Over the last five years, gift cards have attracted a lot of attention from consumers, retailers, and regulators. A 2010 holiday season survey conducted on behalf of the National Retail Federation (“NRF”) found that more than 77 percent of shoppers had in fact purchased, or intended to purchase gift cards. The survey also estimated total gift card purchases to amount to almost $25 billion. And there is no expectation of a decline in the popularity of gift cards. Consumers can purchase and redeem gift cards from mobile devices.
Consumers are attracted to the convenience and flexibility of gift cards, while retailers embrace them as a way to improve cash flow, increase sales and manage inventory. But more than that, unredeemed gift cards present retailers with the opportunity to improve their bottom line through the recognition of revenue from unredeemed gift cards (referred to as breakage revenue). It is estimated that approximately 10 to 19 percent of all gift cards issued remained unredeemed at the end of 2010. Based on the 2010 estimate of total gift card sales of almost $25 billion, 10 to 19 percent translates to roughly $2.5 to $5 billion.
Gift cards can create nexus even in the absence of a physical presence within a state and possibly increase the issuing retailers exposed to state income taxes. The 2010 NRF survey also found that 33.4 percent of shoppers polled, expected to buy gift cards from restaurants. Many restaurateurs see the explosion in gift card popularity as a cost-effective way to market themselves and have embarked on selling gift cards in bulk. While gift cards (other than electronic gift cards) are tangible representations of intangible property, they are property none the less. Therefore, gift cards have the potential to create an economic nexus in a state where the issuing retailer does not otherwise have a physical presence. This is especially true when gift cards are sold through a third party retailer on a consignment basis or offered for sale in supermarkets because title to the cards generally remains with the issuer until they are sold to the consumer. Moreover, the sale of gift cards within a state is a valid indicator of the intent to access the state’s market.
Retailers must become familiar with their liability for abandoned property. From time to time companies are left holding a liability for unclaimed or abandoned property held on behalf of the owner. Property is considered abandoned after a period of dormancy. The dormancy period as defined by each state; and escheat laws vary from state to state. Under the escheat laws, the holders of abandoned property are required to remit the property to the applicable state which then holds the property in custody for the owners. More often than not, gift cards are sold without a record of the owner’s address and as a result gift card issuers may be faced with substantial escheat liabilities. As budgets shrink and cash flows dry up, many states have stepped up their pursuit of unclaimed property.
Generally accepted accounting principles allow businesses to recognize breakage revenue on gift cards, but provides minimal guidance on the appropriate financial statement presentation and disclosures, or how and when to recognize breakage. As noted by the 2010 NRF survey, up to 19 percent of all gift cards issued will never be redeemed. Therefore, retailers sell gift cards with an expectation of breakage revenue (assuming that the state’s escheat rules do not apply). Breakage revenue is unmatched by the cost of sales and can, therefore, have a significant impact on the company’s financial statements. Although generally accepted accounting principles (“GAAP”) do not allow businesses to derecognize liabilities until the liability has been relieved, there is a special exception dealing with gift cards. GAAP allows companies to recognize breakage revenue when the chance redemption of the gift card is remote and it is possible to estimate the amount that will not be redeemed. That is substantially the extent of the guidance provided by GAAP on the issue of breakage revenue.
Guidance provided by the SEC considers the specific identification and homogeneous pool methods as acceptable methodologies for recognizing breakage revenue. Under the specific method, companies may recognize revenue when the chance of redemption of a specific card is remote; even so, there is no clear definition of how long a card needs to be inactive. Most retailers using the specific identification method apply a two year waiting period and have accurate historical and current redemption data. This data is readily available to retailers who use third parties to administer and track their gift cards.
Under the homogeneous pool method, retailers can recognize breakage revenue based on the ratio of the unused percentage to the number of redemptions over the cards estimated useful life. The SEC defined four conditions, all of which must be met before the homogeneous pool method may be applied: (i) The pool of cards must be homogeneous and historical redemption patterns must exist for the pool, (ii) The likelihood that a customer will require full performance must be remote, (iii) it must be possible to reasonably and objectively estimated time period for actual gift card redemptions and (iv) it must be possible to reasonably and objectively determine the amount of breakage.
In addition to the scarcity of guidance on when and how to recognize breakage, there is no guidance on where breakage revenue should be reported on the income statement. As such, some retailers recognize breakage revenue as a component of net sales, while others offset breakage revenue against general and administrative expenses.
Either way, in keeping with the spirit of sufficient disclosures, retailers should, at a minimum, disclose the following: (i) the breakage revenue recognition policy, including methodology applied, and timing (ii) the amount of breakage revenue recognized during the year and where it is included on the income statement, (iii) consideration of state escheat laws and (iv) the extent of unredeemed cards and (v) whether the gift cards are subject to expiration dates and monthly fees.
Federal and state legislators alike are keeping a close eye on gift cards. The Credit Card Accountability, Responsibility and Disclosure Act of 2009 (CARD Act) took effect in early 2010. The CARD Act prohibits issuers from charging fees on cards for 12 months and extends the gift card expiration date to five years after purchase. California gift card laws prohibit the inclusion of expiration dates for cards that are redeemable through a specific seller and its affiliates only and place a certain restriction on service fees. California gift card laws also include a provision that federal law may pre-empt California law where the terms are inconsistent and federal law is more protective of consumers.
Many retailers established separate gift card management companies in states with favorable escheat rules. While this may be an effective way to manage unclaimed property liabilities, it raises the questions: (i) which entity should recognize breakage revenue for income tax purposes and, (ii) assuming that the sale of gift cards is counted as income to the gift card company, which treasury regulation should be applied? The current Treasury regulations allow one or two-year deferral base on specific conditions. To answer these questions, retailers and their advisors must understand Treasury Regulation 1.451-5 and Revenue Procedures 2011-18 and 2011-34.
Because of the popularity with consumers, all things being equal, gift card sales are not expected to slow down in the foreseeable future. Gift cards present many challenges, risks, and opportunities for retailers, but with the proper consideration and handling, gift cards can be a wonderful gift to the receiver and the issuer.
Author: Cas Findlay, FCCA, CPA