Impact of Journal Entry on Financial Statements - Assignment Example

1(a) Journal Entry (ies) attributable to gift cards on sale of cards One of the fundamental recognition criteria d in ment of Financial Accounting Concept No 5’1 is ‘Measurability’ of the transaction. Para 83 of the statement reads, “Revenue and Gains of an enterprise during a period are generally measured by exchange of value of assets or liabilities involved, and recognition involves consideration of two factors a) being realized or realizable and b) being earned, with sometime one or sometimes the other being the more important consideration” So far as gift cards sold by Best Buy for $3,200,000 on December 24, 2007 are concerned, an analysis need to be made on two counts before arriving at journal entries attributable to this transaction, namely, whether consideration of sale have been realized or realizable; and secondly whether the said consideration have been earned. In deciding the journal entry the important point is whether consideration has been earned. In any transaction of sale, sale gets completed only on transfer of title of the goods to the buyer. In the transaction under consideration only a right to select a gift has been allotted to buyer. The buyer has not yet chosen the articles to purchase, as that selection will be made by the recipient pf gift card. When the goods to be sold have not yet been earmarked, there is no question of transfer of title of the goods to the buyer at the time of sale of gift cards. Accordingly Best Buy has not yet earned the consideration received or receivable on sale of the gift cards. Therefore, no income has accrued to Best Buy at the time of sale of gift cards; and hence no credit can be given to an income account through such journal entries. In other words Best Buy has undertaken only a liability and not earned an income. Second aspect of realization of consideration is concerned; the journal transaction will depend upon receipt the amount or commitment to receive the amount of consideration for the sale of gift cards. Accordingly on December 24, 2007 the under noted journal entry can be passed by Best Buy: Bank / Trade Receivables (Current assets) Dr. Gift Cards Liabilities (Current liability) Cr. It is important to note here that revenue, though not earned on the date of issuance of gift cards, is not being deferred for recognisition but straight away being recognized as current liability. The recognition of revenue would be a separate transaction and would occur only on redemption of those gift cards. 1(b) Impact of journal entry (ies) on financial statements The basic purpose of issuance or sale of gift cards is to bring spurt in sales and thereby the income of the entity. But as explained in earlier paragraph the issuance of gift cards does not result into an immediate sale, but a liability is created for the entity to meet its commitment of redeeming the value of cards with supply of gifts(goods) selected by the consumers over a period of time, i.e., till the maturity of cards. It may also be possible that gifts cards are issued without specifying a fixed period of maturity, as is the case in the stated article ‘Accounting for Gift Cards’. Under such circumstances a reasonable period for the redemption of value of cards may be assumed to be few months, as after a reasonable period either the recipients forget to redeem the card they do not like to get the card redeemed. Under such a scenario, the immediate impact, i.e. as on the date of sale of gift cards, of the suggested journal entry on financial statements would be as under: i) Current liabilities will spurt by the total value of gift cards. ii) Current assets will also go up under two different categories, namely, cash (bank) by the value of consideration collected, and trade receivables by the value of consideration yet to be received from buyers of gift cards. “Liabilities are listed generally based on their due dates and they are said to be current or long term. Current liabilities are obligations a company expects to pay off with in the year.”2 There will not be any impact on inventory as stated in current assets as the goods have not yet been sold on the date of issuance of gift cards. In fact net current assets will not be affected by putting the stated journal entry. The only impact on financial statements would be the clear disclosure of current liabilities undertaken by the entity on sale of gift cards. 1 (c) Recognition of consideration of gift cards in annual income statement As gifts cards do not carry a limitation or expiry period (as stated in the article ‘Accounting for Gift Cards’), there is a possibility that only few gift cards would be redeemed with supply of goods till the end of fiscal period (assumed in this case January 31st ). The ownership of goods involved in redeemed gift cards gets transfer to the consumer as soon as supplies are received by the consumer. Under such a situation the sales gets completed and revenue is said to be earned. Therefore income or revenue has to be recognized as per FASB concept No. 5 referred to in para 1(a) above. The current liabilities created for those redeemed gift cards at their issuance would get replaced with sales (income). The effect on income statement would be that revenue will get enhanced by the value of redeemed cards and the corresponding current liability created on their issuance would get reduced by way of under noted journal entry for each such transaction: Gift Cards Liabilities (Current Liabilities) Dr. Sales (or Revenue) Cr. Rest of the consideration belonging to unredeemed cards that was received on sale of gift cards would remain reflected in the balance sheet as current liabilities as on the date of closure of fiscal period. This is so because normally few months are required for all gift cards to get exchanged with the supplies of goods and the period till January 1 is very short period to decide the final action on gift cards. After January 1 and over a period of say few months most of the cards would get redeemed into sales; but few of the cards would remain unredeemed (called ‘breakages’ in the stated article). The accounting treatment and effect of these breakages is explained in the following paragraphs. 2. a) Breakages of gift cards and their treatment in financial statements. Gift cards that consumers fail to redeem are called ‘breakages’ by Charles Owen Kile Jr. in the article under study. Accounting treatment of these breakages is causing problems for the business community. For an accounting treatment that sounds reasonable and within the parameters of existing standards, an assumption with regard to limitation period of use of cards is required to be made. As stated in the article the gift cards are open gift cards. That is to say that period limitation has not been fixed or mentioned on cards. Under such a situation a customary redemption period needs to be assumed or determined on the basis of factors like habits of consumers, festivity period involved, and of course the value of gift cards. This determination or assumption of period of redemption is important for declaring the unredeemed cards as ‘breakages’. Once the unredeemed cards are declared as breakages, their accounting treatment should follow the under mentioned pattern: a) Under no circumstances the current liabilities, created out of consideration received on sales of gift cards, when dissolved cannot be recognized as revenue or sale of goods because i) supplies have not been made to the consumers, and ii) title to any of the goods have not been transferred to any consumer. b) It is important to note that the income has not been earned because of sale of goods, but by virtue of consumers loosing the right to claim back the consideration already given Accordingly this is an income earned out of non- recurring or irregular circumstances. These windfalls of income from breakages of gift cards should be treated as ‘other Income’ coming under ‘operating activities’ but not revenue or sales under operating activities. However, the above pattern is subject to the condition that income from breakages is non- recurring operational income but not an ‘extraordinary income’. 2. b) Point at which breakages be treated as income Determination of point of time for declaring or treating breakages of cards as income is important because before recognizing any transaction as income it should also be treated as ‘earned income’. The expiry period of gift cards, if mentioned on cards, would easily be the point of time when unredeemed cards could be treated as ‘income’ that is earned at that point of time. But in case of open gift cards, assumed or agreed upon expiry period (decided on basis customs or rituals, and/ or circumstances during which cards were issued) would be the point of time of recognition of income from unredeemed gift cards. As stated in 2(a) above the income from breakages of cards would be treated as income earned not out of regular operating activities. It should be treated as income ‘earned’ by default of consumer loosing the claim of refund of amount being treated as liability by the company. So the important point is the point or time at which the cards become ‘breakages’. The income is said to earn at that particular time when cards become ‘breakages’ and liabilities of the company get dissolved. So at that point of time breakages of card should be treated as income earned and liabilities earlier created of the amount received on sale of gift cards be dissolved. 2 ( c) Whether breakages of card is income or expense Simply speaking a business ‘expense’ is a payment made or agreed to pay to earn income. From this simple definition the breakages of gift cards that are not redeemed cannot be treated as expenditure because of the following reasons: i) There was not commitment to make the payment at the time of sale of gift cards. ii) The commitment was to redeem gift cards with supply of goods or services. iii) The payment in fact was received on sale of cards and not paid or agreed to be paid. Breakages are certainly not expenses, but those should be treated as income or not would depend upon the following tests. Income is also called revenue. Revenue has been defined by International Accounting Standard 18 (IAS 18)3 as “The gross inflow of economic benefits (cash, receivables, and other assets) arising from the ordinary operating activities of an enterprise (such as sales of goods, sales of services, interest, royalties, and dividends)” The above definition implies that for declaring a transaction as income or revenue the transaction has to occur in the ordinary course of business. Whether ‘breakages’ of cards are occurrences in ordinary course of business?. Normally speaking an enterprise undertakes various efforts to boost its sale; and issuance or sale of gift cards is an effort in that direction. Those cards are required to be redeemed, within a specified or normal period, if gift cards doesn’t specify period, by the consumers. Few of those cards remain unredeemed and the company can forfeit the amount provided by consumers while purchasing those cards. All these activities, including breakages of cards, indicate that those are undertaken to boost sale; and sale is an activity in the ordinary course of business. Thus one can conclude that whatever is being forfeited on account of breakages of cards is an income or revenue in the direction of raising sales that is ordinary course activity of business. It is important to note that income on account of breakages of cards is not income account of sale of goods though initially cards were issued for the ultimate purpose of increasing sale of goods. But income from breakages is certainly part of operating activities of the business, and form part of operating income in the Income Statement and not an income from extraordinary transactions. Hence under all circumstances breakages of cards are income of the business and not the expenditure. 2 (d) Breakages a recurring or non- recurring income A recurring income is a regular happening, that is to say, it occurs again and again like sale of goods or receipt on account provision of services. Non- recurring income or expenditure is one that happens once a while or unpredictably. When an organization makes sale of gift cards, normally speaking, no prediction or estimation is made at that time about breakages on account of non- redemption of cards. The organization makes purchases on the assumption that all cards would be redeemed. However, some estimation can be made about breakages of cards, as stated in the article under consideration, at time of issuance of cards. Estimation might have been on basis of past experiences, but the objective of transaction of issuance of cards cannot be changed; otherwise the liabilities occurring at the time of issuance of cards need not be recognized to the extent of such estimation. Element of doubt in such estimation can be compared with the idea behind ‘receivables’ becoming bad debts. Bad debts are not recurring in nature. Similarly estimation of breakages, if made at the time of issuance of cards, cannot make breakages recurring transactions at the time of their declaration as breakages. The nature of such breakages will remain only as ‘non- recurring’. Accordingly, breakages have to be treated as ‘non- recurring’ events only as unredeemed gift cards could not be predictable as breakages at the time of issuance . These cards are issued not with intention that some of that card would not be redeemed. It is very important to mention that these non- recurring events are not extraordinary transactions as stated in paragraph 2( c) above. Therefore breakages are only non- recurring transactions emerging out of operating activities. Accordingly income from breakages would be disclosed as ‘other income’ under operational activities but certainly not as the regular sales occurring on accounting of regular business activities. One can say breakages are non- recurring operating transactions. Reference: 1 Statement of Financial Accounting Concept No5, Recognition and Measurement in Financial Statements of Business Enterprises, Para 63 and 83, http://www.fasb.org/pdf/con5.pdf 2 US Securities and Exchange Commission, Beginners’ guide to Financial Statements, viewed on December 9, 2007, http://www.sec.gov/investor/pubs/begfinstmtguide.htm 3 IAS 18 Revenue, Summaries of International Financial Reporting Standards, http://www.iasplus.com/standard/ias18.htm Read More