Excerpts: “Accounting for Gift Cards: An emerging issue for retailers and auditors.”

• Perhaps the greatest benefit to retailers—and one that has distinct accounting implications—is that historical consumer behavior trends show that a portion of many gift card purchases will never be redeemed. The retail and banking industries recognize the tendency of consumers to leave gift card balances unused and refer to the unspent balance of a gift card as breakage. Reported estimates of breakage by consumer research groups vary from 10% to 19%. Even by conservative estimates, gift card breakage has the potential to significantly influence many companies’ bottom lines.
• SEC Staff Accounting Bulletin no. 101 generally requires the transfer of product (merchandise) as a necessary condition for revenue to be recognized. SEC Staff Accounting Bulletin no. 104 provides additional guidance. When a retailer sells a gift card to a customer, the payment for a future purchase is received upfront, but transfer of merchandise is delayed at the consumer’s discretion. So, instead of recognizing actual revenue on the sale of gift cards, retailers record a deferred revenue liability on the balance sheet for the cash exchange until the gift card is redeemed.
• Of the 113 companies that provided gift card information, 80 provided at least some indication as to where the liability can be found on the balance sheet (Exhibit 1, Panel B). The most common practice was to lump the liability into an “accrued expense or other liability.” Others included gift cards in a “deferred revenue” account. However, nine companies viewed the gift card liability significantly enough to create a separate line item on the balance sheet.
• Conceptually, the practices of including unredeemed gift card amounts in sales or as a reduction in cost of goods sold lead to misleading, overstated gross margins, given that unredeemed gift card proceeds have no accompanying inventory costs. For example, some analysts of Best Buy initially misread investor-sensitive sales and gross margin trends. Reducing SG&A expenses with gift card write-offs represents a more conservative approach, but seems conceptually flawed and potentially misleading, since the economic benefit does not originate from expense reduction measures.

Source: Journal of Accountancy