Case study help on 2a,b,c,d.

ISSUES IN ACCOUNTING EDUCATION American Accounting Association

Vol. 27, No. 3 DOI: 10.2308/iace-50080

2012

pp. 783798

Max-Value Stores, Inc.: Financial Reporting

of Gift Cards

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

codification; earnings management.

CASE

Company Overview

Max-Value Stores, Inc. (MVS or the Company) is an operator of discount general

merchandise stores in the southeastern United States. The Companys 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 had grown to over 400 company-owned and 40 franchised

stores by 2009.

Supplemental materials can be accessed by clicking the links in Appendix A.

Published Online: August 2012

783The Companys 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 fiscal 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 fiscal 2008 at a time when many other retailers experienced a

decline. The financial analyst community is impressed with the past performance of MVS and has

assigned a rating of Ab to the Companys bonds (an investment grade rating from Moodys) 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 Companys 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 fiscal 2008.

The preliminary results for fiscal 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 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 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 Boards evaluation of senior managements performance.

While 40 percent of the bonus is based on the Boards subjective evaluation, the remaining amount

(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)

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 MVSs success in recent years is its notable

gift cards program. Presented below is pertinent information relating to the Companys sales of gift

cards of other retailers, issuance of MVSs restricted gift cards during a special Thanksgiving3

promotion, and sales of its own gift cards.

1 MVS recognizes commissions earned on such contracts ratably over the term of the service contract. 2 The Companys fiscal year begins on March 1 and concludes at the end of February. Fiscal year 2007 ended on

February 29, 2008. 3 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 identified 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, 2012Gift Cards of Other Retailers

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 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 fiscal 2008, MVSs 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 fiscal year 2008 were recognized as sales and a decrease in

the liability recorded earlier. MVSs 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 companys 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 Companys statement of

financial position. A footnote in the financial statements of fiscal 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 fiscal 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.

Max-Value Stores, Inc.: Financial Reporting of Gift Cards 785

Issues in Accounting Education

Volume 27, No. 3, 2012the 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 fiscal year in which 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 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 fiscal

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 (fiscal 2008).

Presented below are the Companys yearly and cumulative sales of gift cards:

Fiscal Year

Gift Cards Sold (Amounts in Thousands)

During the Year Cumulative Total

2002 and before $30,484

2003 $10,436 40,920

2004 11,897 52,817

2005 13,562 66,379

2006 15,461 81,840

2007 17,625 99,465

2008 20,093a 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 MVSs 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 taxpayers 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

MVSs unaudited financial statements for the 2008 fiscal year ending on February 28, 2009,

are provided in Exhibit 1. The Companys 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, 2012included 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

Assume that you are an audit senior of the external audit firm 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 Companys existing accounting policies pertaining to the gift card

transactions and an evaluation of the managements 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 Codification, or other relevant resources, if an authoritative pronouncement

is unavailable. The audit partner would like you to consider the plausible motivations for

managements 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 reflecting the

effect of management proposals, and the other reflecting 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 firm on the MVS assignment. Together, you have determined that the task

involves addressing the following specific issues.

Issues in Accounting Education

Volume 27, No. 3, 2012EXHIBIT 1

Financial Statements

Issues in Accounting Education

Volume 27, No. 3, 2012EXHIBIT 1 (continued)

Max-Value Stores, Inc.: Financial Reporting of Gift Cards 789

Issues in Accounting Education

Volume 27, No. 3, 2012As the audit senior on the MVS engagement, you want to be sure that the Companys

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.

Adjusted Statement of Operations (In Compliance with GAAP)

Item

Reported

Amounts

Adjustments, If Any, Resulting from

Adjusted

Amounts

Sale of

Other

Retailers

Gift Cards

Sale of MVS

Gift Cards

Gift Cards

Issued during

Special

Promotion

Net sales $1,248,718,000

Cost of goods sold $950,882,000

Gross profit $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 $44,910,000

W. Avg. shares outstanding 15,000,000 15,000,000

Earnings per share $2.99

2. Evaluation of Management Proposals

a. GAAP Compliance

Discuss whether managements 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 years (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 profit, operating income, other (loss) income, net

earnings, and earnings per share that the Company would report if, in addition to its

790 Gujarathi

Issues in Accounting Education

Volume 27, No. 3, 2012existing reporting policies (regardless of whether they comply with GAAP),

managements 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

Item

Reported

Amounts

Adjustments Resulting from

Proposed

Amounts

Breakage on

Unredeemed

Gift Cards

Gift Cards

Issued during

Special

Promotion

Net sales $1,248,718,000

Cost of goods sold 950,882,000

Gross profit 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 $44,910,000

W. Avg. shares outstanding 15,000 15,000

Earnings per share $2.99

d. Plausible Motivations for Management Proposals

What are plausible motivations for the proposals by the Companys management to

recognize estimated gift card breakage and estimated non-redemption of the restricted

gift cards issued during the special Thanksgiving promotion? Be specific.