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ISSUES IN ACCOUNTING EDUCATION Vol. 27, No. 3 2012 pp. 783-798 American Accounting Association DOI: 10.2308/iace-50080 Max-Value Stores, Inc.: Financial Reporting of Gift Cards Mahendra R. Gujarathi 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. This 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 determine the applicable GAAP (generally accepted accounting principles) for recognizing gift card ''breakage,'' the estimated amount of gift cards that is unlikely to be redeemed. You also must evaluate soundness of the proposals that the management of MVS has made during the process of annual audit to recognize estimated gift card breakage and estimated non-redemption of the restricted gift cards issued during the special Thanksgiving promotion. The case provides you an opportunity to examine several technical and conceptual financial reporting issues in a real-world setting, strengthen accounting research capabilities, understand implications of the choice of an accounting policy for performance measurement and financial statement analysis, and develop critical thinking and professional judgment skills. Keywords: gift cards; revenue recognition; gross vs. net; accounting changes; FASB codication; earnings management. CASE Company Overview M ax-Value Stores, Inc. (MVS or the Company) is an operator of discount general merchandise stores in the southeastern United States. The Company's stores generally serve low-, middle-, and xed-income families that reside in small to medium-sized towns. Founded in 1969 in North Carolina with a single store, MVS has achieved signicant brand recognition in its target markets and had grown to over 400 company-owned and 40 franchised stores by 2009. Mahendra R. Gujarathi is a Professor at Bentley University and a Visiting Professor at the Indian Institute of Management, Ahmedabad. I thank the editor, associate editor, and two anonymous reviewers; Professors Sue Evans, Dorothy Feldmann, Charles Malgwi, Mark Nixon, William Read, Terrance Skelton, and Ari Yezegel; and Mr. Jim Boyer of KPMG for their comments and suggestions on the earlier versions of the case. Supplemental materials can be accessed by clicking the links in Appendix A. Published Online: August 2012 783 784 Gujarathi The Company's strategy consists of meeting the general merchandise needs of its target 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 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.1 Strategy and Performance Foreseeing a weakening retail environment, MVS started implementing a new strategy in the second half of scal 20072 focusing on enhancing its brand, improving operational performance, eliminating underperforming assets, and streamlining cost structure. This has enabled MVS to deliver higher sales and earnings in scal 2008 at a time when many other retailers experienced a decline. The nancial 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 Walmart or Target. Analysts are optimistic that the Company's new strategy will further accelerate its revenue and earnings growth in the coming years. Analysts that follow MVS have an earnings estimate of $3.45 per share for scal 2008. The preliminary results for scal year 2008 (ending on February 28, 2009) indicate, however, that the Company would not meet analysts' consensus earnings estimate. Tough credit markets in 2008 have made additional borrowings difcult 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 cannot 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 the Board's subjective evaluation, the remaining amount (60 percent) is based on meeting the specied targets. For the scal year 2008, these targets are (1) annual sales growth of 12 percent or higher, (2) annual gross prot of 24 percent or higher, and (3) 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. Gift Cards Initiative 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 Thanksgiving3 promotion, and sales of its own gift cards. 1 2 3 MVS recognizes commissions earned on such contracts ratably over the term of the service contract. The Company's scal year begins on March 1 and concludes at the end of February. Fiscal year 2007 ended on February 29, 2008. Thanksgiving 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 identied as a secular holiday on the fourth Thursday in November. In 2008, Thanksgiving Day was on November 27. Issues in Accounting Education Volume 27, No. 3, 2012 Max-Value Stores, Inc.: Financial Reporting of Gift Cards 785 Gift Cards of Other Retailers In scal 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 the cards are swiped through a POS (Point of Sale) terminal of the Company. 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 scal 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 in 2008, the Company announced that for one week, each purchaser of an iPod Touch at the regular price of $299 would receive a $40 MVS gift card. These restricted gift cards would expire after six months. With approximately 500,000 iPods purchased at MVS during the week of Thanksgiving, the Company issued $20 million worth of gift cards. These were recorded as a reduction in sales and as a liability.4 The $18 million of gift cards redeemed by customers before the end of scal 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, 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. 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 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-stripped card through a POS terminal. Customers can add to outstanding amounts on their existing gift cards in 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 onehalf of the annual sales of gift cards occur 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 nancial position. A footnote in the nancial statements of scal 2007 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 scal 2008, after a review of past redemption patterns and relevant escheatment laws, the management of MVS concluded that it could estimate the likely non-redemption 36 months after 4 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 the aggregate sum of those accounts. Issues in Accounting Education Volume 27, No. 3, 2012 Gujarathi 786 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 are sold in. Past experience with redemptions indicates that typically 75 percent of the value of gift cards purchased is redeemed by customers in the scal year in which the gift cards were purchased. Another 12 percent is redeemed in the scal 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 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 a lost, stolen, or damaged card by presenting the original purchase receipt, most customers do not. During the process of annual audit, the management of MVS has proposed thatstarting in scal 2008the estimated breakage (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 year of change (scal 2008). Presented below are the Company's yearly and cumulative sales of gift cards: Gift Cards Sold (Amounts in Thousands) Fiscal Year 2002 and before 2003 2004 2005 2006 2007 2008 During the Year Cumulative Total $10,436 11,897 13,562 15,461 17,625 20,093a $30,484 40,920 52,817 66,379 81,840 99,465 119,558 a The $20 million restricted gift cards issued during the 2008 Thanksgiving Day promotion (described earlier) 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) species 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 of $100 are sold 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. Financial Statements MVS's unaudited nancial statements for the 2008 scal 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 Max-Value Stores, Inc.: Financial Reporting of Gift Cards 787 included in other current assets in the statement of nancial position. The nancial statements are not nal; only upon further evaluation and approval by the external auditing rm will they be led with the Securities and Exchange Commission. The effects of management proposals are not reected in the unaudited nancial statements because the proposals are not yet evaluated by the auditors. Requirements Assume that you are an audit senior of the external audit rm engaged by MVS. To help in the forthcoming presentation for the Board of Directors of the Company, the audit partner has asked you to provide an analysis of the Company's existing accounting policies pertaining to the gift card transactions 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 promotion. Your answers should provide a description of the accounting policies, an assessment of whether they comply with GAAP, and your recommendation for a preferred approach in instances where alternative approaches are permissible under GAAP. Explain your rationale and support your position with citations from the applicable authoritative pronouncements using the FASB Accounting Standards Codication, or other relevant resources, if an authoritative pronouncement is unavailable. The audit partner would like you to consider the plausible motivations for management's choice of existing accounting policies and proposals it has made during the year-end audit. The audit partner would also like you to prepare two income statements: one reecting the effect of management proposals, and the other reecting the accounting policies that you would be willing to support based on your research, analysis, and judgment. Not knowing exactly how to go about executing the above assignment, you consulted with the audit manager of your rm on the MVS assignment. Together, you have determined that the task involves addressing the following specic issues. 1. Analysis of the Existing Accounting Policies for the Gift Card Transactions a. Gift Cards of Other Retailers (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 scal 2008? Why? (ii ) What is a plausible motivation for the management of the Company to report sales and cost of goods sold separately, rather than report the net effect ($7.5 million) of the two as other income? b. Gift Cards Issued during the Special Thanksgiving Promotion Does the Company's nancial reporting of restricted gift cards issued during the special Thanksgiving promotion comply with GAAP? If yes, explain why. If not, explain why not and determine the adjustments, if any, needed to the Statement of Operations in Exhibit 1. c. Gift Cards of Max-Value Stores Assuming that MVS cannot estimate the gift card breakage (i.e., amount of likely nonredemption), is the existing accounting policy of the Company for gift cards compliant with GAAP? If yes, explain why. If not, explain why not 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 Issues in Accounting Education Volume 27, No. 3, 2012 Gujarathi 788 EXHIBIT 1 Financial Statements (continued on next page) Issues in Accounting Education Volume 27, No. 3, 2012 Max-Value Stores, Inc.: Financial Reporting of Gift Cards EXHIBIT 1 (continued) Issues in Accounting Education Volume 27, No. 3, 2012 789 Gujarathi 790 As the audit senior on the MVS engagement, 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 prot, 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. Adjusted Statement of Operations (In Compliance with GAAP) Adjustments, If Any, Resulting from Item Reported Amounts Gift Cards Sale of Issued during Other Special Retailers' Sale of MVS Adjusted Promotion Gift Cards Gift Cards Amounts Net sales $1,248,718,000 Cost of goods sold $950,882,000 Gross prot $297,836,000 Selling, gen. and adm. expenses $221,832,000 Operating income $76,004,000 Interest expense $1,934,000 Other (loss) income $780,000 Income before income taxes $74,850,000 Income tax expense $29,940,000 Net earnings W. Avg. shares outstanding Earnings per share $44,910,000 15,000,000 15,000,000 $2.99 2. Evaluation of Management Proposals a. GAAP Compliance Discuss whether management's proposals to recognize (i ) the estimated non-redemption of the restricted gift cards issued during the special Thanksgiving promotion and (ii ) the estimated gift card breakage would comply with GAAP. Assume that MVS is in compliance with the escheatment (unclaimed property) laws of North Carolina, the state in which it is incorporated. b. Alternative Accounting Approaches for Gift Card Breakage For the recognition of gift card breakage, discuss the alternative accounting approaches that would comply with GAAP. For each approach, compute the current year's (2008) pre-tax impact, as well as cumulative pre-tax impact from the 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 Compute sales, cost of sales, gross prot, operating income, other (loss) income, net earnings, and earnings per share that the Company would report if, in addition to its Issues in Accounting Education Volume 27, No. 3, 2012 Max-Value Stores, Inc.: Financial Reporting of Gift Cards 791 existing reporting policies (regardless of whether they comply with GAAP), management's proposals to recognize (i ) estimated gift card breakage and (ii ) 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 Adjustments Resulting from Breakage on Unredeemed Gift Cards Item Reported Amounts Net sales Cost of goods sold Gross prot Selling, gen. and adm. expenses Operating income Interest expense Other (loss) income Income before income taxes Income tax expense Gift Cards Issued during Special Promotion Proposed Amounts $1,248,718,000 950,882,000 297,836,000 221,832,000 76,004,000 1,934,000 780,000 74,850,000 29,940,000 Net earnings W. Avg. shares outstanding Earnings per share $44,910,000 15,000 15,000 $2.99 d. Plausible Motivations for Management Proposals What are plausible motivations for the proposals by the Company's management to recognize estimated gift card breakage and estimated non-redemption of the restricted gift cards issued during the special Thanksgiving promotion? Be specic. 3. Other Accounting Issues for Gift Card Breakage a. Change in Accounting Estimate versus Change in Accounting Principle Assume that MVS starts to recognize the gift card breakage from scal year 2008. It will now recognize breakage when the prospects of redemption become remote (i.e., the third year after the year in which the gift cards are sold). In the year of change (i.e., scal 2008), MVS wishes to recognize the breakage for prior years as well. (i ) Discuss whether starting to recognize gift card breakage in scal 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. (ii ) If MVS starts to record gift card breakage as a change in accounting principle, how much gift card breakage will it need to report for 2006, 2007, and 2008 in its comparative nancial statements of scal 2008? What would be the adjustment to Issues in Accounting Education Volume 27, No. 3, 2012 Gujarathi 792 the retained earnings balance on March 1, 2006, in the comparative nancial statements for scal 2008? Assume a tax rate of 40 percent. b. Financial Reporting of Deferred Taxes (i ) Taking into account the Company's existing nancial reporting policy of not recognizing the breakage and the rules for taxation of income from gift cards, determine the amount of deferred taxes, if any, included in the Statement of Financial Position at the end of scal 2008. Indicate whether it is a deferred tax asset or a liability. Assume that the average income tax rate is 40 percent and that the pattern of actual redemptions corresponds with the estimates made by the Company. (ii ) Assume that on February 28, 2009, MVS changes its policy for nancial reporting of gift cards. It will now recognize breakage when the prospects of redemption 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 in scal 2008 by including the effect in sales. MVS's policy for income tax reporting of gift card revenue will not change. Assume that the average income tax rate is 40 percent. Present a journal entry to record tax effects of the change. Provide supporting calculations. c. Role of Judgment in Accounting Policy Choices Assume that the nancial controller of MVS concludes that recording gift cards breakage is permissible under GAAP and would like to make the change in nancial reporting from scal 2008. The nancial controller can (i ) report the 2008 income effect in sales or in other income, (ii ) record the change as a change in accounting estimate or a change in accounting principle, and (iii ) choose the approach of recognizing breakage. What choices would the nancial controller likely make, and what are the implications for the nancial analysts of the choices made by the nancial controller? Issues in Accounting Education Volume 27, No. 3, 2012