Who doesn’t love gift cards? They’re a perfect and easy way to get your gift shopping done. Once upon a time, giving gift cards wasn’t as respectable as buying an actual tangible gift, but today, they’re more popular than ever.
Since 1999, gift card purchases have exploded, from $19 billion to an expected $160 billion in 2018. Consumers love them as a way to give someone a gift without worrying about picking the right size or color. Retailers love them because they put money in the cash register right away.
Accounting for the sale and redemption of gift cards under GAAP is pretty straightforward.
When the card is sold, the company debits cash and credits a corresponding gift card liability. As cards are redeemed, the liability is debited and revenue is recognized as a credit to sales, but
what about the unused portions of gift cards, known in the industry as “breakage?” Breakage results most commonly when the remaining value on the gift card is negligible, or when the owner loses it. Across the country, it’s estimated that about $1 billion of the value of gift cards sold every year is never used.
For gift cards with no expiration date, the legal obligation to provide goods and services never expires. Leaving this on the balance sheet indefinitely results in a perpetually growing liability, which doesn’t reflect reality. The seller has the cash, and after enough time has passed, it’s unlikely that the gift card owner will ever redeem it. As a result, the seller really doesn’t owe the owner anything.
Back in 2016, FASB issued Accounting Standards Update (ASU) 2016-09, Revenue from Contracts with Customers (Topic 606), to address this issue. This standard is effective for public companies beginning in 2018 and for non-public companies in 2019. This new standard is part of the convergence between IFRS and U.S. GAAP, and is an attempt to create some uniformity in how companies deal with this.
The new guidance provides two methods for systematically recognizing breakage revenue in earnings. Without a standard means of recognition, this liability could otherwise remain on the balance sheet forever.
The Proportionate Method
Under this method, recognition of breakage revenue is tied to the redemption of gift cards. Breakage revenue is recognized on a pro-rata basis in proportion to the value of actual redemptions. To use this method, the company needs to determine their historic pattern of breakage. Using this pattern, the company estimates the value of the new cards that are unlikely to be redeemed as these cards are sold.
For example, Lesley’s Book Shop has sold gift cards for years and determines that historically 10 percent of the gift cards sold are never redeemed. That means that when Lesley’s sells $1,000 of gift cards in December, $900 worth will be redeemed and $100 of those will never be used. During January, $540 of those cards sold in December is redeemed. This means that $540/$900 = 60 percent were redeemed.
Now, apply that percentage to the estimated amount of breakage to get the amount that needs to be recognized in January: 60 percent times $100 = $60 will be recognized. Here are the journal entries for these transactions:
Sale of the gift cards in December:
DR Cash: 1,000
CR Gift Card Liability: 1,000
Redemption of the gift cards in January:
DR Gift Card Liability: 540
CR Gift Card Revenue: 540
Proportionate recognition of breakage income in January:
DR Gift Card Liability: 60
CR Breakage Revenue: 60
Using this method requires retailers to have enough data to determine their historic pattern of breakage. Retailers lacking this data will recognize breakage revenue using the remote method.
The Remote Method
Under the remote method, revenue is recognized when the likelihood of use becomes remote. For a retailer, this may be deemed to happen when a card hasn’t been used for a certain period of time.
A further wrinkle with gift cards is the escheat laws on the books of some states. Escheat statutes require retailers to turn over unredeemed portions of gift cards after three to five years. For some states, it’s the entire unredeemed balance, but most commonly 60 percent of the balance is paid over to the state.
The new guidance does not apply to those portions that are subject to escheatment laws. A listing of escheatment laws by state can be found here.
Editor’s note: Check out part 2 of Liz Farr’s series on Gift Cards.