As mentioned in the illustrative example of the vendor allowances agreement, ass

Question

As mentioned in the illustrative example of the vendor allowances agreement, assume that on September 1st 2013, CPC paid £560 million to Tesco in exchange for Tesco’s commitment to purchase 3.5 billion units of CPC’s products. At the end of the contract period (August 31st 2014), the amount of sales allowances was calculated based on Tesco’s actual purchases (3.65 billion units at £2 per unit) during the contract period and difference was settled in cash between CPC and Tesco.

Tesco recognized the receipt of £560 on September 1st 2013 as sales revenues, and the cash settlement on August 31st 2014 as an adjustment to sales revenues.

Question: Explain the plausible motivations of Tesco’s management to include sales allowances in sales revenues. For this requirement, assume that the for the contract period, the target gross margin rate for management bonus purposes was the same as in the previous contract period.

Explanation / Answer

Tesco should not recognize the cash settlement of sales allowances with Sales Revenues as it would curtail the true amount of Sale Revenue that it earned.

The amount that Tesco has expended (3.65 billions - 3.5 billions) * 2 i.e, £ 0.3 billion or £ 300 million should be recognized as:

Sales Allowances Dr.   £ 300 million

Cash Cr. £ 300 million

And the Sales Revenues should remain as it is i.e,

CPC Dr.    £ 560 million

Sales Cr. £ 560 million

As the entry of sales allowances would not affect CPC Account.

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