One of the most common challenges we hear from our B2C customers is regarding proper gift card revenue recognition. Gift cards provide a great revenue stream – they bring in cash immediately and are minimal COGS. Gift card purchases are generally classified as a deferred revenue liability. Here’s what you need to know about properly recognizing them.
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Gift card revenue recognition and what complicates things: a primer
From your customer’s perspective, they solve the age-old problem of picking the perfect gift for that special someone. But boy, do they create quite a finance nightmare. As Leapfin’s Chief Architect Jason Berwanger explains in the video below, there’s a number of things to consider when dealing with gift card revenue recognition:
Financially speaking, a gift card is essentially an interest-free loan from the consumer to your company. From a revenue recognition perspective, the funds received from customers amount to deferred revenue (a liability).
Basic and advanced gift card revenue recogniton, journal entries and examples
Let’s examine these issues in more detail:
- No goods or services were rendered upon the purchase of gift cards, so what do you do with them per FASB accounting standards?
- When should you recognize gift card revenue?
- What happens if gift cards are never redeemed?
Basic gift card revenue recognition
Companies cannot recognize revenue upon the initial sale of a gift card because of a key revenue recognition principle that states that revenue is recognized when or as an entity satisfies a performance obligation by transferring a promised good or service to a customer.
What does that mean? When your company sells a gift card, cash has been received, but goods or services have yet to be rendered. You should Infinitely Defer this gift revenue in your Deferred Revenue account.
For example, let’s say your company sells $1,000 worth of gift cards:
| Example 1 | |||
|---|---|---|---|
| Jan 1 | Cash | $1,000 | |
| Deferred Revenue | $1,000 |
You cannot recognize this revenue until there’s a triggered event – namely, providing goods or services when the gift card is redeemed.
The accounting is straightforward; the company recognizes sales revenue and eliminates the liability. Using the same example, let’s assume customers redeemed $1,000 worth of gift cards in February.
| Ex. 1 Continued | |||
|---|---|---|---|
| Feb 15 | Deferred Revenue | $1,000 | |
| Sales Revenue | $1,000 |
Advanced gift card revenue recognition
But… what do you do with unredeemed gift cards?
When a gift card’s value is not redeemed, the company may be stuck waiting for a redemption to trigger revenue recognition. It does not seem to make much sense for the company to keep unearned revenues as liabilities on their balance sheet in perpetuity. This is a big problem for a lot of companies, with an annual estimation of $1B worth of unredeemed gift cards. So how do you recognize these unredeemed gift cards as breakage income?
You can recognize breakage income in proportion to the value of actual gift card redemptions.
For example, company sells $1,000 in gift cards to customers in January. The journal entry for these transactions are:
| Example 2 | |||
|---|---|---|---|
| Jan 1 | Cash | $1,000 | |
| Unearned Revenue | $1,000 |
The company can look at historical redemption patterns, let’s say, approximately 90% of the value of the gift cards sold will be redeemed over the next 12 months, with 10% probably remaining unclaimed. So for the newly sold gift cards in January, you can estimate total gift card redemptions of $1,000 x 90% = $900, and estimated breakage of $1,000 x 10% = $100.
Now, assume one of the gift cards, with a value of $100, is used in March to purchase a product with price of $90. Upon delivery of the product, you can immediately recognize $90 of previously unearned revenue from the gift cards.
The $90 redemption also triggers recognition of breakage income in proportion. Of the $900 expected redemptions, $90 has been redeemed and recognized. This is equal to 10% ($90 ÷ $900) of total expected redemptions. You can now recognize 10% of breakage income: $100 x 10% = $10.
| Ex. 2 Continued | |||
|---|---|---|---|
| Feb 15 | Deferred Revenue | $90 | |
| Sales Revenue | $90 | ||
| Deferred Revenue | $10 | ||
| Breakage Income | $10 |
Even more advanced gift card revenue recognition…
Gift card revenue recogniton can be even more complex than that. In the example below, a company sells $1,000 in gift cards to customers in January. The journal entry for these transactions are:
| Example 3 | |||
|---|---|---|---|
| Jan 1 | Cash | $1,000 | |
| Jan 1 | Deferred Revenue | $1,000 |
Now, assume the gift cards, with a value of $1000, are used in March to place an order on a product with price of $1500, but the order isn’t yet in stock to be shipped and you require at least 50% up front to place the order. The remaining amount booked to receivables is to be charged once the item is back in stock.
| Example 3 | |||
|---|---|---|---|
| Feb 15 | Accounts Receivable | $500 | |
| Feb 15 | Deferred Revenue | $500 |
On March 1, the item is back in stock, you charge the credit card on file for the remaining $500 and your operations ships out the item!
| Example 3 | |||
|---|---|---|---|
| Mar 1 | Cash | $500 | |
| Mar 1 | Accounts Receivable | $500 |
Upon delivery of the product, you can immediately recognize $1000 of previously unearned revenue from the gift cards, $500 for the additional deferred revenue unrelated to the gift card ($1500 total) AND $100 in breakage income (10% of your gift card, per your breakage policy!)
| Example 3 | |||
|---|---|---|---|
| Mar 1 | Deferred Revenue | $1,500 | |
| Mar 1 | Sales Revenue | $1,500 |
You might be wondering, how did I get $1650 in total revenue from a $1500 sale? Well, it’s true, because you were able to take 10% of the gift card in breakage income, and on an individual order/customer it can look funny, but on the whole, with your P&L, it’ll be offset by another gift card purchase not being used and money that was “indefinitely deferred!”
| Example 3 | |||
|---|---|---|---|
| Mar 1 | Deferred Revenue | $100 | |
| Mar 1 | Breakage Income | $100 |
Escheatment
All the examples above only apply to situations where the company is allowed to keep the full amount of the unredeemed gift cards. While most states currently exempt gift cards from escheatment laws, a number of states have enacted abandoned property laws for unredeemed gift card balances, typically after a dormancy period of either 3 or 5 years.
Essentially, some states require retailers to turn over the full unredeemed value of gift cards, while others require retailers to surrender a percentage of the unredeemed value (usually 60%). Because they vary from state to state, escheatment laws can add significant complexity to your revenue recognition processes if you operate in multiple states.
Ultimately…
Properly handling gift card revenue recognition can get messy especially for fast growing companies. While gift cards are great sources of revenue for B2C companies, it’s important to keep in mind accounting rules and regulations while tracking the appropriate data correctly for each gift card issued. Namely, make sure you properly track issue date, original amount, redemption date, and redemption amount. Setting up a system to track these specific data points is a worthy investment since it will save you a lot of headaches down the road.
Further reading on revenue recognition:
- An insight into other revenue recognition challenges
- Everything you need to know about cash accounting revenue recognition for subscription businesses
- Some more revenue recognition issues
- Everything you need to know about revenue recognition for E-commerce companies
