New rules on revenue recognition taking effect for public companies in the first quarter of 2018 have changed the way companies must recognize revenue associated with gift cards and other prepaid cards, especially for amounts that are never redeemed.

The recognition of the sale of a gift card is straightforward. When a company sells a gift card, the cash it receives is recognized as a liability until the gift card is redeemed for goods or services. Upon redemption, then the company reverses the liability and recognizes the revenue.

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But what about gift cards that are never redeemed? Or small amounts that remain stranded on gift cards? In gift card parlance, the term for those amounts is “breakage.” We all have some breakage in our wallets that is likely causing some accounting headaches—a gift card that’s more than a year old to a specialty retailer not commonly visited, or one to a restaurant that just doesn’t come to mind when planning a meal out, or one that hasn’t been spent entirely.

Under requirements in place before the Financial Accounting Standards Board rewrote the rules now contained in Accounting Standards Codification Topic 606, companies had some latitude to decide what to do with the breakage amounts created by unredeemed cards or abandoned balances. That’s because the GAAP standard didn’t provide a lot of explicit guidance, says Scott Lehman, a partner at Crowe Horwath.

In fact, many companies referenced a 2005 speech by a member of the Securities and Exchange Commission staff for guidance on how to recognize breakage, says Lehman. That speech said the SEC would accept one of three methods that involved focus on expiration dates, when the likelihood of redemption was remote, or over time as gift cards are redeemed.

The new standard, however, will create more comparability by requiring companies to follow the same basic process. “In the first quarter of 2018 and on a go-forward basis, each company has to decide: What’s our new delayed recognition model going to look like?” says Jameel Turner, an attorney and member at law firm Bailey Cavalieri. “That’s a case-by-case analysis.”

Before companies can make any accounting determinations, they must first know what state laws might come into play. Some states regard unredeemed gift cards as unclaimed property that should be surrendered to state authorities so it can, in theory at least, be reunited with its rightful owners. Depending on where a company is incorporated or where a gift card owner resides, gift card breakage might be subject to those “escheat” laws, or rules for remitting unclaimed balances to states.

“In the first quarter of 2018 and on a go-forward basis, each company has to decide: What’s our new delayed recognition model going to look like? That’s a case-by-case analysis.”

Jameel Turner, Attorney, Bailey Cavalieri

The accounting rules don’t necessarily spell out that initial step in explicit detail, says Robert Peters, managing director at Duff & Phelps, but it’s important for companies to understand it’s the first step in determining how to treat any given unredeemed gift card balance. “Many gift card issuers are not mindful of that, at least until they delve into the details,” he says.

That process begins, says Peters, by determining ownership of the gift card. If a company has the address of a gift card owner—and many do with the growing popularity of online registration and redemption apps—then the gift card owner’s home state laws apply. If that state collects unclaimed property, any unredeemed gift card balance must be remitted to the state according to its specific rules.

Where a company doesn’t know who owns a gift card balance, then it looks to the state of its incorporation. If the company is incorporated in a state that regards gift cards as subject to unclaimed property law, then that state will ultimately claim possession of any breakage amount.

The new accounting standard on revenue recognition tells companies that they should recognize breakage that is not subject to unclaimed property law in proportion to how they recognize revenue on redemption. That means they have to do some estimating, says Eric Knachel, senior consultation partner at Deloitte & Touche, and that requires some judgment and historic data.

As a simple example, assume a company sells 20 gift cards valued at $50 each for a total gift card liability of $1,000, says Knachel. If historic records tell the company that only $800 of the sold gift card amount will be redeemed, then the company would recognize the $200 in breakage ratably as the $800 is redeemed. When a consumer redeems $80 of those gift cards, the company recognizes that $80 in revenue, plus another $20 in breakage as revenue. When another $160 is redeemed, another $40 in breakage is recognized as revenue.

That breakage estimate is one companies will need to revisit, says Knachel. “It’s not just about making initial estimates, but it’s also about monitoring and revising estimates,” he says. If the expected pattern of revenue recognition slows, so only $700 of the $1,000 will be redeemed, then companies will need to bring $300 into revenue via breakage.

Under historic revenue rules, companies followed different methods with respect to breakage, says Brian Marshall, a partner at audit firm RSM. “Some would keep the liability on the books until they no longer had a legal obligation, so until it is used or expired,” he says. “Another approach would be to wait until the likelihood of redemption was remote and then remove the liability.”

A third approach was to do some estimating of what would become breakage, as the new standard requires, and recognize revenue on breakage at the same rate as redemption. “If a company was in that third bucket, there’s probably not much change in how they recognize revenue under the new standard,” says Marshall. “If they were using either of the first two approaches, it could be a significant change.”

To transition from historic recognition to the new standard, companies that would be accelerating their recognition of revenue under the new standard are likely to begin 2018 with an adjustment to retained earnings to reflect a new pattern of breakage recognition, says Matthew Chenowth, an attorney and senior manager at True Partners Consulting. “For a lot of companies, there’s going to be a pick-up or an accelerated recognition,” he says.

Amazon, for example, recognized breakage in 2016 of $2.4 billion following a delayed pattern of recognition. Starbucks, another big issuer of gift cards, recorded breakage of $60.5 million in 2016 when it deemed the likelihood of recognition to be remote. For both companies and many others, the new requirements under ASC 606 will accelerate recognition by comparison.

Litigation over gift card breakage and unclaimed property

Many companies deal with the uncertainty around unclaimed property by structuring their gift card programs so that they are set up in states that do not regard gift cards as unclaimed property, says Jameel Turner, an attorney and member at law firm Bailey Cavalieri.

Those structures may be facing a serious legal challenge, however, as the state of Delaware pursues legal action against a company administering such programs. An aggressive collector of unclaimed property and home to a large number of corporations, Delaware is of the view that such structures are fraudulent workarounds designed only to subvert unclaimed property law.

The state is pursuing action against Card Compliant, an Ohio-based corporation that assists companies in setting up entities specifically to issue gift cards in states that are not interested in collecting unredeemed gift cards as unclaimed property. The case initially involved dozens of defendants, but for various reasons many have been dropped from the litigation, says Robert Peters, managing director at Duff & Phelps.

The remaining defendants, numbering fewer than a dozen now, says Peters, filed a motion to dismiss in 2017, and that action is still under consideration by the court. Now Delaware’s audit program is targeting companies that have formed captive and third-party gift card arrangements, he said.

“When you read the motion, you get a flavor of how incensed the defendants are that this matter should even be raised,” says Peters. “Based on a matter of law, they believe the facts are overwhelmingly that the judge should dismiss the case before actually going to trial. There’s a compelling argument.”

Gift card breakage is generally rising, says Peters, just judging by the rising breakage figures that companies are recording in financial statements. “More and more people are not using their gift cards,” says Peters, so companies have to figure out how much to report and when while also contending with uncertainty over unclaimed property actions.

Audit Analytics estimates the breakage rate is roughly 2 to 4 percent, based on its analysis of public company filings. The research firm says nearly 50 companies have identified gift card breakage as a figure that will be significantly affected by the new accounting requirements of ASC 606.