Unexercised Rights (Breakage) in ASC 606

Customers are often allowed to purchase the rights to goods or services in advance. Customers can then exercise these rights later, when they want the good or service. Gift cards are just one example of this type of contract. However, some customers don’t fully exercise their rights to the goods or services they’ve paid for. Within practice, customers failing to use the contractual rights they’ve paid for is referred to as “breakage.” Accounting Standards Codification (ASC) 606 allows companies to estimate the amount of breakage, or the consideration related to obligations that they do not expect to be required to fulfill. This article examines the guidance related to these transactions and provides examples.

Methods for Recognizing Revenue with Potential Breakage

To recognize revenue associated with breakage amounts, the entity must first determine whether it expects to be entitled to a breakage amount (Entities may recognize a breakage amount if they expect that customers will not exercise all of their contractual rights). To do so, entities must consider the guidance in ASC 606-10-32-11 through 32-13 on constraining estimates of variable consideration (ASC 606-10-55-48). See Variable Consideration and the Constraint for more information.

Once the entity has determined whether it expects to be entitled to a breakage amount, it must follow the corresponding method for recognizing revenue associated with the breakage amounts (ASC 606-10-55-46 to 55-48):

The entity expects to be entitled to a breakage amount. The entity should reduce the standalone selling price for estimated breakage. Breakage revenue would then be recognized in proportion to the actual performance that the entity provides. Recognizing breakage revenue upfront would be inappropriate, because the entity has not yet provided any goods or services and doing so would understate the entity’s obligation to stand ready to provide future goods and services. See Stand-Ready Obligations for more information on this topic.
The entity does not expect to be entitled to a breakage amount. The entity should recognize revenue on breakage amounts when the likelihood of the customer exercising his or her remaining rights becomes remote.

ASC 606 further limits recognizing revenue on breakage amounts in jurisdictions where escheat laws require companies to remit breakage amounts to the state. If breakage amounts will be owed to the state, then a company should follow the normal process of accounting for breakage amounts with one major difference: when the entity would normally recognize revenue, a liability for breakage amounts payable to the government should be recognized instead (ASC 606-10-55-49).

Where appropriate, using the portfolio approach may facilitate accounting for breakage. Entities may have difficulty predicting the amount of breakage attributable to each individual transaction, but can often estimate the aggregate breakage amount for a portfolio of contracts with reasonable accuracy.

The Cheesecake Factory, Inc. (2019 10-K): Gift Card Breakage

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The Cheesecake Factory has sold gift cards to its customers for many years. This long historical record provides enough information to estimate breakage. The following revenue recognition disclosure describes the way that The Cheesecake Factory recognizes revenue for breakage:

We recognize a liability upon the sale of our gift cards and recognize revenue when these gift cards are redeemed in our restaurants. Based on our historical redemption patterns, we can reasonably estimate the amount of gift cards for which redemption is remote, which is referred to as “breakage.” Breakage is recognized over a three-year period in proportion to historical redemption trends and is classified as revenues in our consolidated statements of income. We recognized $8.0 million, $8.0 million and $7.9 million of gift card breakage in fiscal years 2019, 2018 and 2017, respectively. Incremental direct costs related to gift card sales, including commissions and credit card fees, are deferred and recognized in earnings in the same pattern as the related gift card revenue. There were no changes to our accounting for gift card revenue and related costs upon adoption of the new revenue recognition standard. (2019 Form 10-K)

Target Corporation (2020 10-K): Gift Card Breakage

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Target has sufficient experience with gift cards sales that the company can expect to be entitled to recognize breakage revenue. The following disclosure from Target’s 10-K describes how the company recognizes revenue over time as gift cards are redeemed:

Revenue from Target gift card sales is recognized upon gift card redemption, which is typically within one year of issuance. Our gift cards do not expire. Based on historical redemption rates, a small and relatively stable percentage of gift cards will never be redeemed, referred to as “breakage.” Estimated breakage revenue is recognized over time in proportion to actual gift card redemptions. (2020 10-K)

The Meet Group, Inc. (2019 SEC Correspondence): Virtual Currency Breakage

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The Meet Group offers apps which can be downloaded for free from Apple’s App Store, the Google Play Store, etc. Within these apps, users can purchase subscriptions and In-App Products (virtual currency such as Credits, Points, Gold, etc.). Subscriptions can include an amount of In-App Products, but the currency can also be purchased without the subscription.

Under the Company’s terms and conditions for the use of its applications…, the purchase of any In-App Products grants a customer a limited right-of-use asset for the respective In-App Products in exchange for a fixed, upfront, and non-refundable amount of consideration. Any advanced payment is first recorded as a contract liability (i.e., deferred revenue), which is then subsequently recognized as user pay revenue when the Company’s sole performance obligation is satisfied in accordance with the guidance for advanced payments in ASC Paragraphs 606-10-55-50 through 606-10-55-53. For its in-app purchase products, the Company has a continuous stand-ready obligation to transfer services to its customers, which is satisfied upon the earlier of: (i) the exchange of a customer’s In-App Products for virtual gifts (i.e., satisfaction of the performance obligation); or, (ii) the likelihood of a customer’s use of their In-App Products balance becomes remote, and there is no legal obligation to remit any unredeemed In-App Products to the relevant customer’s residential jurisdiction (per the guidance in ASC Paragraphs 606-10-55-46 through 606-10-55-49). (2019 SEC Correspondence)

Allocating Revenue Based on Standalone Selling Price when Breakage is Expected

Generally, when a contract includes multiple performance obligations and there is a discount in the sales price, revenue is allocated to the performance obligations based on their standalone selling prices. When standalone sales of the performance obligation exist, the standalone selling price can be found more easily and should be used. However, the standalone selling price must be estimated and reduced by the amount of expected breakage when applicable.

The face value of performance obligations should be reduced by the expected breakage amount before being used to allocate the transaction price. The principle of the standard is for companies to recognize revenue in the amount to which they expect to be entitled for transferring goods and services to the customer. In a contract with multiple performance obligations, the customer might not have been willing to pay the full face value for the performance obligation with expected breakage—this is especially the case in arrangements where the performance obligation is some kind of add-in, bonus, or loyalty program, which the company would have been unlikely to sell on a standalone basis. Accounting Standards Update (ASU) 2014-09 BC398 mentions that in many instances, companies would charge more for performance obligations that include breakage if they expected customers to fully exercise their contractual rights.

There is precedent in practice for selling gift cards on a standalone basis at a price less than their face value. Many vendors do so, often with the intent of generating future sales or improving customer loyalty. Because this happens in practice, it is hard to support the view that companies should always use the face value of gift cards and similar performance obligations for allocation purposes.

The guidance for estimating the standalone selling price is the same whether there is one or multiple performance obligations. The standalone selling price should be reduced by the amount of estimated breakage that can be expected.

Example: Gift Card Breakage

On January 1, 2020, Vendor Y enters into a contract with Customer U to provide Product A, Product B, and a gift card for future purchases in exchange for $1,900 from Customer U. Products A and B have standalone selling prices of $1,200 and $800, respectively, and the gift card can be exchanged for $200 of Vendor Y products. Vendor Y determines from its experience with similar gift cards that on average, 20 percent of the balance on any gift card will go unused. On January 15, Products A and B are delivered, but no transactions have occurred related to the gift card. On March 15, Customer U utilizes $100 of the balance on the gift card.

Analysis: Assume that the standalone selling price of the gift card is $160, the actual amount that Vendor Y expects to be required to redeem.

Product	Standalone Selling Price	% of Total Selling Price	Allocation of Transaction Price
Product A	$1,200	$1,200/$2,160=56%	$1,900*56%=$1,055
Product B	$800	$800/$2,160=37%	$1,900*37%=$705
Gift Card	$160	$160/$2,160=7%	$1,900*7%=$140
Totals	$2,160	100%	$1,900

Of the $140 of revenue allocated to the gift card, $28 (20% * $140 = $28) will be recognized as breakage revenue as the customer redeems the gift card. The remaining $112 will be recognized as gift card revenue in proportion to the actual amounts the entity redeems.

Journal Entries on January 15:

When Customer U redeems $100 of the gift card, they are redeeming 62.5 percent ($100/$160) of the expected total that the customer will actually redeem, so they will recognize that percentage of both the revenue attributed to the gift card (62.5% * $112 = $70) and the revenue attributed to breakage amounts (62.5% * $28 = $18). The following journal entries would be made on March 15, when Customer U redeems $100 of the gift card:

Journal Entries on March 15:

Conclusion

If an entity can expect to be entitled to a breakage amount, it should reduce the standalone selling price for the estimated breakage, then recognize breakage revenue in proportion to the actual performance it provides. If the entity can’t expect to be entitled to a breakage amount, it should only recognize revenue for breakage once the possibility that the customer will exercise its rights is remote. When an entity provides multiple performance obligations, and breakage is expected for one or more of the obligations, entities should reduce the standalone selling price for estimated breakage before allocating revenue.

Resources Consulted

ASC 606-10-55-46 to 55-49
ASU 2014-09: “Revenue from Contracts with Customers.” BC396-BC401.
EY, Financial Reporting Developments: “Revenue from Contracts with Customers (ASC 606).” January 2020. Section 7.9.
Deloitte, “A Roadmap to Applying the New Revenue Recognition Standard.” July 2019. Section 8.8.
PwC, “Revenue from contracts with customers, global edition.” March 2020. Section 7.2.1.