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

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

CASE DESCRIPTION

The primary subject matter of this case concerns 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 gift cards and identify issues that arise in accounting for their issuance and redemption. Students also learn how accountants apply financial statement disclosure rules to new business practices as they emerge.

INSTRUCTORS' NOTES

Recommendations for Teaching Approaches

A good way to begin the case discussion is to ask students if they have purchased or received a gift card in the past year. If they received a gift card, ask them how quickly they redeemed it. About one-third of retail gift cards are redeemed within 30 days. You could ask if they have lost or misplaced the card. Other questions you can use include: Did they partially use the card so that some stored value still remains on the card? Did they choose not to use it for some reason?

These questions can get many students involved in the discussion, which can lead to wider participation as the class progresses through the specific questions in the case. Students might also initiate discussion on topics not addressed specifically in the case. For example, students may have experience with incentive programs in which a customer that buys an expensive item is rewarded by the retailer with a gift card that can be redeemed on future purchases. Students might have seen bank-issued cards (the open-system cards mentioned in the case) that carry a Visa or MasterCard logo. You can make the point that this case deals with closed-system cards issued by the retailers themselves. Many students might not understand the distinction (and its importance) after reading through the case one time.

The case can be used at the undergraduate level in introductory financial accounting, early in an intermediate financial accounting sequence, or in an introductory financial accounting class for MBAs. The case can also be used in financial statement analysis courses or case courses that deal with financial reporting issues at either the undergraduate or MBA levels. This case introduces ideas about how emerging business practices are reported in financial statements, so it can be used relatively early in a course.

Students should be familiar with the accounting for accounts receivable, uncollectible accounts expense, and unearned revenue before undertaking this case. These topics are reviewed in the text of the case, but the coverage there is unlikely to be sufficient for students who have never seen these topics to gain a full understanding of them.

Instructors can proceed through the case questions in order, as some later questions build on answers to some of the earlier questions. Depending on course level, time constraints, or topic preferences, instructors can eliminate questions or re-order them. For example, instructors might want to defer discussion of breakage if they will be covering quality of earnings issues or ratio analysis later in the course. In this case, questions 1-7 and 9 could be used for discussion of gift card basics and financial statement presentation of the liability. Question 9 offers the opportunity for an extended discussion if students have obtained financial statements for a variety of different companies and it does give students a chance to use the SEC's EDGAR system. If the audience is accounting majors, greater emphasis can be placed on the journal entries in discussing questions 6 and 7. MBA students could be asked to perform additional analysis of gift card breakage and the likelihood of earnings management at Best Buy or at another selected retailer.

QUESTIONS FOR DISCUSSION (WITH SUGGESTED ANSWERS)

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

A liability represents a probable future sacrifice of resources of the firm. Satisfaction of a liability could result from a payment of cash, the transfer of non-cash assets (for example, barter), or completing the performance of a service (performance of a service would consume resources). The FASB defines "liability" in its Statement on Financial Accounting Concepts No. 6 (FASB, 1985).

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?

A gift card becomes a liability to the firm when the firm sells the gift card. At that point, the retailer received a resource from a customer (in the form of cash or in the form of accounts receivable if the customers uses the store's own credit card to purchase the gift card) and the firm has an obligation to perform in the future by providing goods or services. There is no liability associated with unissued cards because the firm has no obligation yet. When the customer redeems the card for merchandise, then the retailer has satisfied its obligation (to the extent the card's value was exhausted), thus no further liability exists for the retailer in association with that card.

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.

No. The value of the gift card liability on the balance sheet is unlikely to reflect the amount of gift cards sold during the year. The amount reported as unredeemed gift card liability represents the value on the balance sheet date of the retailer's obligation to sacrifice resources in the future when customers redeem the cards for merchandise. This amount could differ day to day. Some gift cards sold this year might have been redeemed already, so they would not appear as part of this liability. Some gift cards sold last year might remain unredeemed and could be included in this liability.

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?

Most financial statement readers would regard this as favorable news. Although students might think of liabilities as unfavorable because they represent an obligation to sacrifice resources in the future, an increase in this unearned revenue account portends increased sales in the future as these cards are redeemed (or expire and contribute to increases in breakage revenue estimates).

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

In doing so the retailer would violate one of the two revenue recognition criteria in GAAP (these are both are mentioned in the case). The retailer receives cash (and increases that asset account) when the gift card is sold, but the earnings process is not complete because the gift card has not been redeemed. In fact, the gift card might never be redeemed (or might be only partially redeemed). The company has not earned the revenue yet. Thus, the retailer would use an unearned revenue account to record the liability associated with gift cards when they are sold.

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.

When the gift card is sold, the journal entry is a $75 debit to Cash and a $75 credit to Unearned Revenue (or Unredeemed Gift Card Liability). A liability is recorded for the value assigned to the gift card because the merchant owes the goods and services that will ultimately be "sold" to the customer who redeems the gift card.

When the gift card is partially redeemed, two journal entries should be recorded. The first is a $50 debit to Unearned Revenue and a $50 credit to Sales Revenue. The second is a $40 debit to Cost of Goods Sold and a $40 credit to Inventory.

We believe that it is important to discuss the expense side of this transaction, although many students will not think of it. The effect on net income of this transaction is different than a breakage transaction (in which there would be no cost of goods sold as an expense). Note that this treatment is similar to the journal entries presented in the case for unearned revenue. The important learning objective here is to get students thinking about the account titles and realizing that the general form journal entries they have learned (or are learning) are templates for the journal entries they will devise in practice as they record business practices that have not yet been invented. Note: This journal entry assumes that the company is using a perpetual inventory system. If your students have not seen journal entries for a perpetual system, you should substitute the appropriate entry for a periodic system here.

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.

The expiration of an unused gift card does not involve the transfer of inventory that occurs when a gift card is redeemed. Thus, the earnings are greater on the expiration of an unused gift card (breakage). Both require the recording of an increase to revenue or other operating income, but a gift card redemption also requires that the expense (cost of goods sold) be recognized.

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

Gift card breakage occurs when the holder of a gift card does not redeem the gift card in exchange for merchandise or services. In technical terms, the holder does not demand full performance. The card holder might have lost or misplaced the card. The card holder might have redeemed a part of the stored value on the card and the remaining value is too small to justify a trip to the retailer. The card might have expired (if the card was issued with an expiration date) or might have been consumed by dormancy fees (if the card were issued with dormancy fees). Finally, it is possible that the consumer still has the card but simply has not used it yet.

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.

You can instruct students to search Forms 10-K of likely card issuers (retailers) for terms such as "gift," "gift card," or "shopping card." Wal-Mart, Circuit City, Target, and The Gap are all companies with which students might be familiar and they all have some information in their Forms 10-K regarding gift cards. Nieman-Marcus, which uses its cards as part of a customer loyalty program, includes a number of detailed statements regarding its accounting for gift cards. You can certainly direct students to specific companies or assign companies to teams if you wish.

Best Buy records revenue for unredeemed gift cards when "the likelihood of the gift card being redeemed by the customer is remote ("gift card breakage"), and we determine that we do not have a legal obligation to remit the value of unredeemed gift cards to the relevant jurisdictions. We determine our gift card breakage rate based upon historical redemption patterns. Based on our historical information, the likelihood of a gift card remaining unredeemed can be determined 24 months after the gift card is issued. At that time, we recognize breakage income ... [which] is included in revenue in our consolidated statement of earnings." (Best Buy, 2008, 52).

Students may be curious as to why Best Buy needs to "determine that we do not have a legal obligation to remit the value of unredeemed gift cards to the relevant jurisdictions" (Best Buy, 2008, 72). Many other companies do not mention this. If you have time, you can lead students into a discussion of the general operation of escheat laws. Kile and Wall (2008) provide an overview of specific provisions of escheat laws by state.

Best Buy reports the amount of breakage recognized in each fiscal year in its notes to the financial statements. Many other companies do not disclose how much they record as breakage income in any year.

There is no standard accounting treatment under current accounting standards for cards that are never redeemed. According to Schlosser (2005), there are three acceptable accounting methods of recognizing revenue (or "breakage") for gift cards that are never redeemed: (1) If the gift card has an expiration date, the seller (vendor) can recognize revenue for the unredeemed amount on the expiration date; (2) If the gift card has no expiration date, then the seller can recognize revenue when the seller determines that the likelihood of redemption has become remote; and (3) If the gift card has no expiration date, another approach permitted by the SEC is for the seller to recognize revenue in a way that represents the proportion of actual gift card redemption.

Best Buy, follows the second option stated above, as did Circuit City. Other companies will report other options. Some companies (for example, Wal-Mart) simply make a general statement in their "significant accounting policies" that they do not recognize gift card revenue until the card is redeemed and a customer purchases merchandise.

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.

The retailer is not giving up any inventory so there is no cost of goods sold in that sense. However, there may be costs related to the management of gift card transactions that are expensed to cost of goods sold. The important point is that if the firm is including breakage income with sales or revenue without having to relinquish inventory, the gross margin is overstated. If a firm records higher breakage in one year than another and includes breakages in revenue, then the gross margin is likely to be higher than a year with lower breakage. This could lead to greater volatility in gross margins and gross margin percentages across the years and hence reduce the usefulness of the ratio as a predictor of future profits. If some firms are recording breakage as revenue and others are recording breakage as elsewhere on the income statement (for example, as "other operating income"), then the comparability of gross margins across those firms is also compromised.

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.

Most firms in the study report the unredeemed gift card liability as part of accrued expense or other liability. This effectively hides the amount unless it is disclosed separately in the footnotes. Given the information in Best Buy's (2008) balance sheet, unredeemed gift cards accounted for eight percent of total current liabilities. If the amount is significant (and Best Buy's seems significant), separate identification either in the footnotes or in a separate gift card line item would probably be preferred by users of the financial statements. It would help those users assess any trends in gift card activity that the company was experiencing. Further, gift cards may be perceived as more favorable than other sorts of liabilities on a company's books. Showing them separately would let a financial statement user adjust for that difference.

Including the liability as part of unearned revenue may work well, also. It seems likely that most or all deferred revenue for a retailer would be in the form of unredeemed gift cards.

Including the liability in accounts payable seems misleading. If unredeemed gift cards are a significant amount, including them in accounts payable could cause a user to make misleading comparisons across firms for the days' purchases number in the accounts payable ratio. Creditors and other financial statement users often want to know how long it takes a retailer to pay its suppliers for inventory. Including gift card liability in accounts payable would distort that performance measure.

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.

Reporting breakage as other income and disclosing the amount of breakage in a footnote has the benefit of providing transparency and does not distort gross profit (or any ratios calculated using gross profit). This treatment also affords financial statement users with the opportunity to evaluate the persistence of this component of earnings separately from that of other items on the income statement.

Recording breakage as net sales (the most frequent treatment in the sample) may distort gross profit because there is no related increase in cost of goods sold. Recording breakage as a reduction of cost of goods sold similarly produces a misleading gross profit ratio if the amount of breakage is significant. If the amount of breakage changes from year to year and the breakage is reported as net sales or as a reduction to cost of goods sold, then the comparison of gross profit ratios between periods is less meaningful. The portion of the change due to breakage is not a reflection of the company's success at raising prices or at controlling its product costs (including buying costs, distribution costs, and occupancy costs that are often included in a retailers cost of goods sold).

If a company reports significant breakage amounts as a reduction in selling, general, and administrative (SG&A), investors and creditors may be more likely to assume that the company has done a better job of controlling operating expenses than it actually has. If some firms are recording breakage as a reduction in SG&A and others are recording it elsewhere, then the comparability across those firms is also compromised.

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?

Quality of earnings is the ability of a firm's income statement (and accompanying disclosures) to present the firm's true earnings. It also can be measured by how well the income statement can be used to predict future earnings. The position of items on an income statement can affect the ability of a user to predict future earnings. See discussions related to question 9 and 10 above. Separate disclosure of breakage revenue (or earnings) could enhance the quality of earnings because a user can evaluate it separately from other earnings. In terms used by Belovaray, et al. (2005), the breakage revenue could be assigned a different degree of "earnings persistence" than ordinary sales revenue would be assigned.

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

Best Buy's reported net earnings for 2008 were $1,407 million. It is likely that the $34 million of breakage income (about 2.4% of earnings) is not material. Depending on how deeply your students understand the concept of materiality, this could lead to an extended discussion of the term and its implications. Such a discussion can be used if appropriate, but it is not necessary for this case.

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.

It was likely more than $34 million, but how much more is impossible to determine. The $34 million is just the income effect from the gift cards for which redemption was deemed remote. Some retail industry observers estimate that this income effect tends to average about 10% of annual gift card sales. But that kind of estimate would likely vary across firms and across years. If we knew the amount of gift card redemptions (which is not disclosed), we could subtract an estimate of the cost of goods sold associated with those redemptions and add the breakage of $34 million. This would yield a very rough estimate of how the gift cards impact earnings. But that would not mean that the firm's earnings would be lower by that amount if it were not to have a gift card program.

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

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

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.

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.

Janice L. Ammons, Quinnipiac University

Gary P. Schneider, Quinnipiac University

Aamer Sheikh, Quinnipiac University