Accounting for retailer-issued gift cards: revenue recognition and financial statement disclosures.

Ammons, Janice L. ; Schneider, Gary P. ; Sheikh, Aamer 等

CASE DESCRIPTION

This case deals with the appropriate accounting for and disclosure of gift card revenue on the financial statements. Secondary issues examined include materiality, the quality of reported earnings, and contingent liabilities. Underlying these specific issues is the general issue of accounting policy choice and its effect on the comparability of reported financial results across companies. The case requires students to find and review authoritative accounting literature (including appropriate professional standards) and relevant financial filings (for example, Forms 10-K) for several companies. This case has a difficulty level of three, four, or five. The case is designed to be taught in two class hours and is expected to require five hours of outside preparation by students.

CASE SYNOPSIS

Using example disclosures from Best Buy Co., Inc. and other retailers, students learn about the use of retailer-issued gift cards and identify issues that arise in accounting for their issuance and redemption. Students also learn about the more general topic of how accountants apply financial statement disclosure rules to new business practices as they emerge.

INTRODUCTION

Retailers have sold gift certificates in one form or another for more than a hundred years (Waits, 1993). In recent years, a specific form of gift certificate known as the gift card or shopping card has become quite popular among consumers. The gift card has also become widely used as a business promotion tool, issued by retailers to their frequent customers much as airlines use frequent flier mileage plans. Gift cards are also used by companies as small-denomination performance awards for employees and as "thank-you" gifts to customers, vendors, partners, and others (Horne, 2007).

Recent estimates of U.S. sales of gift cards include $83 billion in 2006 and $97 billion in 2007 (Mitchell, 2008). Gift card sales outside the United States are growing rapidly, also (Horne, et al., 2005). Although gift card sales were down somewhat in the 2008 holiday shopping season, retailers expect them to begin increasing again when the economy recovers (Bohen, 2008; BusinessWeek, 2008).

CHARACTERISTICS OF GIFT CARDS

Consumers find gift cards appealing because they allow a person to purchase a gift when they do not know the intended recipient well enough to guess what the recipient will find pleasing or suitable (Horne and Kelly, 1995). This reduces the loss to both parties (the gift-giver and the gift-recipient) that results when a suboptimal gift is purchased and must be returned or simply not used (Waldfogel, 1993).

Despite their benefits and efficiencies, gift cards do expose the giver and recipient to the risk of losses (Horne, 2007). Some gift cards have expiration dates. If a gift recipient does not use the card, or misplaces the card, the value of the gift is lost. Some gift cards also have a small dormancy fee that reduces the value of the card each month it is not used after some time period (typically a year) of inactivity. The purpose of this dormancy fee is twofold. First, it prevents the issuing company from accumulating a large liability over time; second, it avoids any requirement the issuer might have to pay over the balance to a state government under that state's escheat laws (Kile and Wall, 2008). If a gift card issuer enters bankruptcy protection, any unspent balances on gift cards it has outstanding could become worthless unless allowed to remain by the bankruptcy court judge (Consumer Reports, 2008).

Open-System and Closed-System Gift Cards

Two kinds of gift cards exist, open-system and closed-system. An open-system card is issued by a bank, bears the logo of a well-known credit card (for example, American Express, Discover, MasterCard, or Visa) and works very much like a bank debit card. A closed-system gift card is a stored-value card that represents money on deposit with the issuer (retailer). Instead of drawing down the balance in a checking account as a bank debit card would, the open-system card draws down the stored value of that card. Open-system gift card issuers can earn substantial profits from cards that expire or that remain unused long enough to yield dormancy fees. These cards also yield the standard interchange fees charged to merchants by any branded credit or debit card. Thus, an open-system issuer earns more profit on cards that are misplaced or not used.

Closed-system gift cards are issued by retailers and bear that store's logo. The retailer benefits by gaining the use of the funds (the value of the float) on unredeemed balances and can profit from cards that expire or are misplaced and can earn dormancy fees on cards that are not used. Unlike the issuers of open-system cards, however, closed-system issuers are motivated to have consumers use their gift cards (Horne, 2007). When a consumer enters a store with a $50 gift card, chances are good that that consumer will spend more than the value of the card. Also, a consumer that carries a retailer-branded gift card will be reminded frequently of the retailer's brand and market presence as a shopping destination. Retailers spend millions of dollars each year to accomplish these objectives.

This case deals with the accounting procedures and financial statement disclosures for retailers who issue closed-system gift cards. In these transactions, the retailer sells a card that contains a specific denomination of stored value to a customer. The customer gives the card to another person, the gift recipient, who will visit the retailer (in person or online) and spend the stored value. Of course, the retailer hopes that the gift recipient will enjoy the environment of its physical location (or its Web site), find its products enticing, and decide to spend additional money while browsing.

REVENUE RECOGNITION ISSUES

Most of the profit that a retailer earns in a gift card transaction is the profit on the sale that occurs when the card recipient spends the stored value on the card. However, the retailer does earn other income from a gift card transaction.

Two Sources of Revenue

The retailer receives cash from the card purchaser at the time the card is sold. The retailer has the use of that money starting at that point in time. The effect is similar to a sale transaction in which a customer makes a cash deposit when placing an order for an item to be delivered later. The retailer must record the cash receipt, but has not made a sale yet.

A second source of revenue from a gift card transaction occurs because not all gift cards are redeemed. Even if the retailer does not impose a dormancy fee or enforce an expiration date on the card, at some point in time, the retailer will decide that the likelihood a gift card will be redeemed has dropped close to zero and the gift card should be written off. The revenue a retailer earns because some gift cards are never used (or because they expire or are consumed by dormancy fees) is called breakage, breakage revenue, or breakage income (Kile, 2007).

This situation requires an accounting procedure that is similar to (although opposite in effect) the accounting for money owed by a company's customers on their accounts that is unlikely to be collected. In the case of uncollectible accounts receivable, the company estimates an uncollectible accounts expense in the period of the sale and sets up an allowance for doubtful accounts as a contra-asset account. When a specific account receivable is identified as uncollectible (which could easily happen in a year subsequent to the recognition of the sale and its related uncollectible accounts expense), that receivable is written off against (reduces) the allowance for doubtful accounts.

Generally Accepted Accounting Principles (GAAP) and Unearned Revenue

GAAP requires that revenue be recognized at the earliest point in the firm's operating cycle when it meets both of the following criteria: revenue is realized or realizable, and revenue is earned. If a firm receives cash in exchange for a promised future delivery of products or services, it records the increase in cash (an asset account) and the increase in unearned revenue (a liability account).

When the product is delivered or the service is provided, the firm recognizes revenue (by crediting the revenue account) and reduces the liability, unearned revenue (by debiting the liability account). The transaction is recorded as follows:

FINANCIAL STATEMENT DISCLOSURE ISSUES

Recent accounting literature on accounting for gift cards includes articles (Feinson, 2008; Kile, 2007; Kile and Wall, 2008) and a speech made by a Securities and Exchange Commission (SEC) staff member (Schlosser, 2005).

The relevant Statement on Financial Accounting Standards is Statement 140 (FASB, 2000). Although the basic premises of disclosure are not very complex for gift cards, the issue is perceived by the SEC staff (Schlosser, 2005) and by accounting academics (Marden and Forsyth, 2007) as one that is new and not particularly well settled. As new business practices are developed, accountants must apply their existing rules and interpretations to those new practices. An important disclosure issue for new practices is always how best to report the accounting information in a way that maintains the quality of earnings reported (Bellovary, et al. 2005).

One good way to learn how companies are reporting a new business practice is to search the financial disclosures filed by companies in the industry. One of the most useful financial disclosure filings is the Form 10-K, which is required by the SEC to be filed annually by U.S. companies whose shares are publicly traded. Forms 10-K are available on companies' Web sites or on the SEC Web site for its Electronic Data Gathering, Analysis, and Retrieval (EDGAR) System (SEC, 2009).

QUESTIONS FOR DISCUSSION

1. Provide a broad definition of the term "liability" as it is used in accounting. When is a liability satisfied?

2. When does a closed-system gift card become a liability for the retailer who sells the gift card? Is it when the card is placed on a rack for sale in the store? When it is sold to a customer? Or is it when the holder of the card (either the original purchaser or the gift recipient) redeems the card for merchandise at the retailer's store or Web site?

3. Obtain the fiscal 2008 annual financial statements or Form 10-K for Best Buy, the consumer electronics retailer. Does the value on the unredeemed gift card liability account on the balance sheet ($531 million) represent the dollar value of the gift cards that Best Buy sold during that year? If not, describe what it does represent.

4. Continue to use the Best Buy financial statements or Form 10-K for fiscal 2008 for this question. Best Buy's unredeemed gift card liability increased from 2007 to 2008. Would you interpret this as favorable or unfavorable news for Best Buy?

5. Why would a retailer not record revenue when it receives cash for the sale of a gift card?

6. Prepare two journal entries, one for the sale of a gift card with a stored value of $75, and another for the subsequent partial redemption of that gift card for goods that have a selling price of $50 and a cost of $40.

7. In what way (if any) would the journal entries for recording the redemption of a gift card differ from the journal entries for recording the expiration of an unused gift card? Explain.

8. What is gift card breakage? Why and how does it occur?

9. Obtain the annual financial statements or the Form 10-K for a retailer other than Best Buy that issues gift cards and discloses information about gift cards. Compare the treatment of gift card liabilities and revenues (or earnings) in the two companies.

10. Does GAAP require firms to record any cost of goods sold as an expense when they record breakage as revenue? Explain how your answer to this question might affect an analysis of gross profit percentages over time or across firms.

11. Review the different choices described in Kile (2007) that various firms made about how to report unredeemed gift card liability. Critique these choices by considering the following questions: Which disclosure choice do you believe would best serve a financial statement user? Why? Which option(s) do you think could mislead a financial statement user? Explain.

12. Review Kile (2007) to identify the different choices that various firms made regarding how to report gift card breakage on their income statements. Which disclosure choice do you believe would provide the best information to a financial statement user? Why? Which option(s) do you believe are potentially misleading to a financial statement user? Explain.

13. Briefly define the term "quality of earnings." How might the accounting for and disclosure of gift card breakage affect the quality of earnings reported by a particular firm?

14. Does the breakage income that Best Buy (2008) reports, $34 million, represent a significant percentage of Best Buy's fiscal 2008 earnings?

15. Review Best Buy's (2008) financial statements or Form 10-K for fiscal 2008. Can you determine or estimate the amount that gift card sales contributed to that year's earnings? Was it more than $34 million, approximately $34 million, less than $34 million? Explain.

REFERENCES

Bellovaray, J., D. Giacomino, and M. Akers. (2005, November). Earnings quality: It's time to measure and report. The CPA Journal, 75(11), 32-37. Retrieved on January 23, 2009 from: http://www.nysscpa.org/cpajournal/2005/1105/essentials/p32.htm

Best Buy. (2008). Best Buy Co., Inc. Form 10-K. Retrieved on December 11, 2008 from: http://www.sec.gov/Archives/edgar/data/764478/000104746908005591/a2185101z10- k.htm

Bohen, C. (2008, December 1). NRF expects lower holiday gift card sales. This Week in Consumer Electronics. Retrieved February 15, 2009 from http://www.twice.com/article/CA6618376.html

BusinessWeek. (2008, November 24). Gift-card pitfalls. 10.

Consumer Reports. (2008). What Consumers Union is doing: Advocacy groups including Consumers Union have petitioned the Federal Trade Commission to require that retailers set aside and hold in trust sufficient funds to back up gift cards should the retailer file for bankruptcy. 73(12), 5.

Financial Accounting Standards Board (FASB). (1985). Statement of Financial Accounting Concepts No. 6: Elements of Financial Statements. Stamford, CT: FASB. Retrieved March 10, 2009 from: http://www.fasb.org/pdf/con6.pdf

Financial Accounting Standards Board (FASB). (2000). Statement of Financial Accounting Standards No. 140: Accounting for transfers and servicing of financial assets and extinguishments of liabilities, a replacement of FASB Statement No. 125. Stamford, CT: FASB. Retrieved January 11, 2009 from: http://www.fasb.org/pdf/aop_FAS140.pdf

Feinson, Carla. (2008). The steep rise of gift card purchases by the consumer is changing the method of accounting and reporting of gift card income by corporate retailers. Journal of Business & Economics Research, 6(4), 7-12.

Horne, D. (2007). Gift cards: Disclosure one step removed. Journal of Consumer Affairs, 41(2), 341-350.

Horne, D., T. Craddock, and P. Norberg. (2005). The European guide to gift and stored value cards. London: Giftex.

Horne, D. and J. Kelly. (1995). Gift certificates and customer value: Some preliminary findings. In Pelligrini, L. (Ed.), Research in the Distributive Trades, 8th Edition. (pp. B6.20-B6.24). Milan: Cento Di Studi ul Commercio.

Kile, Charles Owen, Jr. (2007, November). Accounting for gift cards: An emerging issue for retailers and auditors. Journal of Accountancy, 204(5), 38-43.

Kile, C., and P. Wall. (2008, December). States bite into broken gift cards. Journal of Accountancy, 206(6) 76-80.

Marden, R. and T. Forsyth. (2007, November). Gift cards and financial reporting: Unwrapping the uncertainties of revenue-recognition and other issues. The CPA Journal, 77(11), 28-32. Retrieved January 3, 2009 from: http://www.nysscpa.org/cpajournal/2007/1107/essentials/p28.htm

Mitchell, D. (2008, January 5). Fruitcake might be a better gift. The New York Times. Retrieved March 10, 2009 from: http://www.nytimes.com/2008/01/05/technology/05online.html

Schlosser, Pamela R. 2005. Statement by SEC staff: Remarks before the 2005 AICPA national conference on current SEC and PCAOB developments. Retrieved January 22, 2009 from: http://www.sec.gov/news/speech/spch120505ps.htm.

Waits, W. (1993). The modern Christmas in America. New York: New York University Press.

Waldfogel, J. (1993). The deadweight loss of Christmas. American Economic Review, 32(4), 1328-1336.

Janice L. Ammons, Quinnipiac University

Gary P. Schneider, Quinnipiac University

Aamer Sheikh, Quinnipiac University