Gift Card, Inc.

I learned something new today which I thought was cool and felt the need to write about it. I was pouring through American Eagle’s recent 10Q looking for positive nuggets that may infer some directional predictability. I came across a section in the report regarding it’s revenue recognition on gift cards. I always wondered, from an accounting perspective, how this was recorded.

In this case, Revenue is not recorded on the issuance of gift cards. A current liability is recorded upon issuance, and revenue is recognized when the gift card is redeemed for merchandise. Additionally, the Company recognizes revenue on gift card breakage, determined through historical redemption trends. Revenue on unredeemed gift cards, based on an estimate of the amounts that will not be redeemed (“gift card breakage”), is recorded in proportion to actual gift cards redemptions as a component of total net revenue.

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.

The accounting is straightforward; the company recognizes sales revenue and eliminates the liability. At the point of sale of the gift card, the revenue is recorded in a deferred revenue entry on the balance sheet which falls under a liability (again, not recognized as revenue, thus not being recorded as an asset).

Since goods are services are not transferred or rendered at the point of sale of a gift card, You cannot recognize this revenue until there’s a triggered event — namely, providing goods or services when the gift card is reemded. For accounting, this is known as a performance obligation — An entity’s performance obligation is a promise in a contract with a customer to transfer an asset (such as a good or a service) to that customer or to that customer’s nominee as per the terms of the contract.

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 .Since not all gift cards get redeemed, companies have to determine a rate and factor the transfer of cash from the deferred revenue account into the asset side of the liability (otherwise, the value of unused gift cards would pile up in perpetuity and lock out the net cash that could be otherwise deployed in other areas of the company). Unredeemed gift cards is known as “gift card breakage”.

In the case of American Eagle, Revenue on unredeemed gift cards, based on an estimate of the amounts that will not be redeemed (“gift card breakage”), is recorded in proportion to actual gift cards redemptions as a component of total net revenue. The Company determines an estimated gift card breakage rate by continuously evaluating historical redemption data and the time when there is a remote likelihood that a gift card will be redeemed.

During the 13 weeks ended April 29, 2023 and April 30, 2022, the Company recorded approximately $2.3 million and $2.7 million, respectively, of revenue related to gift card breakage. $5 million in one year is not a bad amount of “free money” to collect.