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ISSUES IN ACCOUNTING EDUCATION Vol. 27, No. 3 American Accounting Association 2012 DOI: 10.2308/iace-50080 784 Gujarathi pp. 783-798 The Company's strategy consists of meeting the general merchandise needs of its target Max-Value Stores, Inc.: Financial Reporting customers by offering (1) a wider variety of quality merchandise and a more attractive price-to-value relationship than the smaller variety/dollar stores, (2) a shopper-friendly format that is more of Gift Cards convenient than larger-sized discount merchandise stores, and (3) customer service, which exceeds that of both. MVS guarantees quality of all the products it sells and also offers extended service contracts on behalf of third parties on higher-priced items such as appliances and electronic products.' Mahendra R. Gujarathi Strategy and Performance Foreseeing a weakening retail environment, MVS started implementing a new strategy in the ABSTRACT: Max-Value Stores, Inc., a discount general merchandise operator, has second half of fiscal 2007" focusing on enhancing its brand, improving operational performance. initiated a program to sell its own gift cards and those of other retailers. This case eliminating underperforming assets, and streamlining cost structure. This has enabled MVS to provides an opportunity to apply your understanding of various financial reporting topics deliver higher sales and earnings in fiscal 2008 at a time when many other retailers experienced a (revenue recognition, liability de-recognition, accounting changes, and deferred tax decline. The financial analyst community is impressed with the past performance of MVS and has accounting) to determine the applicable GAAP (generally accepted accounting assigned a rating of Ab to the Company's bonds (an investment grade rating from Moody's) and a principles) for recognizing gift card "breakage," the estimated amount of gift cards that multiple of 18 to its current earnings, well above the multiples for national retailers such as Walmart is unlikely to be redeemed. You also must evaluate soundness of the proposals that the or Target. Analysts are optimistic that the Company's new strategy will further accelerate its management of MVS has made during the process of annual audit to recognize revenue and earnings growth in the coming years. Analysts that follow MVS have an earnings estimated gift card breakage and estimated non-redemption of the restricted gift cards estimate of $3.45 per share for fiscal 2008. issued during the special Thanksgiving promotion. The case provides you an opportunity The preliminary results for fiscal year 2008 (ending on February 28, 2009) indicate, however, to examine several technical and conceptual financial reporting issues in a real-world that the Company would not meet analysts' consensus earnings estimate. Tough credit markets in setting, strengthen accounting research capabilities, understand implications of the 2008 have made additional borrowings difficult and expensive for MVS. The senior management of choice of an accounting policy for performance measurement and financial statement the Company is particularly concerned that a debt covenant with one of its crucial lenders is likely O analysis, and develop critical thinking and professional judgment skills. to be violated if MVS cannot maintain a current ratio of 1.40 or higher. If a violation occurs, the Keywords: gift cards; revenue recognition; gross vs. net; accounting changes; FASB O creditor would have the right to accelerate maturity of the debt or seize the collateralized assets. codification; earnings management. Executive Compensation Impressed with the past performance of its senior management, the Board of Directors of MVS CASE 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 Company Overview 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 the Board's subjective evaluation, the remaining amount ax-Value Stores, Inc. (MVS or the Company) is an operator of discount general Mmerchandise stores in the southeastem United States, The Company's stores generally (60 percent) is based on meeting the specified targets. For the fiscal year 2008, these targets are (1) annual sales growth of 12 percent or higher, (2) annual gross profit of 24 percent or higher, and (3) serve low-, middle-, and fixed-income families that reside in small to medium-sized earnings per share (EPS) of $2.95 or higher. Senior management is entitled to a bonus of 20 percent of base salary for each target achieved. towns. Founded in 1969 in North Carolina with a single store, MVS has achieved significant brand recognition in its target markets and had grown to over 400 company-owned and 40 franchised Gift Cards Initiative stores by 2009. Among the several factors that have contributed to MVS's success in recent years is its notable gift cards 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" Mahendra R. Gujarathi is a Professor at Bentley University and a Visiting Professor at the Indian Institute of promotion, and sales of its own gift cards. Management, Ahmedabad. I thank the editor, associate editor, and two anonymous reviewers; Professors Sue Evans, Dorothy Feldmann, Charles MVS recognizes commissions earned on such contracts ratably over the term of the service contract. Malgwi, Mark Nixon, William Read, Terrance Skelton, and Ari Yezegel; and Mr. Jim Boyer of KPMG for their February 29, 2008. The Company's fiscal year begins on March 1 and concludes at the end of February. Fiscal year 2007 ended on comments and suggestions on the earlier versions of the case Thanksgiving is a harvest festival in the U.S. aimed to give thanks for the harvest and express gratitude in Supplemental materials can be accessed by clicking the links in Appendix A. general. While perhaps religious in origin, Thanksgiving is now primarily identified as a secular holiday on the fourth Thursday in November. In 2008. Thanksgiving Day was on November 27.786 Gujarathi Max-Value Stores, Inc.: Financial Reporting of Gift Cards 785 Gift Cards of Other Retailers 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 In fiscal 2008, MVS began selling gift cards of several other regional and national retailers. of which state the gift cards are sold in. MVS receives a commission of 15 percent of the value of the gift cards when the cards are swiped Past experience with redemptions indicates that typically 75 percent of the value of gift cards through a POS (Point of Sale) terminal of the Company. The sale of other retailers' gift cards by purchased is redeemed by customers in the fiscal year in which the gift cards were purchased. MVS is non-refundable, and the cards can be redeemed only at the sales channels of the respective Another 12 percent is redeemed in the fiscal year after the year of purchase, and 3 percent in the retailers. In fiscal 2008, MVS's management recorded $50 million as sales of gift cards of other following year. On average, 10 percent of the value of the gift cards is never redeemed. The most retailers and $42.5 million as the cost of goods sold. common reasons for non-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 Gift Cards Issued during the Special Thanksgiving Promotion a lost, stolen, or damaged card by presenting the original purchase receipt, most customers do not. As a special promotion around Thanksgiving in 2008, the Company announced that for one During the process of annual audit, the management of MVS has proposed that-starting in fiscal week, each purchaser of an ipod Touch at the regular price of $299 would receive a $40 MVS gift 2008-the estimated breakage (10 percent of the gift cards sold) be recognized as sales in the year in card. These restricted gift cards would expire after six months. With approximately 500,000 iPods which the gift cards are sold. In addition, the cumulative effect of previously unrecognized income purchased at MVS during the week of Thanksgiving, the Company issued $20 million worth of gift from such breakage is proposed to be recognized as sales in the year of change (fiscal 2008). cards. These were recorded as a reduction in sales and as a liability." The $18 million of gift cards Presented below are the Company's yearly and cumulative sales of gift cards: redeemed by customers before the end of fiscal year 2008 were recognized as sales and a decrease in the liability recorded earlier. MVS's management estimates that it is unlikely that customers will redeem the remaining gift card amount ($2 million). During the process of its year-end audit, Gift Cards Sold (Amounts in Thousands) management proposed that this amount be recognized as sales and a decrease in the liability recorded earlier in 2008. MVS does not have any prior experience with running a special promotion like this. Fiscal Year During the Year Cumulative Total Gift Cards of Max-Value Stores 2002 and before $30.484 The Company started selling MVS gift cards in its retail stores in 1998 and on the web in 2000. 2003 $10,436 40,920 The company's gift cards have been recognized by Consumer Affairs as a "top pick" for not having 2004 11,897 52,817 2005 deceptive features such as expiration dates, dormancy fees, and post-purchase fees. The amount of 13,562 66,379 2006 15,461 81.840 the "gift" value is loaded and stored on the host database by swiping a magnetic-stripped card 2007 17,625 99.465 through a POS terminal. Customers can add to outstanding amounts on their existing gift cards in 2008 20,093" 119,558 the Company stores or on its website. Customers can choose from a variety of gift card 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- The $20 million restricted gift cards issued during the 2008 Thanksgiving Day promotion half of the annual sales of gift cards occur around the Christmas holiday season. Most customers (described earlier) are not included in this number. 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 Taxation of Gift Card Breakage on MVS's Gift Cards recognizes sales revenue in the amount of redemption and reduces the gift card liability. To date, MVS follows the accrual method of accounting for tax purposes. Although advance payments MVS has not recognized any income for unredeemed gift cards. Instead, the cumulative amount of (such as interest and rent receipts) are generally taxed in the year of receipt, Reg. $1.451-5(c) unredeemed gift cards is included in "other current liabilities" in the Company's statement of specifies exceptions for inventoried goods. If a taxpayer receives an advance payment in a taxable financial position. A footnote in the financial statements of fiscal 2007 stated: year with respect to an agreement (such as a gift card), then all payments received that are not The Company has not recognized any revenue from gift card "breakage" since the previously included in income in accordance with the taxpayer's accrual method of accounting shall inception of the program in 1998 and does not expect to record any "breakage" revenue be included in the taxable income of the second taxable year following the year in which the until there is certainty regarding our ability to retain such amounts in light of current payments were received. For instance, if gift cards of $100 are sold in year 1, and redemptions in consumer protection and state escheatment (i.e., unclaimed property) laws. years 1, 2, 3, and 4 are $60, $15, $13, and $4, respectively, the taxable income from gift cards In fiscal 2008, after a review of past redemption patterns and relevant escheatment laws, the would be $60 in year 1 and $15 in year 2, the same as the income recognized under the accrual management of MVS concluded that it could estimate the likely non-redemption 36 months after 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. The Company recognizes revenue when the customer takes possession of the merchandise. Although MVS uses Financial Statements 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 the aggregate sum of those accounts. MVS's unaudited financial statements for the 2008 fiscal year ending on February 28, 2009, are provided in Exhibit 1. The Company's unredeemed gift card liabilities, unearned revenues, and deferred tax liabilities are included in other current liabilities, and deferred tax assets are Issues in Accounting Education Volume 27, No. 3, 2012 Issues in Accounting Education Volume 27, No. 3, 2012Max-Value Stores, Inc.: Financial Reporting of Gift Cards 787 788 Gujarathi 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 EXHIBIT 1 filed with the Securities and Exchange Commission. The effects of management proposals are not Financial Statements Max-Value Stores, Inc. auditors. reflected in the unaudited financial statements because the proposals are not yet evaluated by the Statement of Financial Position EXHIBIT 1 (continued) (Amounts in thousands) 2/28/2009 Max-Value Stores, Inc. (Unaudited) 2/29/2008 Statement of Operations Year ended February 29 or 28 Current Assets (Amounts in thousands except per 2009 Percent of Percent of Percent of Cash and cash equivalents $44,865 $37,596 share data) (Unaudited) Sales 2008 Sales 2007 Sales Receivables 17,129 57,658 Merchandise inventories 146,890 125,112 Net sales $1,248,718 100.00 $1,121,141 100.00 $993,034 100.00 847.548 76.57 Other current assets Cost of goods sold 950,882 21,091 37,814 76.15 75.60 760,406 Gross profit 97.836 23.85 273.593 24.40 232,628 23.43 Total Current Assets 229,97 258,180 Selling, general and adm. expenses 21,832 17.76 211,224 18.84 181.958 18.32 Property and Equipment Operating income 76,004 6.09 62 369 5 56 50.670 5.10 Land and buildings $36,098 $21,996 Interest expense 1.934 0.15 967 0.09 942 0.09 Leasehold improvements 64,802 48,048 Other (loss) income 780 0.06 936 0.08 880 0.09 Fixtures and equipment 109,980 89,388 Income before income taxes 74,850 5.99 62,338 5.56 50,608 5.10 210,880 159,432 Income tax expense 29.940 2.40 24.935 2.22 20.243 2.04 Less: accumulated depreciation Net earnings 44,910 71,822 3.60 37,403 3.34 30,365 3.06 51,339 139,058 98.093 W. Avg. common shares outstanding 15,000 15,000 15,000 Other Assets 47,736 23.868 Total assets $416.769 $380,141 Earnings per share $2.99 $2.49 $2.02 Statement of Retained Earnings 2009 Current Liabilities (Amounts in thousands) (Unaudited) 2008 2007 Accounts payable $127,940 $1 13,096 Beginning balance $125,212 $111.922 $103,428 Accrued income taxes 15,786 17,737 Net earnings 44.910 37,403 30,365 Other current liabilities 29,132 43.449 Dividends (27,612) (24,113) (21,871) Total Current Liabilities 172,858 174,282 Ending balance $142,510 $125,212 $111,922 Long Term Debt $86,738 $65,983 Max Value Stores Requirements Shareholders' Equity Common stock, $0.01 par value; Authorized - 50 m shares $1.248 $1.248 The audit partner has asked you to prepare a memo for the audit file that considers all of the Additional paid in capital 13.417 13,416 following issues. The memo should follow the format discussed in the Collins book used in the Retained earnings 142,509 125,212 class, which principally agrees with the Graduate Case Write Up outline provided on MUOnline. Total Shareholders' Equity Total Liabilities and Shareholders' Equity 157,174 139.876 Also, in completing this case, remember to consider the Elements of Reasoning. In completing $416,770 $380,141 the case analysis, assume that you are completing the audit for the fiscal year ending February 28, 2019. A Determine, using appropriate authoritative guidance, how the gift cards discussed in the case should be accounted for. B. Discuss whether management's proposed treatment for gift card accounting is consistent C. with GAAP. If not, be specific about how the proposed treatment departs from GAAP. Explain to the partner what may have motivated management's proposals. In this regard, reference theories discussed in class that may explain management's motivation as well as specifics regarding the company and its current financial situation. D. Make recommendations regarding the accounting for the gift cards and potential changes to the management compensation agreement that could benefit the company's shareholders. Defend those recommendations with appropriate references to authoritative literature or theories discussed in class