Prepaid cards and several other payable-based consumer products are popular retail items and marketing tools. Portions of the proposed revenue recognition standard that FASB is working on will affect gift card programs. Companies with gift card programs need to be prepared as the proposed standard will require the recognition of breakage, or unused customer rights, into revenue.
Examples of the products are gift cards, gift certificates, coupons, and promotional and incentive instruments. These products are considered to be “payable based” consumer products because they place future performance obligations upon their issuers. They usually have four characteristics: (1) The products confer a right on the consumer to purchase or claim goods or services; (2) the consumer typically prepays for the product or, in the case of a promotional product, the product is prefunded by the promoter; (3) the products are not typically refundable or redeemable for cash; and (4) the purchase of the product results in the issuer’s holding an obligation for future performance.
Many consumers do not use these products, resulting in unexercised customer rights, commonly known as breakage, and stale liabilities being held by the issuer. The unexercised customer rights may be significant and result in inflated obligations on the issuer’s financial statements. To manage this situation, issuers may use a revenue recognition technique whereby the issuer derecognizes the breakage liability and recognizes breakage revenue.
The purpose of this article is to highlight the portions of the proposed revenue recognition standard that will impact gift card programs.
The SEC’s Pamela R. Schlosser addressed the recognition of breakage revenue when delivering a speech at the 2005 AICPA National Conference on Current SEC and PCAOB Developments. The SEC advised that recognition of breakage revenue was appropriate in limited situations. The SEC speech became the predominant guidance relied upon by many gift card issuers regarding recognition of gift card breakage revenue.
As a result, many large retailers derecognize stale gift card liabilities. For example, the 10-K filed by Best Buy Co. Inc. in May 2012 discloses the technique: “We recognize breakage income for those cards for which the likelihood of redemption is deemed remote and we do not have a legal obligation to remit the value of such unredeemed gift cards to the relevant jurisdictions.” Best Buy’s filing further indicates the company uses historical redemption patterns to determine the rate at which its gift cards break and also the age for which the likelihood of redemption is deemed remote.
Guidance in the joint revenue recognition project
FASB and the International Accounting Standards Board (IASB) are engaged in a joint project to create uniform accounting standards for revenue recognition. This project resulted in an exposure draft that the boards issued in November 2011 regarding proposed changes to GAAP and IFRS. The ED provides guidance regarding the revenue recognition of breakage.
Before the boards’ proposed guidance on the subject, the recognition of breakage into revenue was largely based on the 2005 SEC speech. The boards’ decision to address the matter allows the recognition of breakage revenue to be more broadly applied and provides a higher level of authoritative guidance. Stated otherwise, the recognition of breakage revenue will be required. The following review of four key points is provided to assist in navigating the ED:
1. Creation of a card liability
In a typical gift card transaction, the consumer pays a card issuer in exchange for purchasing the gift card. In doing so, the consumer is prepaying for the right to receive goods and services in the future. The resultant obligation is recorded by the card issuer as a liability (ED, paragraph IG25).
2. Exercised customer rights: Revenue from redemptions using a gift card
When a gift card is used, marking the point at which the goods or services are transferred, the card issuer should reduce the corresponding liability for the card, simultaneously recognizing revenue by the amount for which the card was used.
3. Unexercised customer rights: Revenue from breakage
The ED addresses the issue of unexercised customer rights arising when a consumer does not use a gift card. The ED expressly provides for the use of derecognition to reduce the stale liabilities and to recognize revenue by stating that a card issuer “should” derecognize stale liabilities, so long as the entity is reasonably assured of the breakage amount, or when otherwise appropriate under the guidance.
The ED provides for two methods by which derecognition of breakage should be implemented: proportionate and remote. If the “reasonably assured” standard is met, the entity should recognize the expected breakage as revenue “in proportion to the pattern of rights exercised by the customer.”
The reasonably assured standard
A “reasonably assured” standard was introduced as it relates to the recognition of breakage into revenue. An entity must first be reasonably assured of the breakage amount if an entity uses the proportionate method. The ED identifies two criteria to be satisfied in applying a “reasonably assured” standard: (1) The entity applying the standard must have experience with similar types of performance obligations (or must have other evidence, such as access to the experience of other entities), and (2) the entity’s experience or other evidence must be predictive.
Translated to gift card portfolios, the transaction data used to forecast the breakage amount for the card portfolio must be data regarding similar cards, and the data must be predictive in nature.
Gift card data that is similar and predictive may be difficult to accumulate and maintain. Some entities use costly internal forecasting systems that require full-time employees and regular maintenance. Other entities outsource the accumulation, subsequent analysis, and reporting of their gift card data. There are also entities that choose not to collect or analyze the data.
Many entities contract with an external transaction processor to facilitate the technical aspects of a gift card program. When an external transaction processor is used, the data collection required to recognize breakage revenue under the proportionate method will likely need to involve the transaction processor. It is often costly to obtain the transaction data from an external transaction processor. Once the data are collected, a process will likely need to be built to analyze the data and determine whether the data can be used to recognize breakage revenue under the proportionate method.
There are many reasons an entity may decide to not collect or analyze the card program data: It cannot afford the expense, does not believe a sufficient amount of similar data exists, does not believe the data will be predictive in nature, etc. Under the proposed standard, an entity is not required to have similar and predictive data, because an entity can recognize revenue under the remote method; however, the method by which breakage revenue is to be recognized will be affected.
The boards, through their redeliberation process, in anticipation of issuing the final standard, are discussing the use of the phrase “reasonably assured” throughout the ED and the final standard. It appears this verbiage may change, but it is unclear what impact it will have on the breakage guidance.
The proportionate method
The boards decided that the proportionate approach “represents the most appropriate pattern of revenue recognition for breakage.” Under the proportionate method, each redemption results in two forms of income: revenue from the sale of goods and service, and income from the proportionate share of breakage.
The remote method
If the “reasonably assured” standard is not met, the entity should recognize the expected breakage as revenue when the “likelihood of the customer exercising its remaining rights becomes remote.” The term “remote” is not specific but likely will require statistical support, particularly if short time periods are used. As such, the remote technique is particularly useful in small card programs where the data may not be sufficient to determine the breakage amount under a “reasonably assured” standard.
The remote technique should result in slower revenue recognition than the proportionate method as the breakage on the cards will be taken to revenue in a lump-sum amount at a specific time, such as after two years. Under the proportionate method, the breakage will be amortized over the course of the two years. Breakage would be taken to revenue in proportion to the pattern of rights exercised, likely over the same two-year period.
It should be noted that the boards have specifically rejected the approach of taking the breakage to earnings on day one at the time of sale. The boards stated they “considered, but rejected” a method that would allow an entity to recognize all of the estimated breakage as revenue upon receipt of prepayment from a customer, as the entity has not yet performed under the contract.
4. The impact of escheat
The ED addresses the impact of escheat upon derecognition by stating liabilities subject to escheat should not be derecognized. This guidance is consistent with the premise that cards subject to escheat cannot be derecognized in that the liability is owed to the state when the cards reach presumed abandoned status under an unclaimed property law. If the card must be escheated, it cannot be taken into revenue.
Proper application of escheat may become complicated in multistate programs where the card issuer is domiciled in one state, the card owner or gift recipient resides in another state, the card sales occur in different states, or, finally, the cards are used in other states. The U.S. Supreme Court has provided for two priority rules to govern which state has escheat priority in multistate programs. Additionally, some states have adopted a third priority rule whereby the card issuer looks to the state where the card was sold. Many practitioners believe this third priority rule is unconstitutional and unenforceable, and their position finds support in the recent decision by the Third Circuit Court of Appeals (New Jersey Retail Merchants Ass’n v. Sidamon-Eristoff, 669 F.3d 374 (3d Cir. 2012)).
Under the first priority rule, the card issuer first looks to the state of the card owner’s residence. If the card issuer’s records do not show the state of residence, or the state of residence does not provide for escheat, the card issuer then applies the second priority rule, which is the state of the card issuer’s domicile. If the second priority state does not provide for escheat, the third priority rule provides for escheat to the state where the transaction giving rise to the card occurred. All three priority rules may be subject to nuances in a particular state statute.
Many states have exempted, in whole or in part, gift cards and other related products from their unclaimed property laws. As the duty to escheat has been lowered under the state statutes, the barrier to using derecognition has eroded. However, under the ED, an entity must take appropriate steps to determine if the breakage is escheatable property before using the derecognition technique.
Gift cards, and other similar instruments, are popular consumer products that place future performance obligations on the issuer. To properly account for the performance obligations that go unredeemed, an issuer must first determine whether the obligation is escheatable property. If the obligation is not escheatable property, a preparer must properly navigate the final standard to derecognize the stale card liability.
Great care should be exercised in the application of the ED’s principles regarding the “reasonably assured” standard, the proportionate method, the remote method, and the validation that the obligation is not escheatable property. The boards are scheduled to release the final standard in the first half of 2013. Until the final standard is released, the boards reserve the right to change their position on what has been stated above.
Tori Blake, CPA, (firstname.lastname@example.org) is senior director of accounting technologies and operations, and Phillip C. Rouse, J.D., is chief architect and general counsel, both at Card Compliant LLC in Kansas City, Mo.