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.
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.
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.
- 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.