Breakage

What Is Breakage?

Breakage is a term used to describe revenue gained by retailers through unredeemed gift cards or other prepaid services that are never claimed. In these cases, the company pockets the money paid for these items, without actually providing the service or item for which the customer initially paid. Although nearly all of this money is considered to be a profit to the company, accounting uncertainty due to breakage has been a recurring problem throughout the years.

How Breakage Works

Breakage has been an accounting issue for a long time. Some companies have been accused of inflating their revenue figures with breakage estimates. In 2006, it was estimated that consumers lost over $8 billion annually due to breakage.

Most retailers no longer place restrictions (i.e., dormancy fees, expiration dates, etc.) on their gift cards in a concerted effort to eliminate accounting uncertainty. In 2007, the Federal Trade Commission (FTC) settled a case it brought against Darden Restaurants for failure to disclose its gift cards dormancy fees. It reached the same outcome in a similar action it earlier filed against Kmart. The rulings required both companies to reimburse customers who lost money, due to the inadequately disclosed gift card fees.

Example of Breakage

Consider the following example of a breakage: if a customer purchases a $50 gift card, the company received $50, as well as a future liability for $50 worth of goods or services. This could be for a clothing retailer, a restaurant chain, or any other merchant that installs such gift card programs.

Now let's assume that the recipient of the gift card uses it to make a $48 purchase. In this case, the company would remove $48 from its liability, which would be recognized as revenue. And if after the purchase, the customer discards the gift card, the $2 left on it would never be used. That leftover amount is considered breakage.

Breakage Solutions

The Financial Accounting Standards Board (FASB) developed a new model for accounting for prepaid services and goods that addresses the breakage that goes along with selling these items. FASB intended to create a more transparent method of financial reporting through these improved measures.

To help reduce the accounting ambiguity caused by reporting breakage, the FASB released an Accounting Standards Update in 2016, which requires companies to comply with new guidelines for recording liabilities associated with a gift card and other prepaid service sales and revenue/profits associated with breakage. All affected companies are expected to adopt the new measures before December 15, 2019.

[Important: The legal mandates for remedying unexercised gift cards differ from one jurisdiction to another.]