Recognition of Breakage Revenue Under the New Revenue Recognition Standard
In May 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, as subsequently amended, which resulted in the most significant revision to revenue recognition standards that GAAP has ever seen. One significant impact from ASU 2014-09 relates to the recognition of breakage revenue.
Breakage is defined as any type of service that is unused by a customer that has already been paid for in full. Thus breakage revenue is a company recognizing into revenue a portion of a liability that will not be redeemed by the customer. The easiest example of breakage relates to gift cards. If a customer buys a $25 gift card, the company now has cash of $25 and a liability for future services of $25. Now if the customer uses the gift card and spends $24.50, the company would remove $24.50 from the liability and recognize this as revenue. After the purchase the customer just throws away the remaining gift card, thus the 50 cents will never be used (breakage). In an effort to keep from having a liability on its books indefinitely, companies typically estimate a breakage amount and recognize this into revenue.
ASU 2014-09 will change the way that revenue is recognized across all industries and the recognition of breakage revenue is no different. Let’s revisit the breakage from gift card sales. The initial accounting for a gift card sale is essentially the same under both current accounting standards and ASU 2014-09. Gift card sales are initially recognized as a liability. The gift card revenue is recognized after a gift card is redeemed. But the accounting for the breakage revenue on these gift cards will change under ASU 2014-09 compared to current practice.
Breakage revenue currently is recognized under one of three methods, all of which were equally acceptable under current standards and industry practice:
- Released obligation method: Under the released obligation method, the breakage revenue is not recognized until the company is legally released from its obligation (i.e., a gift card expiring).
- Remote Method: Under the remote method, the breakage revenue is recognized once the probability of the redemption of a gift card becomes remote.
- Redemption Pattern Method: Under the redemption pattern method, breakage revenue is recognized on a pro-rated basis determined by the redemption pattern of the outstanding gift cards redeemed.
The FASB was concerned that having three methods would allow for inconsistencies in practice and reduce comparability of financials. Therefore, under ASU 2014-09, companies are expected to use the redemption pattern method. ASU 2014-09 does eliminate diversity in practice related to the recognition of breakage revenue but estimates are still required in determining the breakage revenue to recognize and can dramatically impact the amount recognized. It is important to note that ASU 2014-09 does still allow the remote method, but the standard states that this method should only be utilized when a company expects there to be no breakage at all. If a company has a history of breakage, it will be a challenge for that company to still use the remote method as it would not be reasonable to expect zero breakage. A company that is unable to conclude whether there will be any breakage, or the extent of such breakage, should consider the constraint on variable consideration outlined in ASU 2014-09, including the potential need to record any minimum amounts of breakage as revenue under the variable consideration guidance of ASU 2014-09.
Since the redemption pattern method will be the primary acceptable method under ASU 2014-09, let’s look more at this method and how it works. There are two main components that drive the redemption pattern method: the breakage rate and the redemption pattern.
The breakage rate is an estimated rate at which a company expects its gift cards to not be redeemed. For example if a company estimates a breakage rate of five percent, then it is saying that of all the gift cards sold, it expects five percent of those to never be redeemed. Breakage rates can vary based on the industry and the nature of the operations. Most companies calculate breakage rates under one of two methods. First is a comparison to public information on breakage rates for similar companies. For example, a franchisee of a restaurant might look at the franchisor’s breakage rate used to determine the breakage rate it will use. Public companies are required to disclose their estimated breakage rate used in the footnotes to their financial statements. Another method used by companies is a calculation based on historical data. For example, a company would track its gift cards over a period of time and then determine the percentage of breakage over that period. In other words, after the set period what percentage of those gift cards are still not redeemed. The actual time period to analyze would be based on the company’s industry. It is important to note that the estimate of breakage should be assessed and updated at each reporting date.
Once a company has determined their breakage rate, they can start to recognize the appropriate amount of breakage revenue. ASU 2014-09 states that a company should recognize estimated breakage as revenue in proportion to the pattern of exercised rights (the redemption pattern). In other words, the company will pick up a portion of breakage revenue as gift cards are redeemed.
Let’s take a look at an example:
ABC Restaurant, Inc. (ABC) sells 10 gift cards with a value of $100 per gift card. At the time of the sale, ABC will debit cash for the $1,000 and establish a gift card accrual for $1,000, related to the liability for future performance under the gift cards. ABC has assessed breakage and determined that it normally experiences a breakage rate of 10 percent or $100 in our example.
Customer A comes into ABC and redeems $400 of the gift cards sold. What should ABC recognize into revenue? To start, ABC will recognize $400 of revenue for the actual sales transaction and reduce its gift card liability by $400. In addition, ABC needs to recognize $40 of breakage revenue and reduce the gift card liability by the $40. This is calculated as $400/$1,000 (the percentage of redemption) x $100 (the estimated total breakage) = $40.
It is important to note that the legal requirements of unexercised customer rights vary from jurisdiction to jurisdiction. There are jurisdictions that require an entity to remit payments received from a customer and not redeemed to a governmental entity (examples would be “unclaimed property laws” or “escheat laws”). ASU 2014-09 clearly states that if a company’s breakage is required to be remitted to a governmental entity, then the company should not recognize any breakage revenue on its transactions.
So what will be the impact of ASU 2014-09 on companies with breakage revenue? Those companies that are already using the redemption pattern method will likely have very little change and experience minimal impact. Companies that currently use the released obligation method or the remote method will likely have to switch to the redemption pattern method. Since most of the gift cards are redeemed in the year of issuance, it is likely that these companies will accelerate breakage revenue recognition when moving to the redemption pattern method.
Complying with the new standard will have an impact on all companies that have the potential for breakage on unexercised customer rights (gift cards, loyalty rewards points, etc.). As such, all companies that offer programs that allow for unexercised customer rights should start assessing the impact ASU 2014-09 will have on their revenue recognition policy. Public companies will be required to comply with the new standard for the year ending Dec. 31, 2018, while most nonpublic companies are provided an additional year requiring compliance for the year ending Dec. 31, 2019.
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