Hendrickson Thesis

I Table of Contents Introduction 3 General Facts about Gift Cards Tax Accounting Implications 7 Recognition 7 Gift Card Companies Statement Laws 10 Financial Accounting Implications Recognition 13 Disclosure 15 Further Research 20 Conclusions 21 works Cited 22 Introduction 4 13 “Gift cards have become an area of both opportunity and risk for retailers. They have come to provide a critical source of earnings, yet at the same time, the regulatory environment, including tax and financial reporting for gift cards, has become increasingly complex.

The bottom line is that financial executives within the retail industry cannot afford to be blindsided by tax, regulatory and financial reporting changes in this area;” Giles Sutton, State and Local Tax (SALT) partner and national Retail Tax practice leader. (Grant Thornton ALP. , 2011) In the recent years gift cards and certificates have become immensely popular with both retailers and customers. Gift card sales for 2010 are currently estimated to have exceeded $200 billion, with $25 billion coming from holiday season spending.

This can be compared to $24. 1 billion in the 2 holiday season and $24. 9 billion in 2 (Duff & Phelps Corp., 2011) The large amount of money that gift cards represent indicates that they must be clearly regulated from both a tax accounting and financial accounting perspective. This is not entirely the case. Tax laws have changed several times over the past decade in regards to gift card revenue recognition and may yet change again. GAP does not currently have any specific literature regarding how gift card revenue should be recorded and reported.

The main issue that is confounding both of these perspectives is what to do with gift cards that are unlikely to be redeemed. It’s estimated that the percentage of gift card balances that remain unredeemed, known as breakage, range from 10 to 19 percent. (Grant Thornton ALP. , 2011) Accounting for breakage income will be the main topic of this paper. General Facts about Gift Cards There are two basic types of gift cards; ones issued by credit card companies like Visa, and ones that aren’t. Those that aren’t issued by credit card companies are called embank gift cards or, frequently, closed-system cards.

They get this name because they are used only at the retailers that issue them. In addition to retailers; restaurants, grocery stores, movie theaters and more have all begun to use these loses system cards. Embank gift cards are either distributed by the retailer or by a gift card company. A gift card company is a separate legal entity that is formed by a company as a subsidiary for the sole purpose of administering the company’s gift card program. (Marred & Forsyth, 2007) Unlike cards from Visa or Mastered, other gift cards do not come under the Jurisdiction of federal banking laws.

This lack of legal regulation of embank gift cards leads to companies attaching a variety of conditions to their cards. Cards may carry monthly fees, carry activation fees, and may have an expiration date. These attachments aren’t as common as they used to be, however, due to customer complaints. The existence of these attachments on some cards however will influence how they are accounted for, as we will discuss later. (Marred ; Forsyth, 2007) Gift cards are prized by both companies and customers. Customers love them for several reasons.

They’re convenient, easy to use, easy to carry, and everyone appreciates them. There is no worry of getting the wrong gift and they’re appropriate for everyone be it family, friend or employee. While customers are limited to one retailer in using the card, they can purchase anything hey want from the retailer which can persuade people to buy items they otherwise wouldn’t have. (Marred & Forsyth, 2007) A recent survey has shown that 57% of adults wished to receive a gift card for the holidays in 2010. (Grant Thornton ALP. , 2011) Companies love gift cards even more than customers do.

Gift cards lead to increased sales, increased marketing opportunities, and help with cash flow and inventory management. Gift cards have a huge influence on sales. On top of the initial gift card purchase, customers are almost guaranteed to spend more than the amount of the gift card when they redeem it. The way that pricing works, customers are extremely unlikely to perfectly use up their gift cards with no excess paid out of pocket. Rather than leave a balance on the card, customers are inclined to treat the gift card amount as a minimum purchase price.

Studies have shown that customers spend an average of 1. 4 times the amount on their cards in the transaction where they redeem them. The prevalence of gift cards as holiday gifts effectively extends the holiday gist buying season, making the January and February clearance sales into some of the most lucrative non-holiday periods for companies. (Marred & Forsyth, 2007) Marketers love gift cards because they generate two customer contacts and two sales opportunities. Marketers can also use incremental information gathered from gift card transactions to design future marketing plans and promotions.

Gift cards benefit inventory management and cash flow in a big way as well. The delay in the transfer of inventory allows for significant operating cash flow benefits to a business by allowing them to purchase inventory over time instead of all at once. This delay also meaner that since gift cards are predominantly sold during the holiday season and redeemed in the off season, businesses will have mother COGS expenses over the entire period, instead of huge Jumps in COGS at one time. (Kill, 2007) As mentioned before, 10 to 19% of the value of all gift cards sold never gets redeemed.

Customers may lose a card, or intentionally fail to use it. Some customers forget to use up their balances before the expiration date. Some customers use the card and leave money left on the balance. This remainder is then either forgotten about or disregarded as being immaterial. Whatever the reason, these unredeemed cards can add much to a business’s bottom line, should they be allowed to recognize it. Kill, 2007) Gift cards do have a downside however. Any retail store that uses gift cards can fall victim to fraud, either due to customers or employees perpetrating the fraud.

Customers can shoplift cards, either using the cards themselves or stealing the authorization information from the magnetic strip with an electronic device. Stolen, fake, and empty cards are also frequently sold on auction sites or bargain sites. Employees are Just as likely to steal cards, but also have other opportunities to commit fraud. They may pretend a customer’s card is empty or deactivated and convince the customer to hand over the card. Or they may use sleight of hand to swap the customers card with an empty one.

Losses from fraud can be significant, but the benefits a company gains from its gift card program often far outweigh the losses. (Marred & Forsyth, 2007) Tax Accounting Implications Gift cards pose several problems when related to taxation. Most basic is at what point companies should recognize income for gift card sales for tax purposes? Gift card companies must be sure whether they can claim money received as for gift cards as income at all. When should gift card fees be recognized? How do state statement laws impact gift cards? All of these topics will be examined in this section.

Recognition In general revenues is recorded when it is earned for financial accounting purposes, and when it is received for tax purposes. Retailers that used gift cards understandably were resistant to this. To have all their gift card sales count upfront would make it so that they could not balance out these sales with their related expenses as they would not have been incurred yet. The IRS forbids realizing COGS before the cards is redeemed as it cannot be predicted what product will be purchased wit n the card. (Suitors &amp Bender 2009) It a company can properly use the advance payment deferral rules from Treasury Regulation S 1. 51-5 and Revenue Procedure 2004-34 then unredeemed gift card income can be deferred until up to the last day of the second tax year after the card is sold. (Smith, 2009)