P4. As Easy as ABC INTRODUCTION ABC Warehouse operates a chain of 35 discount retail appliance and electronics stores in Michigan, Ohio, and Indiana. The firm is privately held and began operations with a single Michigan location in 1964. ABC\'s operations are similar to national retailer BestBuy, but on a smaller scale ABC offered a special promotion to its customers, promising a 50 percent cash rebate ten years after the date of purchase. The case asks you to consider the economics and judgment made by management in deciding to offer this promotion. You are then asked to decide how ABC should account for sales revenue and the promised rebates under this promotion. The case requires you to consider the role of estimation in accounting and financial reporting, including appropriate consideration of the potential contingent liability THE ABC WAREHOUSE REBATE OFFER ABC Warehouse advertised the following special offer to customers A 50 percent cash rebate on your purchases in ten years The offer was subiect to several conditions: .The application form and a copy of the store receipt must be mailed within 21 days of . The rebate certificate must be available ten years from today and must be submitted . Customers must survive; rebates are not transferable. Customers are protected even if ABC goes out of business or is sold. ABC will purchase This offer applies to all purchases purchase. Upon receipt, ABC would issue a rebate certificate within 90 days of the ten-year maturity date. Customers cannot misplace any of the documents. insurance to guarantee payment of the rebates in the (unlikely) event they go bankrupt. Assuming all of the conditions were met, ABC would send a 50 percent cash rebate after ten years The offer received attention in the local and regional business press. The offer appeared unique in the U.S., but the reporter noted that such promotions had been successfully employed in the past in both Canada and Europe. The offer was made near the end of ABC\'s fiscal year (Year 0). Assume that the promotion ran for two weeks and generated sales of S5 million. For simplicity, you may assume that all sales were cash sales. You may also assume the ABC\'s gross margin is 20 percent of sales. Reminder: I don\'t need a Cash amount (balance) on the B/S
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For the year ended 0 , ABC would normally account for its sales on the income statement (5 million - assuming this was the whole sales during the year). It\'s Gross profit would be 5*0.2= 1m. Both these are the items of the income statement. As far as balance sheet is concerned, sales of 5m will increase its cash balance by the same amount. Assuming expenses were paid in cash, therefore cash will fall by 4m (80% of 5m). So net cash will increase by 1m. Profits of 1m will increase equity by 1m.
Now the most important thing is the accounting of rebate offer announced by the comoany. Now offer is subjected to various terms and conditions. Has it been unconditional then company would need to book PV of 2.5m (50% of 5m) as expense today. Now company need to make estimate as to how many customers will fulfill all such conditions and be therefore eligible for the 50% cash rebate. Suppose company estimates that only 40% of the customers will complete all T&C , so company will make a provision of PV of 1m (40% of 50% of 5m) today in its financials and show it as liability in the balance sheet. For rest 60%, can\'t may choose to show it as contingent liability. The amount recognised as expense say 0.3m (PV of 1m is assumed to be say 0.3m discounted 10 years back say @ 8%), will grow every year @8% in balance sheet and the same will be recorded as interest expense for respective years.
If at the end of the 10 years, rebate claimed is lower than the provisions mamade by the company, then the unclaimed rebates will be transferred to profit and loss statement. If rebate cclaimed is higher than the amount provided by the company in its books, then extra rebate will be booked as expense of the year in which rebate will be paid.
The rationale behind offering such rebate is obviously boosting current sales. But from customer\'s point of view, 10 years is too long a period to wait to get the rebate and that too after fulfilling so many conditions. So the customers may not be lured to buy more due to such offer.
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