Mattel, Inc. and Toys R Us – Evaluating Collectibility when a Customer Experiences Financial Distress: Case Study

Case Introduction and Overview of Collectibility Under ASC 606

ASC 606 requires that collectibility be probable for revenue to be recognized from a contract with a customer. Without establishing probable collectibility, a company is not allowed to recognize revenue unless certain other criteria are met. These criteria, as well as a more in-depth understanding of collectibility, can be found in our Collectibility of Consideration article.

This case study discusses Mattel Inc. (Mattel) and its efforts to properly recognize revenue from, and evaluate collectibility for, a major customer, Toys R Us (TRU), that experienced financial distress. The facts of this case are heavily derived from Mattel’s August 2018 correspondence with the SEC; disclosures and excerpts are drawn from Mattel’s 10-K and 10-Q SEC Filings.

As a note, ASC 606 was adopted by Mattel beginning January 2018. This case study examines accounting decisions made both before, during, and after Mattel’s transition to the new standard. Under both the old and new standard, an important requirement is to analyze the collectibility of revenue as part of the recognition process, so a distinction is not drawn between the two standards for the purposes of this case.

Mattel, Inc. Background

Mattel is a publicly traded toy manufacturer founded in 1945 and headquartered in El Segundo, California. A Fortune 500 company, Mattel has come to produce many household names such as Fisher-Price, Barbie, and American Girl. For many years, the company’s largest customers have included Toys R Us, Walmart, Target, and other large retailers.

Mattel’s operations involve shipping toys to its customers on account and receiving payment at a future time. In its 2019 10-K SEC Filing, Mattel disclosed that “Revenue is recognized when control of the goods is transferred to the customer, which is either upon shipment or upon receipt of finished goods by the customer, depending on the contract terms.” Mattel generally makes a journal entry impacting revenue and accounts receivable for its shipments. Thus, evaluating payment collectibility has been, and will continue to be, an integral part of identifying Mattel’s contracts with its customers.

Mattel's Evaluation of Revenue Collectibility

Collectibility of Revenue from Toys R Us Prior to Bankruptcy

When evaluating collectibility, companies should consider the intent and ability of the customer to pay. Historical payments can provide reassurance that the customer intends to pay, while the customer’s ability to pay depends more on its financial capacity. Financial capacity can be analyzed with metrics such as credit risk and credit history.

In Mattel’s response to the SEC’s comment letter, Mattel offers its analysis of why TRU had the intent and ability to pay prior to bankruptcy (August 2018 Letter). These are the factors Mattel listed:

1. Timely and accurate historical cash collections from TRU
2. Regular review of market indicators by Mattel, including any trends showing a deterioration in TRU’s financial condition
3. Belief that TRU had/has adequate liquidity to cover any vendor payments if needed, as brought about by a review of TRU’s financial information and covenant compliance
4. Review of an internal Mattel “credit insurance scorecard” showing the passable financial capacity of TRU

Because the revenue was considered collectible, Mattel recorded revenue as it regularly shipped toys to TRU.

At the end of this and subsequent sections is a summary of the key points discussed, which includes sample numbers. Some of the numbers directly match the figures Mattel disclosed while other numbers were randomly selected. This is because Mattel requested confidentiality in its correspondence with the SEC for certain numbers it disclosed. Thus, the numbers found in the summary boxes were generated to illustrate how Mattel accounted for revenue from its contract with Toys R Us.

Toys R Us Files for Bankruptcy

In the third quarter of 2017, TRU was gearing up for a spending-filled holiday season, but word had started circulating that the company was on the brink of financial distress, and vendors became hesitant to continue shipping toys. TRU ultimately filed for Chapter 11 Bankruptcy in mid-September 2017. Near the time TRU declared bankruptcy, Mattel stopped shipping toys to TRU. However, Mattel still had a significant accounts receivable balance related to toys previously shipped.

ASC 606-10-25-5 prescribes that an event triggering a significant change in facts and circumstances surrounding the financial capabilities of a customer should give rise to a reevaluation of revenue collectibility. This reevaluation could impact the existence of a contract and will determine whether future revenue should be recorded at all.

When TRU filed for Chapter 11 Bankruptcy, the amount of receivables Mattel could recover became dependent on court rulings. Even though revenue was previously recorded for toys Mattel had shipped to TRU, the collectibility of the outstanding accounts receivable was no longer probable. Mattel considered two accounting options to represent the change in collectibility:

1. Reduce the accounts receivable balance with an adjustment to bad debt expense
2. Reduce the accounts receivable balance with a decrease in (reversal of previously recorded) revenue

The two accounting treatments generate the same overall impact on operating income but do so through different line items on the income statement. In the ASC 606 Background Information and Basis for Conclusions publication, the Financial Accounting Standards Board (FASB) clarifies why reevaluating collectibility is important and discusses the accounting treatment when a contract goes bad:

"It is important to reassess the criteria [when a significant change in facts and circumstances occurs] because that change might clearly indicate that the remaining contractual rights and obligations are no longer enforceable. The word remaining in paragraph 606-10-25-5 indicates that the criteria would only be applied to those rights and obligations that have not yet transferred. That is, an entity would not include in the reassessment (and therefore would not reverse) any receivables, revenue or contract assets already recognized."

According to the FASB, companies generally should not make changes to previously recognized receivables and revenues. However, this guidance is not authoritative as it is not part of the FASB’s codification; instead, the guidance shows the reasoning behind the codification. In some cases, it makes greater sense for a company to adjust previously recognized balances as long as it is all within the same reporting period.

In its discussion with the SEC, Mattel cited PwC’s Accounting and Reporting Manual (9A.50), explaining that “bad debt expense should not be recognized in the same period revenue is recognized from the same customer.” Mattel had enough information prior to the end of the reporting period to determine that revenue recognition criteria had not been met because collectibility was not reasonably assured. For this reason, even though PwC’s manual is also not authoritative guidance, the principles guiding the analysis supported Mattel’s accounting decision.

After its analysis, Mattel chose to reverse revenue it had previously recognized in the current quarter rather than recognizing bad debt expense. The amount that Mattel reversed is discussed in the next section.

Toys R Us Receives Support for Ongoing Operations and Signs a New Agreement

During the third and fourth quarters of 2017, TRU’s bankruptcy proceedings provided some level of clarity for Mattel. As part of its efforts to restructure, TRU announced that it had secured more than $3 billion in debtor-in-possession (DIP) financing. This would allow TRU to continue its operations and work towards a “going concern” status (an indication from an external auditor that the company is likely to continue operating for the 12 months following the issuance of an audit report). The court-approved financing came with a set of strict covenants that would force TRU to meet certain financial criteria.

In addition, during September and October 2017, the bankruptcy court authorized TRU to use up to $525 million towards administrative expenses and to pay off a portion of critical vendors’ pre-bankruptcy outstanding balances. TRU considered Mattel a critical vendor and negotiated a legally binding term sheet with Mattel under which the two companies would continue to do business. The term sheet clarified how much of the pre-bankruptcy receivables balance Mattel would receive payment for and outlined the promise of future payments for continued toy shipments.

Even though Mattel would not receive full payment from TRU for its balance prior to bankruptcy, Mattel was now optimistic that it would at least recover some of the amount, as specified in the term sheet. In addition, the company was confident that future revenue was collectible due to the following factors (August 2018 Letter):

1. TRU had the “ability and authority to enter into and execute agreements with its vendors utilizing the pool of funds approved and authorized” by the bankruptcy court, which included the term sheet with Mattel.
2. Due to the DIP financing and court-authorized funds, TRU had “sufficient access to sources of liquidity.
3. Mattel received its first two scheduled payments in accordance with the term sheet.
4. Covenants associated with the DIP financing required a certain level of financial strength.
5. None of the other vendors made a motion in court to force TRU to make payments due to lack of or slow payment.
6. None of the other lenders indicated that TRU had broken any of the financial covenants.

Rather than reversing the entire amount of TRU’s outstanding receivables balance prior to bankruptcy, Mattel only reversed revenue for the balance it would not eventually receive payment for, based on the signed term sheet. Additionally, for the above reasons Mattel felt confident fully recognizing revenue for future shipments made to TRU under the new operating agreement during the fourth quarter of 2017.

Mattel made the following disclosure regarding the reversal of revenue:

As a result of Toys “R” Us filing for bankruptcy, Mattel reversed approximately $47 million of gross sales in the third quarter of 2017. In addition, Mattel began to reduce shipping to Toys “R” Us in early September, which resulted in a loss of revenue in the third quarter of 2017.

As a result of the Toys “R” Us net sales reversal, gross margin includes the cost of sales for the inventory sold but excludes the corresponding net sales. (Q3 2017 10-Q)

Toys R Us Announces Liquidation

Throughout the first quarter of 2018, Mattel continued to sell toys to TRU and fully recognize revenue for the following reasons, according to its August 2018 comment letter to the SEC:

1. No public information indicated that TRU had broken any of its covenants.
2. TRU was actively working toward a restructuring that would allow it to continue as an operating company.
3. Mattel continued to receive cash collections in accordance with the term sheet.
4. No other vendors sought to compel payment from TRU, indicating that TRU was making proper payments to all its vendors.

In other words, no change in the facts and circumstances (which were being closely monitored at the time) surrounding TRU’s in-bankruptcy operations occurred. However, on March 2, 2018, Mattel was notified that TRU had failed to submit a revised budget on time. This budget was a requirement from the secured lenders, and TRU was in the process of negotiating a waiver, which was the first sign of a potential change in facts and circumstances. In its March 15, 2018 SEC Form 8-K Filing, TRU officially announced the liquidation of all U.S. stores, which it had sought approval from the Bankruptcy Court to do just the day before.

The liquidation announcement represented another significant change in facts and circumstances because it became unlikely that Mattel would receive full payment for the outstanding amount TRU owed. Collectibility was no longer probable because of the following factors:

1. TRU was not in compliance with its covenants.
2. TRU would not continue as an operating company in the United States.
3. Mattel stopped receiving timely payments “shortly before TRU’s March 15, 2018 filing.

Mattel made the decision to write off $87 million of accounts receivable related to TRU. Of this amount, Mattel explained that “approximately $30 million was recorded as a reversal of sales which occurred during the first quarter of 2018 (i.e., sales were reversed within the same quarter in which those sales were originally recognized).” For the remainder, Mattel explained that it wrote off “approximately $57 million as bad debt expense related to outstanding TRU accounts receivable, primarily for the U.S., as of December 31, 2017” (Q1 2018 10-Q). This treatment was consistent with its method of writing off accounts receivable during the third quarter of 2017.

The following represents the disclosure Mattel made in its 10-Q SEC Filing for the first quarter of 2018:

As a result of the Toys "R" Us liquidation, Mattel reversed net sales which occurred in the first quarter of 2018 of approximately $30 million. Gross margin in the first quarter of 2018 excludes these net sales but includes the corresponding cost of sales for the inventory sold to Toys "R" Us. Further, Mattel recorded bad debt expense related to outstanding Toys "R" Us receivables as of December 31, 2017 of approximately $57 million within other selling and administrative expenses.

Mattel Reinstates a Small Portion of Accounts Receivable and Reaches a Settlement with Toys R Us

In July 2018, TRU reached a bankruptcy settlement that included Mattel. As a result, Mattel was entitled to a payout based on the outstanding AR balance that arose throughout the bankruptcy process. Mattel expected to receive payments, but the amount was uncertain because the pool of funds available for distribution among the creditors was dependent on the amounts Toys R Us could obtain by selling off certain assets.

When collectibility is not probable, companies can only recognize revenue in certain circumstances. Under ASC 606, one of these conditions is if the company both (1) receives cash payment and (2) has no remaining obligation, having already transferred control to the customer. Because Mattel met these conditions, it was able to recognize revenue for individual cash receipts it received in the months following the liquidation.

In addition, as individual cash payments became probable, Mattel elected to undo the accounts receivable reversal. In its second-quarter 2018 10-Q Filing, Mattel disclosed that it had successfully recovered $7 million of its previously written-down TRU accounts receivable balance. Mattel concluded that it would “continue to assess the recoverability of TRU accounts receivable, if events or circumstances indicate that the recovery of such receivables is not probable.

Conclusion

Probability of collection is a key component of revenue recognition. Significant changes in the facts and circumstances surrounding a customer’s intent or ability to pay can cause a company to stop recognizing revenue and either reverse previously recorded revenue or increase bad debt expense. The details of a specific company’s situation will impact the correct accounting treatment, so companies should carefully evaluate collectibility for each revenue contract and reevaluate when changes occur. Each company’s situation will be unique, but Mattel’s experience with Toys R Us provides an interesting practical example.

Resources Consulted:

• ASC 606-10-25-5.
• ASU 2014-09. “Revenue from Contracts with Customers.” BC 34.
• PwC Accounting and Reporting Manual: 9A.50. 08 December 2017.
• Mattel’s 3^rd Quarter 2017 Form 10-Q.
• Mattel’s 2017 Form 10-K.
• Mattel’s 1^st Quarter 2018 Form 10-Q.
• Mattel’s 2^nd Quarter 2018 Form 10-Q.