Advanced Game Products, Inc.

Baird, Jane E. ; Zelin, Robert C., II

CASE DESCRIPTION

This case primarily concerns the application of financial reporting standards and current tax law to certain transactions of a company called Advance Game Products, Inc. (AGP). Internal control issues are also presented. Specifically, the case involves issues related to the accounting and tax treatment for two types of sales rebates, licensing arrangements whereby professional athletes permit their likeness to be used in the company's video games, and a contract with another company under which it will be the primary creative force behind the development of certain new games while AGP will take on the primary role of marketing those games. Students are also asked to identify potential concerns over the processing of the rebates and make recommendations on what internal controls the company should implement. The case has a difficulty level of 4, although the assignment could be easily adapted for use in a second Intermediate Accounting course or junior level business tax course. The case is designed require 1 to 4 hours of class time and require 12 to 15 hours of student preparation outside of class if all questions are assigned.

CASE SYNOPSIS

Jamie Jetson, a recent college graduate with an Accounting degree, has been assigned to the Advanced Game Products, Inc. (AGP) client engagement. The company operates in the dynamic video game industry, where creativity is paramount. Jamie's firm has been hired to do the audit and tax work for AGP. There were several big changes at AGP during the year, and Jamie's accounting firm has to determine how to deal with those items. AGP has recently signed contracts with celebrities for the rights to use their likenesses in video games under development. Unfortunately, one of the professional athletes, who already received a large advance, was involved in a big public scandal, so AGP has cancelled the development of his game. Another big change was that the company recently started a sales rebate program for both games sold in stores and games downloadable from the Internet. AGP has also signed a new agreement with another company to help it develop new games to work with new gaming platforms. With these new developments come both opportunities and concerns for AGP.

ADVANCED GAME PRODUCTS, INC.

Jamie Jetson recently graduated from Galactica State University and landed a job in the Chicago office of a regional public accounting firm. She has been assigned to work on the engagement team for Advanced Game Products, Inc. (AGP). Jamie's firm does both the audit and tax work for AGP. The team has been gearing up for the audit of the 2010 financial statements and the preparation of the 2010 tax returns. Jamie has been asked by the engagement manager to do some research on the proper accounting and tax treatment for transactions that are new to AGP in 2010. The following information has been gathered from the audit planning documents.

Advanced Game Products, Inc. (AGP) designs, produces and distributes video games for electronic platforms, including game consoles (Nintendo Wii, Microsoft Xbox 360, and Playstation 3), handheld game devices, cellular phones, and computers. The company was founded in 1995 by Jackson Packman, who began with one game he designed in the basement of his home. Since then, the company has had one hit game after another, along with many game designs that never came to fruition. Revenues have grown an average of 15 percent per year for the past five years, despite a downturn in the economy. However, the company has had very minimal profits due to high research and development costs combined with short product life cycles. The company now has 1200 employees, but is still privately held, with Mr. Packman retaining 75 percent ownership and five other investors owning the remainder. The company's main headquarters is in Chicago, Illinois. AGP is an accrual-basis taxpayer and is taxed as a corporation.

The company now has hundreds of games in its product mix, and introduced 25 new titles in 2010. Many of the products are sold in disk or cartridge format at retail stores, while others are sold in downloadable format or online-only format directly to consumers via the Internet. A majority of the products are designed in-house by staff developers, while others are purchased from independent developers. Management is hoping to take the company public some day, but before that can happen the company needs to boost its profits to attract investors. The management team has decided to approach that goal through both increasing sales and decreasing costs.

As part of the company's efforts to increase sales, it recently began a sales incentive program. The games sold in retail stores range in price from $29.99 to $79.99. The company is offering mail-in rebates on select games sold by retailers. If the game retails for $49.99 or more, the rebate is $10. If the game retails for less, the rebate is $5. There is a maximum rebate per household of $25. The rebates still allow AGP to earn a good profit margin on each product. The company has never offered rebates before, and management does not know what to expect in terms of additional sales generation or how many customers will actually return the rebate requests. The rebates will be offered for one month at a time, with an additional 2-week window for customers to return the rebate forms and receipts. The company plans for 10 games to have rebate incentives at any one time, with rebates offered on and off through the year on different titles.

A second type of rebate incentive will be offered as a sort of customer loyalty award. These rebates will be offered only on download products and online game products. The products sold on the company's website are not available elsewhere--they are not the same products that AGP sells to retail stores. The download products are primarily games for cellphones or handheld devices, but there are some downloadable games for the Wii and other game consoles. The online games are not downloaded, but are played online. For every $100 a customer spends on these products, the customer will be eligible for a $10 rebate. There is no rebate for purchase increments of less than $100, but the rebates are based on cumulative purchase levels rather than one-time purchases. However, the cumulative totals must be achieved within a six-month time frame, with no carryover of amounts. So, for example, a customer making one purchase of $30 in January and another purchase of $75 in March would be eligible for a $10 rebate, but if the same customer made the second purchase in July instead of March he would not be eligible for the rebate. The customer must apply for the rebate by submitting an online form. If the customer has met the purchase criteria, then a rebate check is mailed to the customer.

Also new in 2010 is a line of sports-based games using the names and likenesses of real professional athletes. This requires AGP to sign license agreements with those individuals for the rights to use their names and likenesses in the games for a specified period of time. There is quite a bit of competition to negotiate license arrangements within the video game industry, and AGP has now become a big enough player in the industry to land some of these contracts. The licensing arrangements required AGP to pay nonrefundable, upfront fees to the athletes as advanced minimum royalty payments. The agreements state that the athletes are entitled to the minimum royalty amount regardless of the level of sales of the product, and beyond that will be entitled to 10 percent of the gross receipts from the product. During 2010, AGP paid $250,000 each to four different athletes for the advanced minimum royalties. One of the games has already achieved a high enough sales volume that AGP owes additional royalties on the sales. These royalties have not yet been paid. Two others launched just before the Christmas sales season had respectable sales, but as of December 31, 2010 the royalties earned by the athletes were still less than the advance amount, so no additional amounts were owed. Unfortunately, one of the athletes was involved in a major scandal shortly after the agreement was signed and the company decided it was in its best interests to cancel the game's release. AGP did not have a morals clause in the contract and, therefore, was obligated to pay the fee even though the athlete will not be associated with the product. The game is now being reworked to include a different athlete who signed a licensing arrangement with AGP in April 2011.

As part of its cost control efforts, AGP has pursued ways to expand into new markets without locking into greater fixed costs in terms of facilities and fulltime employees. As a result, in December 2010, AGP entered into a contract with another company, Creative Designs Inc. (CDI) to design, produce and market downloadable games for the Apple iPad and similar new devises as they hit the market. CDI is a smaller company, but has already achieved success in game design. Under the arrangement, Creative Designs Inc. (CDI) will be the creative force behind the game development, from initial idea inception to the completion of the game programming. Under the agreement, CDI is prohibited from working with other companies to develop or market any IPad games, but is free to pursue arrangements with other companies for game development for other platforms. AGP will provide all of the marketing expertise, and provide the sales function through its already established Internet platform. AGP will also take care of the arrangements with the technology developers, such as its agreement with Apple for rights to create games for the iPad. Each company is assuming 50 percent of all costs and will share any profits equally. No separate entity has been formed as a result of this contract. AGP hopes to pursue other arrangements of this type if this one proves to be successful. As of December 31, 2010, three games were in early stages of development. AGP has not yet incurred any marketing costs, but has paid a fee to Apple. CDI has incurred costs for product development, but had not yet billed AGP for its share of those costs.

Jane E. Baird, Minnesota State University, Mankato

Robert C. Zelin II, Minnesota State University, Mankato