Gift cards are popular with consumers, and companies make big pushes to sell them. In this video, see how companies receive cash and record gift cards as a liability.
- Have you noticed that around the holiday season companies make a big push to sell gift cards? They're wonderful as stocking stuffers. They're easy to wrap. The recipient can use them when they want. What's not to like about a gift card? Well, companies like them for another reason. We lose them or we don't use them. When a company sells a gift card, they receive the cash and they record a liability. By the way, this is about the best kind of liability you can have. You already have the cash to do with what you will.
The technical term for this kind of liability is called unearned revenue. You've received the cash, you just haven't provided the service yet. Microsoft, for example, has a big unearned revenue liability. They've received the cash, and have promised to provide services and software upgrades in the future. Delta Air Lines is another company with a big unearned revenue liability. They have received cash, and have agreed to fly individuals from here to there in the future. Now back to gift cards.
The company reports a liability equal to the amount of cash received, and promises to provide a product or service in the future. The company can put that cash to work now, and then use cash sometime in the future to satisfy their obligation. Well, that makes sense. But what if the company does not have to provide a good or service in the future? What if that liability is never satisfied? Let's take Home Depot as an example. Home Depot is a huge do-it-yourself store. You want to fix something in your house? Home Depot probably has a solution.
And you can buy gift cards at Home Depot for those on your holiday gift-giving list. Buy a Home Depot gift card, give it to that special someone, and they can buy what they want when they want, or they can lose the card. What does Home Depot do when someone loses a gift card? They had recorded a liability, but since the card is lost, they don't have to satisfy that liability. They just get to keep the cash. Now Home Depot doesn't know when you lose a gift card, but they can estimate using historical information just how many gift cards are not going to be redeemed.
They actually have a name for this. They call it gift card breakage. In the notes to their financial statements, they state the following. Gift card breakage income is recognized based upon historical redemption patterns and represents the balance of gift cards for which the company believes the likelihood of redemption by the customer is remote. You lose your gift card, they count it as income. You gave them cash for which they had to do nothing. How much are we talking here? For Home Depot for fiscal 2016, the amount of gift card breakage they recorded was $34 million.
$34 million for which they had to do nothing. Now it's not Home Depot's fault. We as consumers didn't redeem the cards. It's on us. But Home Depot doesn't mind. Delta Air Lines does the same thing. They make breakage estimates for the frequent flyer miles that they do not think will be redeemed. Now I frequent a restaurant where every holiday season they offer this deal. Buy five $20 gift cards and get a free $20 gift card. In other words, pay $100 and get $120 worth of gift cards.
How can they afford to give away $20 like that? Now we know they know exactly what they're doing. Not only do they hope that those using gift cards will become regular customers and spend even more money in the future, they've also done some calculations and determined that some of that liability associated with the gift cards will become breakage in the future. They are counting on you and me losing or not redeeming some of those cards. So hang on to those cards.
Let someone else provide breakage. Let's not have that be us.
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