Question

Hrudka Corp. has manufactured a broad range of quality products since 1988. The following information is available for the company’s fiscal year ended February 28, 2014. Hrudka follows ASPE. 1. The company has $4 million of bonds payable outstanding at February 28, 2014, that were issued at par in 2003. The bonds carry an interest rate of 7%, payable semi-annually each June 1 and December 1. 2. Hrudka has several notes payable outstanding with its primary banking institution at February 28, 2014. In each case, the annual interest is due on the anniversary date of the note each year (same as the due dates listed). The notes are as follows: Due Date Amount Due Interest Rate Apr. 1, 2014 $150,000 8% Jan. 31, 2015 200,000 9% Mar. 15, 2015 500,000 7% Oct. 30, 2016 250,000 8% 3. Hrudka uses the expense approach to account for warranties. The company has a two-year warranty on selected products, with an estimated cost of 1% of sales being returned in the 12 months following the sale, and a cost of 1.5% of sales being returned in months 13 to 24 following sale. The warranty liability outstanding at February 28, 2013, was $5,700. Sales of warrantied products in the year ended February 28, 2014, were $154,000. Actual warranty costs incurred during the current fiscal year are as follows: Warranty claims honoured on 2012–2013 sales $4,900 Warranty claims honoured on 2013–2014 sales 1,100 $6,000 4. Regular trade payables for supplies and purchases of goods and services on open account are $414,000 at February 28, 2014. Included in this amount is a loan of $23,000 owing to an affiliated company. 5. The following information relates to Hrudka’s payroll for the month of February 2014. The company’s required contribution for EI is 1.4 times that of the employee contribution; for CPP it is 1.0 times that of the employee contribution. Salaries and wages outstanding at February 28, 2014 $220,000 EI withheld from employees 9,500 CPP withheld from employees 16,900 Income taxes withheld from employees 48,700 Union dues withheld from employees 21,500 6. Hrudka regularly pays GST owing to the government on the 15th of the month. Hrudka’s GST transactions include the GST that it charges to customers and the GST that it is charged by suppliers. During February 2014, purchases attracted $28,000 of GST, while the GST charged on invoices to customers totalled $39,900. At January 31, 2014, the balances in the GST Receivable and GST Payable accounts were $34,000 and $60,000, respectively. 7. Other miscellaneous liabilities included $50,000 of dividends payable on March 15, 2014; $25,000 of bonuses payable to company executives (75% payable in September 2014, and 25% payable the following March); and $75,000 in accrued audit fees covering the year ended February 28, 2014. 8. Hrudka sells gift cards to its customers. The company does not set a redemption date and customers can use their cards at any time. At March 1, 2013, Hrudka had a balance outstanding of $950,000 in its Unearned Revenues—Gift Cards account. The company received $225,000 in cash for gift cards purchased during the current year and $375,000 in redemptions took place during the year. Based on past experience, 15% of customer gift card balances never get redeemed. At the end of each year, Hrudka recognizes 15% of the opening balance of Unearned Revenues as earned during the year. Instruction. For a manufacturer such as Hrudka, how should the revenue from unredeemed gift cards be shown on the income statement, as opposed to revenue from redeemed gift cards?

Answer 1

As per the applicable rules, Hrudka should estimate the percentage of unredeemed gift cards (also known as breakage) on a periodical basis (in proportion to the gift cards actually redeemed) and should transfer the amount of such gift cards from unearned revenue to breakage revenue/income. This percentage may change from time to time and may require revision. This percentage can be established by reviewing the historical redemption patterns. In the given case, we have been provided that Hrudka estimates that 15% of customer gift card balances never get redeemed. Hrudka should report the amount of unredeemed gift cards balance as "Breakage Income" and the amount of gift cards actually redeemed as "Sales Revenue" as the per the applicable rules. The amount of breakage income will be required to be adjusted as and when the redemption of gift cards take place. For Instance, let us assume that a redemption of $5,000 is made on a gift card and the total expected gift card redemptions during a particular month are $25,000 which is 85% of $29,412. This would result in a percentage redemeption of 20% (5,000/25,000). As a result, the company can recognize a breakage income (from unredeemed gift cards) of $882.40 [(29,412 - 25,000)*20%]. The following journal entries will be passed to recognize the earned revenue and revenue from breakage income:

Account Titles	Debit	Credit
Unearned Revenue	$5,000
Sales		$5,000
(To recognize revenue from redemption of gift cards)
Unearned Revenue	$882
Breakage Income		$882
(To recognize income from unredeemed gift cards)