Gift cards – that one-size-fits-all present for any occasion – can be an excellent choice for both giver and receiver. But how do companies account for them when the card is never redeemed?

Gift cards are big business. According to TowerGroup, sales of gift cards are expected to reach $130 billion by 2014. With increasing sales of gift cards, especially in the retailing and restaurant industries, comes the accounting issue of recognizing income from unredeemed gift cards. Since 2005, about $41 billion worth of the money on gift cards has gone unclaimed. While the estimates of non-redemption of gift cards vary, Consumer Reports noted that 19 percent of the people who received a gift card in 2005 never used it.

In the August 2012 Issues in Accounting Education, Bentley Accountancy Professor Mahendra Gujarathi examines how and when companies recognize income from unredeemed gift cards. Final financial reporting practices vary widely with respect to the timing of “breakage” recognition, the method by which it is calculated, and the place in the financial statements where it is presented. Some companies (Best Buy and Home Depot, for example) do not recognize breakage until the time when probability of redemption becomes remote, whereas some (Target, and Collective Brands, for example) recognize the estimated breakage income in proportion to actual gift card redemptions.

Those that recognize gift card breakage when the probability of redemption becomes remote use varying lengths of time before determining the likelihood of non-redemption (i.e. estimating breakage). For instance, Best Buy makes such determination after 24 months from the sale of gift cards, but Limited Brands does the same after 36 months. The placement of gift card breakage in financial statements also varies across companies. Whereas some companies (Kohl’s, Target, Limited Brands, and Best Buy, for instance) record breakage as sales, many others (Home Depot, Macy’s, Safeway, Circuit City and Walgreens, for example) record it as a reduction in selling and administrative expenses.

Significant amounts and differential recognition of gift card breakage has important implications for evaluation of management’s performance. As noted by Marden and Forsyth (2007), “being able to control when, where, and how a substantial amount of revenue can be inserted into the financial statements can be beneficial for management, but can be misleading for financial statement readers.”

That important metrics like sales growth or comparable store sales growth can be affected by the amounts and classification of gift cards is reflected in the 2006 annual report of Home Depot, which stated that the comparable store sales gain was partly due to income related to the initial recognition of gift card breakage. Recognizing gift card breakage as sales has significant implications for inter-year and inter-firm comparability, especially in light of the rapid increase in the gift cards sales. As noted by Atkins (2005), “The difficulty from an analyst’s perspective is that total sales and comparable same-store sales are skewed downward by the change in year-to-year gift card sales, as what would otherwise be holiday sales are pushed into January and beyond.”

The findings help both companies and financial analysts better understand the diversity of accounting policies to account for unredeemed gift cards. Implications include:

• Informing companies as they devise their financial reporting strategy
• Instructing financial analysts to understand and interpret financial statements
• Indicating to regulators the need for additional guidance in the area

Findings also challenge a view common among college students that accounting is black and white. For accounting educators, Gujarathi provides a context that is interesting and important, but for which a definitive accounting standard is not yet available. He points to a need for both accounting students and instructors to search accounting literature to develop professional judgment on issues that are more complex. He says, “Students find it fascinating that there are no definitive answers in a subject like accounting, that there is a significant discretion available to the companies. They use it strategically to achieve desired objectives such as meeting the expectations of capital markets and beefing up the bonus packages of senior management.