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.

INSTRUCTORS' NOTES

Recommendations for Teaching Approaches

This case presents several issues covering the gamut of audit, tax, and financial reporting. As such, it has been used in an undergraduate, senior-level capstone course. However, the case can easily be used in an auditing course, a tax course, or an intermediate financial accounting course simply by requiring students to only address the issues relevant to the particular topic. Issues 1, 3, and 5 would be appropriate to assign in an intermediate financial accounting course. Issue 2 and 4 would be appropriate for a business tax course. Issues 1, 3, 5 and the internal control questions would all be appropriate for an auditing course. In addition to helping students to learn the specific topics involved in the issues, the case can be used to achieve several learning objectives. To address the issues in the case, students must research professional standards and/or tax law. This gives students practical experience in using professional databases to solve real accounting and tax issues.

In a capstone or other senior level class, this case enables students to see that transactions, such as the rebates, have financial reporting, tax, and internal control ramifications. Therefore, they are approaching the issue from a more integrated viewpoint. Instructors can also use this case to help students develop their professional writing skills and oral presentation skills. We recommend that students be asked to document their research findings in a technical workpaper memo, such as would be found in an audit file, using a format similar to that used in the assignments and solutions section. Even the better writers among the students tend to be more familiar with creative writing or term paper assignments, with little exposure to real business writing. Instructors should emphasize the need for concise, clear writing. However, an equal emphasis should be placed on having complete documentation to support the conclusions. In lieu of or in conjunction with a written report, students could be asked to present their findings to the class, thus practicing their oral presentation skills.

This case works best as a team assignment. Students benefit from brainstorming ideas, especially in the initial research phase. Sometimes, the key to success is the ability to identify the right search term to use in the databases. Students will need access to the Accounting Standards Codification to complete the financial reporting questions. They will need access to sources of tax law, such as CCH or RIA Checkpoint, to be able to research the tax questions. If students do not have access to these resources, the instructor can use the case for an in-class discussion of what the students think the answer should be, and help lead them to the proper conclusions. If students are researching the topics outside of class, the instructor should plan for an average of 2 to 3 hours per issue.

Although this case was inspired by the company UBISOFT and information about the industry was gathered from its website for background purposes (http://www.ubisoftgroup.com), the information contained in the case is fictional.

ASSIGNMENTS AND SOLUTIONS

We suggest that students be asked to assume the role of Jamie and research the following issues:

1. How should the two types of rebates be reported in the financial statements?

2. How should the two types of rebates be treated on the federal income tax return?

3. How should the advance payments and royalties under the licensing arrangements be reported on the financial statements? Also, for financial reporting purposes, what impact, if any, does the cancellation of the one athlete's game have on the treatment of the advance payment made to him?

4. How should the licensing fees be treated on AGP's tax return?

5. How should the contract with CDI be treated for financial reporting purposes? Include discussion of how the costs and revenues will be reported, as well as any required disclosures.

In addition, assume that Jamie has been asked to look into the new rebate program and the effect that it will have over the company's controls. Jamie's supervisor would like Jamie to make client inquiries about the controls that may or may not be in place. In that regard, you should address the following questions:

1. What internal control issues surround the rebate program for the retail stores?

2. What internal control issues relate to the rebate incentive program for customers that download games from the Internet?

3. Assuming that internal controls are adequate for the rebate area, construct an audit program for substantive testing over the recording of rebates.

Solutions for Research Issues

Issue One: How should the two types of rebates be reported in the financial statements?

Conclusion One: The rebates for the in-store items should be recognized by AGP when the sale is made to the retailers, at the same time the revenue is recognized. At that time, AGP must record a liability for the rebates and a corresponding reduction in the sales revenue. Since it has no experience with rebates to estimate the amount of "breakage", the conservative approach would be to recognize 100% of the potential rebate as a liability. For the Internet downloads, the rebates should be recognized as a reduction in sales price in a systematic manner for all sales based on the percentage estimate of sales that will ultimately qualify for rebates.

Analysis One: For the in-store sales, ASC 605-50-25 applies. Per ASC 605-50-25-1, this section applies if both of the following conditions are met:

* The incentive is earned from a single sales transaction (multiple purchases are not required)

* The vendor does not receive an identifiable benefit from the incentive program.

Therefore, this section applies to the sales rebates for the in-store sales, but not the internet sales.

ASC 605-50-25-3 states that if the sales incentive will not result in a loss to the vendor, the cost of the incentive should be recognized at the later of the following two dates:

a. The date when the vendor recognizes the related revenue on the sale

b. The date on which the sales incentive is offered (for example, a manufacturer might offer discounts on products already sold to retailers).

For AGP, these two dates are essentially the same, because at the time the products are sold to the retailers, the rebate is offered to the customer. Therefore, the rebates should be recorded at the time the sales revenue is recorded by AGP.

Per ASC 605-50-25-4, for this type of mail-in rebate, the company should recognize a liability, such as a deferred revenue account, for the estimated amount of rebates that will be requested by the customers. This liability should be recorded at the later of the date on which the vendor recognizes the revenue from the sale or the date on which the sales incentive is offered to the customer. If this amount cannot be reliably and reasonably estimated by AGP, then the liability should be for the maximum amount of rebates that could be claimed by customers, assuming no "breakage". Breakage is the amount of rebates that go unfilled, either because the customer elects not to file the paperwork or the company rejects the rebate due to missing documentation or some other reason. ASC 605-50-25-4 further explains that the ability to make the estimates will vary from situation to situation, but that the following factors should be considered:

a. The longer the period over which a rebate can be claimed, the more difficult to estimate the amount that will be claimed.

b. A lack of historical experience for the company with similar types of incentives on similar types of products may indicate that the company does not have the ability to come up with a reasonable estimate. Or, it may be difficult to know whether that experience can be relied upon due to changing circumstances.

c. If a company does not have a large volume of similar transactions, estimating becomes more difficult.

AGP has no experience with rebates at all and, therefore, paragraph b above applies. The conservative approach would be to record a liability for the full potential rebate amount at the time of sale.

As for where to recognize rebates on the income statement, ASC 605-50-451 addresses whether the rebate is a reduction in revenues recognized or is an expense associated with the sale. ASC 605-50-45-2 states that a cash rebate given to a customer is normally assumed to be a sales price reduction and, therefore, would be recorded as an offset to the sales revenue account. However, if both of the following two conditions are met, then the rebate would be considered a cost incurred and should be recorded as an expense:

a. The seller receives, or will receive, a benefit, in the form of goods or services, in exchange for the rebate payment. This benefit would have to be something in addition to the revenue generated by the sale of the product.

b. The fair value of the benefit received by the seller can be reasonably estimated by the seller.

If both of the above conditions are met, then the rebate would be recognized as an expense to the extent of the value of the benefit received by the seller. Any excess of the rebate over the fair value of a benefit received would be considered a reduction in revenue. Neither of the above conditions holds true for AGP and, therefore, the rebates should be treated as a reduction in revenue rather than as an expense.

ASC 605-50-25-7 deals with the type of rebate that AGP is offering on its online downloads. These rebates are only earned by the customer after multiple purchases have been made. Per ASC 605-50-25-7, the seller (AGP) should record the rebate as a reduction of revenue using a systematic allocation method to divide the rebate over all of the sales transactions used to accumulate the rebate. As with the other rebates, the estimate of the total rebate obligation should take breakage into account. If the amount cannot be reasonably estimated, then the liability should be recorded for the total amount of potential rebates based on the amount of product sold. Under this section, the considerations as to whether or not the company can reasonably estimate the amount are the same as for the rebates for the in-store sales:

a. The longer the period over which a rebate can be claimed, the more difficult to estimate the amount that will be claimed.

b. A lack of historical experience for the company with similar types of incentives on similar types of products may indicate that the company does not have the ability to come up with a reasonable estimate. In other circumstances, it may be difficult to know whether that experience can be relied upon due to changing circumstances.

c. If a company does not have a large volume of similar transactions, estimating becomes more difficult.

AGP has no experience with rebates, but may have experience with how many customers purchase enough to qualify for the rebates. Therefore, it should recognize 100 percent of the rebates that it estimates will be earned by the customers and this should be recognized as a reduction in sales on a systematic basis. For example, if the company estimates that 40% of its customers will accumulate enough purchases to get the rebate, then it should take 40 percent of the cost of a rebate against each sale made. (According to 605-50-45-3, credits to the customers accounts are treated the same as cash consideration.)

Issue two: How should the two types or rebates be treated on the federal income tax return?

Conclusion Two: For income tax purposes, the rebates cannot be used to reduce taxable income until they are paid to the customers.

Analysis Two: For income tax purposes, the "all events test" needs to be considered to determine the proper timing of when the rebates can be used to reduce taxable income. Under Reg [section] 1.461-4(a), a liability cannot be considered to be incurred by an accrual basis taxpayer until economic performance has occurred. IRC Reg. 1.461-4(g)(3) specifically addresses rebates, as follows:

"If the liability of a taxpayer is to pay a rebate, refund, or similar payment to another person (whether paid in property, money, or as a reduction in the price of goods or services to be provided in the future by the taxpayer), economic performance occurs as payment is made to the person to which the liability is owed. This paragraph (g)(3) applies to all rebates, refunds, and payments or transfers in the nature of a rebate or refund regardless of whether they are characterized as a deduction from gross income, an adjustment to gross receipts or total sales, or an adjustment or addition to cost of goods sold. In the case of a rebate or refund made as a reduction in the price of goods or services to be provided in the future by the taxpayer, "payment" is deemed to occur as the taxpayer would otherwise be required to recognize income resulting from a disposition at an unreduced price."

Therefore, AGP's rebates meet the all events test when delivered in the form of a check to the customer, for rebates on the in-store sales, and when credited against the customer's account for the online sales. This will create a book to tax timing difference for AGP related to the rebate recognition.

Issue Three: How should the licensing agreements and related advance payments and royalties be reported on the financial statements? Also, for financial reporting purposes, what impact, if any, does the cancellation of the one athlete's game have on the treatment of the advance payment made to him?

Conclusion Three: For financial reporting, the advance payments are recorded initially as an asset, like a prepaid item, and then expensed as they are earned by the licensee in accordance with the agreement. For the license with the athlete who is no longer being used in the game, the entire amount can be expensed in the current year since the cost will not be recoverable through future use of the rights.

Analysis Three: AGP's licensing arrangements guarantee a minimum amount and include an advance payment. Per ASC 928-340-25-4, if guaranteed minimum amounts are paid to a licensor in advance, they should be reported as an asset on the licensee's balance sheet. According to ASC 928-340-35-3, this asset should then be expensed over time corresponding to the terms of the license agreement as to when the fees are earned by the licensor. Per ASC 928-720-25-3, if, at any time, a portion of that minimum guarantee is determined to be unrecoverable, then that portion should be expensed at that time. In AGP's case, the game with the disgraced athlete will not be produced, and, therefore, the minimum license fees already paid will never be recovered by AGP through product sales or by any other means. Therefore, it is appropriate for AGP to write off 100 percent of that amount as an expense in the current year's financial statements.

Issue Four: How should the licensing fees be treated on AGP's income tax return?

Conclusion Four: For tax purposes, the licensing fees/royalties are capitalized into inventory and then expensed as cost of goods sold when the items are sold.

Analysis Four: Per Reg. 1.263A-1(a)(3), IRC 263A applies to any tangible personal property produced, whether that property is for internal use or for sale. All direct costs and attributable indirect costs must be capitalized into inventory and then expensed as part of cost of goods sold when the product is actually sold. Reg. 1.263A-1(e)(3)(ii)(U) specifically identifies licensing fees, including initial fees and royalties, as indirect costs required to be capitalized.

Issue Five: How should the contract with CDI be treated for financial reporting purposes? Include discussion of how the costs and revenues will be reported, as well as any required disclosures.

Conclusion Five: For financial reporting, this should be treated as a collaborative arrangement. AGP should report 100 percent of any sales in its financial statements, and include the 50 percent of sales owed to the other company as part of cost of goods sold. AGP should report 100 percent of the marketing costs on its financial statements and the 50 percent it bills to the other company as "income from collaborative arrangements."

Analysis Five: This is a collaborative arrangement under ASC 808. There is no separate legal entity and, therefore, it is not a corporate joint venture. Per ASC 808-10-65-1, the equity method of accounting should not be used in these types of arrangements. Per ASC 808-10-45-2, for transactions with third parties, the member of the collaborative arrangement that is considered the "principal participant", determined on a transaction-level basis, should record the gross amount of that transaction in its financial statements. Under AGP's agreement, it is the principal participant in the sales function, while the other company is the principal participant in the game development function.

Under ASC 808-10-45-3, payments made between the collaborative arrangement's participants should be recorded according to authoritative accounting literature. According to ASC 808-10-45-4, "An entity shall evaluate the income statement classification of payments between participants pursuant to a collaborative arrangement based on the nature of the arrangement, the nature of its business operations, the contractual terms of the arrangement, and whether those payments are within the scope of other authoritative accounting literature on income statement classification. If the payments are within the scope of other authoritative accounting literature, then the entity shall apply the relevant provisions of that literature. To the extent that these payments are not within the scope of other authoritative accounting literature, the income statement classification for the payments shall be based on an analogy to authoritative accounting literature or if there is no appropriate analogy, a reasonable, rational, and consistently applied accounting policy election. For example, if one party to an arrangement is required to make a payment to the other party to reimburse a portion of that party's research and development cost, that portion of the net payment may be classified as research and development expense in the payor's financial statements pursuant to Topic 730." There is an example illustrated in ASC 808-10-55-3 which closely resembles AGP's situation. Following this example, AGP should report 100 percent of any sales in its financial statements, because it is the "principal participant" for the sales function under the agreement. Since AGP must then pay 50 percent of the sales amount to the other company, it should include the 50 percent owed to the other company as part of cost of goods sold on its income statement. AGP is also the principal participant in the marketing function, so it should report 100 percent of the marketing costs on its financial statements. AGP then bills the other company for one half of the marketing costs incurred, and this amount to be recovered from the other company should be reported as "income from collaborative arrangements." When AGP is billed by the other company for 50 percent of the development costs, it can report those costs on its income statement as product development expenses.

ASC 808-10-50-1 describes what financial statement disclosures are required. For the current financial statements, and for all reporting period after, AGP should disclose:

a. a description of the arrangement and its purpose

b. the entity's rights and obligations under the agreement

c. the accounting policy used pertaining to the agreement, and

d. the amounts included in the financial statements as a result of transactions between the parties related to the collaborative arrangement and their income statement classification.

SOLUTIONS FOR INTERNAL CONTROL QUESTIONS

Student responses will vary in this section and will require some critical thinking and creativity. Below are suggested items for consideration.

1. What internal control issues surround the rebate program for the retail stores? Has someone sent in duplicate rebate requests for the same purchase?

The company should have a database that tracks of all rebate requests with each person's name, address, item(s) purchased, prices, and dates of purchase. Alternatively, the company could outsource this to a rebate management company.

a. How does the company prevent a customer from submitting forged or altered receipts?

The customers should be required to cut out and mail in the UPC code along with the receipt. AGP should check the name of the retailer against AGP's customer list to determine that the retailer is valid. Original receipts must be required-no photocopies. If possible, AGP should work with its retailers to request summary reports from them showing all sales of AGP products to customers. This database can then be used to verify the receipts sent in by customers requesting rebates.

b. How does the company prevent ineligible customers from receiving a rebate? These could be employees, customers who have already received the maximum rebate, or customers not making qualifying purchases.

The company should match the name on the rebate request against the company's personnel files to make sure employees are not trying to get rebates. The company should check rebate requests against the database of already paid rebates to ensure that the current rebate request does not exceed the maximum allowable cumulative rebate. An employee should verify that the product code on the receipt matches that of a product that qualifies for the rebate.

Each rebate should be checked against the database names and addresses to make sure that the same household does not receive more than one rebate. If there are duplicate names but different addresses, the company could attempt to compare the two receipts to determine if they were paid for with the same credit card.

c. How does the company control against AGP employees submitting fictitious rebate claims?

The company should have access controls over the rebate requests received from customers to ensure that an employee cannot take UPC codes and receipts that have already been used for rebates and resubmit them under their own names.

d. How does the company deal with customers who try to return a product after they have received the rebate?

Requiring the customer to send the original receipt will help limit this behavior, since most stores would require the receipt for a return. Removing the UPC code is another control-retailers should be instructed that no returns should be accepted if the UPC code is missing. The company's policy should be to not send rebate checks until after the return policy has passed, such as 60 days from the sale date.

2. What internal control issues relate to the rebate incentive program for customers that download games from the Internet?

The company will need controls to prevent the time limit from being exceeded (the sales that accumulate to the level required for the rebate must be within a 6 month period). Controls should ensure that no rebates are paid out on cumulative sales less than $100. Since these are online transactions, these controls should be built into the system.

3. Assuming that internal controls are adequate for the rebate area, construct an audit program for substantive testing over the recording of rebates.

The following is a sample audit program:

1. Review the company's rebate program policies to gain an understanding of the program details.

2. Examine the client's calculation of the estimated rebate payable. Evaluate the method for reasonableness and test it for clerical accuracy.

3. Verify the total debits to the liability account against the detailed rebate records and note agreement with the amount of rebates paid.

4. Review rebates paid after year end and open rebate claims to determine if the client's estimate may need revision.

5. Determine if any disclosures are required under AU Section 342.

Normally, the auditor could compare the rebate percentages and amounts with prior years, but since this is the first year AGP had rebates, that will not be possible.

Jane E. Baird, Minnesota State University, Mankato

Robert C. Zelin II, Minnesota State University, Mankato