Gift Card Industry Revenue and Breakage Standart Management Suggestions for Gift Card Companies

Introduction

Powerful May 2014, the FASB and the International Accounting Standards Board (ISAB), developed and gave merged standard on the recognition of revenue recognition from contracts with customers. The motivation behind this change was to provide a more robust framework for addressing revenue recognition issues, increase the usefulness of disclosure or revenue recognition and to give exhaustive income comprehensive revenue recognition model for all agreements with clients.

With this came a lot of changes to many industries with the way they record Breakage of gift cards and Returns. Those profoundly affected of Breakage change are ventures like technology more so than those entities such as retailers. Breakage rates can fluctuate depending on the business and the idea of the activities. One method companies use to determine breakage is the calculation on historical data, and or a comparison for breakage rates from similar companies. Public companies are required to disclose their breakage rate on the footnotes of their financial statements. Which should also be assessed, reported and updated in each reporting period. Why the revenue recognition principle changes, What and how it changes - According to Fried, Holtzam & Rotenstein (2015), more than $118 billion worth of gift card transactions incurred in 2013, yet approximately $1.18 billion worth of gift card sold were considered to be never redeemed. In an effort to keep having a liability on a business’s book indefinitely for this unredeemed gift card sold, the Board developed a five-step model from contracts with customers as following: identify the contract, identify performance obligations, determine transaction price, allocate transaction price, and recognition revenue.

The initial accounting for a gift card sale ultimately remains the same under both the practices; however, Accounting Standard Codification Topic 606 will change the recognition for breakage revenue. Under a new standard, a business will need to estimate the amount of consideration to which the business will be entitled upon satisfying performance obligations (FASB, 606-10-32-5). FASB establishes that “an entity shall include in the transaction price some or all of an amount of variable consideration estimated” (FASB, 606-10-32-11), as well as “allocating a variable amount entirely to a performance obligation” (FASB, 606-10-32-40). Based on execution of the new practice, a business is expected to allocate breakage revenue sooner than previously exercised.

Revenue is one of the most important financial metrics. Gift Cards for accounting is somewhat unique. Under the new ASC 606 we need to change how we recognize the revenue. When a purchase is made of a gift card or certificate we need to debit cash and credit a liability contra account for the value of the cards sold. The money in the contra account cannot be recognized as revenue; due to the fact at the time of sale no goods or services were provided. Only after the customer or account has redeemed the gift card can we recognize the value as revenue. The business cannot recognize the whole value of the gift card; only what was redeemed. When a company sells a gift card for $2000 they must debit cash, and credit the liability account for $2000. Once the customer redeems the gift card or partial balance only can we can only then recognize the revenue. We are going to debit the liability account for the amount they redeemed, $150 and then we need to credit revenue for the same amount, $150. The remaining balance will be left into the gift card liability account until it is redeemed or applicable to breakage and escheatment laws.

Some customers never redeem their gift cards, creating a breakage, which is the amount of value on a card that will not be redeemed. Prior to ASC 606, company’s accounted for breakage revenue with gift cards using three different methods. These methods were Released Obligation Method, Remote Method, and Redemption Method. Having three methods in place induces inconsistencies in practice and reduces comparability of financial statements, hence FASB solved this problem by issuing “Accounting Standards Codification Topic 606, “Revenue from Contracts with Customers,” taking place in 2018 for public companies and 2019 for non-public companies. (Farr, 2019) This new standard will create some uniformity between IFRS and U.S. GAAP. Under topic 606, a company should recognize estimated breakage as a revenue in portion to the redemption pattern; therefore, FASB is requesting that company’s use the Redemption Method. (FASB 606-10-65-1).

Under this Method, breakage revenue is recognized on historical data determined by the pattern of outstanding gift cards redeemed. Meaning that a company will determine, over a series of time, how many gift cards are not redeemed and calculate their percentage of write-off to their revenue account. Once the company estimates their percentage of unredeemed gift cards, they are now ready to complete their journal entries. The company sold $2,000 worth of gift cards and estimated 10% of the gift cards sold were to be unredeemed. They estimate their breakage to be $200 ($2,000/10%=$200). A month later a customer redeems $150 of the gift cards, so the company has an actual breakage rate of 8% ($150/2000) X $200 (of estimated breakage) =$16 total estimated breakage. We need to Debit Unearned Revenue for $150 and Credit Sales Revenue for $150 and then Debit Unearned Revenue for $16 and credit Breakage Revenue for $16. Moreover, Fried et ad. (2015) asset that a business needs to understand its legal obligations before implementing the accounting practices for breakage revenue recognition. Legal requirement for payment received on unexercised rights varies among jurisdictions. If a business’s jurisdiction requires a business to remit payment received on unexercised rights to a governmental entity, then a business should not recognize breakage revenue.

Gift Card Issued for Merchandise Returns

Other than selling gift cards, issuing gift cards as refunds for returned merchandise has also been a very common business practice. Many businesses have argued to treat gift card issued for merchandise returns the same as cash refund in order to simplify the accounting processes. However, unlike a cash refund which is a fixed amount given back the customer, gift cards issued as refund is a liability to the business until the performance obligation is satisfied (Fitzpatric, 2011). Moreover, there is no guarantee on the exhaustion of gift card since redemption is completed influenced by customers. In order to standardize accounting practices, IRS issued Revenue Procedures 2011 – 17 to provide safe harbor method of accounting for the treatment of gift cards issued in exchange for returned goods; IRS allowed businesses to treat gift card issued for returned goods as the payment of cash refund and a sale of gift card. (IRS, 2011). The IRS decided to treat gift cards issued for merchandise returns as if the business had paid customers with a cash refund, and then customers immediately used the cash refund to purchase a gift card. In a nutshell, IRS concludes that the treatment of gift card issued as a refund be the same as gift card sales. As discussed previously therein, at the point of sale of a gift card, revenue will be deferred, until performance obligation is satisfied. Sales revenue and breakage revenue will be recognized at the time of redemption. Fundamentally, guidance on treatment of gift card issued for merchandise return is consistent with revenue recognition update ASC 606 issued by FASB.

Conclusion

It was the case that companies who sold gift cards were told not to record revenue at the sale of a gift card. Under the old guidelines a company would record the sale as a liability, namely because when a customer purchased a gift card, he or she had the right to receive the service from the company at a future point of time. Nevertheless, more than 1 billion worth of gift cards were not redeemed at all, which left companies who sold gift cards with more liabilities than they deserved on their books. Under the new guidelines, a company needs to determine how much breakage amount it should recognize in proportion to the total pool of redemptions of the gift cards issued. As many analysts had projected, the new guidelines should benefit most retailers if not all, and it is simply because companies can get recognized much earlier. Instead of holding the breakage revenue until the gift card expires, companies are allowed to expedite the recognition process. In addition, the changes are not just limited to benefit the large corporates, mom and pop stores or anyone who could issue a gift card should see the bright side of the new guidelines. The new guidelines are not perfect and they certainly contain the downsides, but it is hard to argue the cons can completely offset the pros of the new guidelines.