting the net effect of the two ($7.5 million) as other income? Gift Cards Issued during the Special Thanksgiving Promotion (10 points) Does the Company's financial reporting of restricted gift cards issued during the special Thanksgiving promotion comply with GAAP? If yes, explain why. If not, explain why and determine the adjustments, if any, needed to the Statement of Operations in Exhibit 1. c. Gift Cards of Max-Value Stores (5 points) Assuming that MVS cannot estimate the gift card 'breakage' (i.e., amount of likely non-redemption), is the existing accounting policy of the Company for gift cards compliant with GAAP? If yes, explain why. If not, explain why and determine the adjustments, if any, needed to the Statement of Operations in Exhibit 1. d. Combined effect of GAAP Adjustments on Statement of Operations (8 points) As an audit senior, you want to be sure that the Company's reporting in the three areas above complies with GAAP. What adjustments, if any, would you recommend to the reported sales, cost of sales, gross profit, operating income, other (loss) income, net earnings, and earnings per share? Provide your answer in the following format. Assume that the average income tax rate is 40 percent. 7 Adjusted Statement of Operations (in compliance with GAAP) Item Net sales Cost of goods sold Gross profit Selling, gen. and adm. expenses Operating income Interest expense Other (loss) income Income before income taxes Income tax expense Net earnings W. Avg. shares outstanding Earnings per share 2. Reported amounts Adjustments, if any, resulting from Gift cards issued Sale of other Sale of MVS Gift during special retailers' gift cards Cards promotion Adjusted amounts $1,248,717,600 950,882,400 297,835,980 221,832,000 76,003,980 1,934,400 780,000 74,849,580 29,939,520 $44,910,060 15,000,000 15,000,000 $2.99 Evaluation of the Management Proposals (51 Points) a. GAAP Compliance (14 points) Discuss whether or not management's proposals to recognize the estimated non-redemption of the restricted gift cards issued during the special Thanksgiving promotion and the estimated gift card 'breakage' would comply with GAAP. b. Alternative Accounting Approaches for Gift Card 'Breakage' (16 points) For the recognition of gift card 'breakage', discuss the alternative accounting approaches/methods that would comply with the GAAP. For each approach/method, compute the current year's (2008) pre-tax impact as well as cumulative pre-tax impact from all prior years. Discuss where in the statement of operations the gift card 'breakage' should be presented. c. Combined Effect of Management Proposals on Statement of Operations (5 points) Compute sales, cost of sales, gross profit, operating income, other (loss) income, net earnings, and earnings per share that the Company would report if, in addition to its existing reporting policies (regardless of whether they comply with GAAP or not), management's proposals to 8 recognize estimated gift card 'breakage' and estimated non-redemption of the restricted gift cards issued during the special Thanksgiving promotion are accepted by the auditors. Present your answer in the following format. Assume that the average income tax rate is 40 percent. Effect of Management Proposals Item Net sales Cost of goods sold Gross profit Selling, gen. and adm. expenses Operating income Interest expense Other (loss) income Income before income taxes Income tax expense Net earnings W. Avg. shares outstanding Reported amounts Proposed amounts $1,248,717,600 950,882,400 297,835,980 221,832,000 76,003,980 1,934,400 780,000 74,849,580 29,939,520 $44,910,060 15,000,000 Earnings per share d. Adjustments resulting from Gift cards Breakage on issued during unredeemed special gift cards promotion 15,000,000 $2.99 Plausible Motivations for Management Proposals (16 points) What are plausible motivations for management's proposals to recognize estimated gift card 'breakage' and estimated non-redemption of the restricted gift cards issued during the special Thanksgiving promotion? Be specific. 3. Other Accounting Issues for Gift Card 'Breakage' (16 points) a. Change in Accounting Estimate versus Change in Accounting Principle (8 points) Assume that MVS starts to recognize the 'breakage' relating to gift cards from fiscal year 2008. It will now recognize 'breakage' income when the prospects of redemption of gift 9 cards become remote (i.e. the third year after the year in which the gift cards are sold). In the year of change (i.e. fiscal 2008), it wishes to recognize the 'breakage' for prior years as well. (i) (ii) b. Discuss whether starting to recognize 'breakage' on the gift card sales in fiscal 2008 will constitute a change in the accounting principle, a change in the accounting estimate, or correction of an error. Explain your rationale and cite applicable authoritative pronouncements. If MVS records the effect as a change in accounting principle, how much gift card 'breakage' will it report for 2006, 2007 and 2008 in its comparative financial statements of fiscal 2008? Assuming a tax rate of 40 percent, what would be the adjustment to the retained earnings balance on March 1, 2006 in the comparative financial statements for fiscal 2008? Financial Reporting of Deferred Taxes (8 points) (i) Taking into account the Company's current financial reporting policy of not recognizing the 'breakage' and the rules for taxation of income from gift cards, determine the amount of deferred taxes included in the statement of financial position at the end of the fiscal year 2008. Assume that the average income tax rate is 40 percent. Indicate whether it is a deferred tax asset, or a liability. Assume that the pattern of actual redemptions correspond with the estimates of the Company. (ii) Assume that on 2/28/2009, MVS changes its policy for financial reporting of gift cards. It will now recognize 'breakage' income when the prospects of redemption of gift cards become remote (i.e. third year after the year in which the gift cards are sold). The change is instituted for all prior years as well and is accounted for as a change in estimate, recorded in sales. MVS's policy for income tax reporting of gift card revenue continues to be the same. Assume that the average income tax rate is 40 percent. Present a journal entry to record the tax effects of the change. Provide supporting calculations. 10 Exhibit 1 Max-Value Stores, Inc. Statement of financial position 2/28/2009 (Unaudited) (Amounts in thousands) Current assets Cash and cash equivalents Receivables Merchandise inventories Other current assets Total Current Assets Property and Equipment Land and buildings Leasehold improvements Fixtures and equipment 2/29/2008 $44,865 17,129 146,890 21,091 229,975 $36,098 64,802 109,980 210,880 71,822 139,058 47,736 $416,769 Less: accumulated depreciation Other assets Total assets Current Liabilities Accounts payable Accrued income taxes Other current liabilities Total Current Liabilities Long term debt Shareholders' Equity Common stock, $0.01 par value; Authorized - 50 m shares Additional paid in capital Retained earnings Total Shareholders' Equity Total Liabilities and Shareholders' Equity 11 $37,596 57,658 125,112 37,814 258,180 $21,996 48,048 89,388 159,432 61,339 98,093 23,868 $380,141 $127,940 15,786 29,132 172,858 $86,738 $113,096 17,737 43,449 174,282 $65,983 $1,248 13,417 142,509 157,174 $416,770 $1,248 13,416 125,212 139,876 $380,141 Exhibit 1 (Continued) Max-Value Stores, Inc. Statement of Operations Year ended February 29 or 28 (Amounts in thousands except per share data) Net sales Cost of goods sold Gross profit Selling, general and adm. expenses Operating income Interest expense Other (loss) income Income before income taxes Income tax expense Net earnings W. Avg. common shares outstanding Earnings per share Statement of Retained Earnings (Amounts in thousands) Beginning balance Net earnings Dividends Ending balance 2009 (Unaudited) % of sales $1,248,718 950,882 297,836 221,832 76,004 1,934 780 74,850 29,940 44,910 100.00 76.15 23.85 17.76 6.09 0.15 0.06 5.99 2.40 3.60 2008 % of sales $1,121,141 847,548 273,593 211,224 62,369 967 936 62,338 24,935 37,403 100.00 75.60 24.40 18.84 5.56 0.09 0.08 5.56 2.22 3.34 2007 % of sales $993,034 760,406 232,628 181,958 50,670 942 880 50,608 20,243 30,365 15,000 15,000 15,000 $2.99 $2.49 $2.02 2009 (Unaudited) $125,212 44,910 (27,612) $142,509 12 2008 2007 $111,922 37,403 (24,113) $125,212 $103,428 30,365 (21,871) $111,922 100.00 76.57 23.43 18.32 5.10 0.09 0.09 5.10 2.04 3.06