Many contracts allow customers to pay now for goods or services to be delivered later, when the customer asks for them. For some transactions, customers never fully exercise their rights to the goods or services provided in the contract. Within practice, customers failing to exercise their contractual rights is referred to as “breakage.” Accounting Standards Codification (ASC) 606 allows entities to estimate the amount of consideration related to obligations that they do not expect to be required to fulfill. This article examines the new guidance related to these transactions, discusses a potential issue in practice, and summarizes the differences between ASC 605 and ASC 606.
There are two potential methods for recognizing revenue associated with breakage amounts (ASC 606-10-55-46 and 55-47):
- If the entity expects some amount of breakage, then it should treat the estimated breakage amount as variable consideration, possibly subject to the constraint (see Variable Consideration and the Constraint). 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 recognizing breakage revenue would understate the entity’s obligation to stand ready to provide future goods and services. For a discussion of other situations where an entity is obligated to stand ready to provide a good or service, see Stand-Ready Obligations.
- If the entity does not expect breakage, then it should wait to recognize revenue on breakage amounts until it determines that the likelihood of the customer exercising its 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.
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.
Diversity in Thought
Issue 1: How should revenue be allocated to performance obligations that include a possibility of breakage?
The standard is silent on how to allocate revenue to the different performance obligations in the contract when the entity expects breakage. Generally, when a contract includes multiple performance obligations, and there is a discount in the total consideration due to the vendor, revenue is allocated to performance obligations on the basis of their standalone selling prices. It is clear that in cases where standalone sales of the performance obligation exist, the standalone selling price should be used. However, when standalone selling price must be estimated, questions have arisen about whether the estimated standalone selling price of performance obligations with possible breakage amounts should be the total price of that performance obligation, or whether the price should be adjusted downward to reflect the expected breakage amount.
To make the distinction more clear, consider the following facts:
On January 1, 2015, 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% 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 A: Assume that the standalone selling price of the gift card is $200, the face value of the card. Further assume that Vendor Y considered the constraint, and determined that the estimate of breakage did not need to be constrained. Consideration would be allocated as follows:
Of the $173 of revenue allocated to the gift card, $35 (20% * $173 = $35) will be recognized as breakage revenue as the customer uses the gift card in payment of future purchases, as shown below. The remaining $138 will be recognized as revenue related to the gift card proportionately as the customer redeems gift card amounts.
The following journal entries would be made on January 15, when products A and B are delivered:
Contract Liability – products A and B: ……………$1,727
….Revenue from products A and B: …………………………….$1,727
Recognizing the revenue allocated to Products A and B ($1,036 + $691 = $1,727)
When Customer U redeems $100 of the gift card, they are redeeming 62.5% ($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% * $138 = $ 86) and the revenue attributed to breakage amounts (62.5% * $35 = $22). The following journal entries would be made on March 15, when Customer U redeems $100 of the gift card:
Contract Liability – gift card and breakage: ……$108
….Revenue – gift card: ………………………………………………….$86
….Revenue – breakage: ………………………………………………..$22
Note that these accounts are disaggregated in this manner for illustration purposes.
Analysis B: Assume that the standalone selling price of the gift card is $160, the actual amount that Vendor Y expects to be required to redeem.
As above, $28 (20% * $140 = $28) of the $140 allocated to the gift card 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:
Contract Liability – products A and B: ……………$1,760
….Revenue from products A and B: …………………………….$1760
Recognizing the revenue allocated to Products A and B ($1,055 + $705 = $1,760)
In this scenario, the customer is once again exercising 62.5% of the amount they are expected to exercise, so Vendor Y will recognize 62.5% of both the amount related to the gift card (62.5% * $112 = $70) and to the breakage amount (62.5% * $28 = $18) on March 15.
Journal Entries on March 15:
Contract Liability – gift card and breakage: ……$88
….Revenue – gift card: …………………………………………………..$70
….Revenue – breakage: …………………………………………………$18
Note that these accounts are disaggregated in this manner for illustration purposes.
View A. The face value of performance obligations before expected breakage should be used as the standalone selling price for the purposes of allocating the transaction price. This is consistent with Analysis A in the example above. Proponents of this view argue that the value of the performance obligation (in this case the gift card) should reflect the price of the other goods or services that could be purchased on a standalone basis with the card. The entity can be obligated to provide goods and services in the amount of the full value of the gift card. This would make it inappropriate to discount the standalone selling price, as this might understate the liability an entity has to provide future performance. View A also has the advantage of using only the face value of the gift card as an input, which may qualify as an observable input (note that 606-10-32-33 requires maximizing observable inputs in an estimated selling price).
Proponents of view A would apply this reasoning to other performance obligations with expected breakage. As in the example above, this allocates more consideration to the performance obligation with the expected breakage, which would usually result in less revenue upfront and more revenue being recognized over time.
View B. The face value of performance obligations may be reduced by the expected breakage amount before being used to allocate the transaction price in a transaction. This is consistent with Analysis B in the example above. Proponents of view B would argue that 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. Basis for Conclusion (BC) 398 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. Proponents of view B might use this paragraph as support of the idea that in many cases, the true “standalone selling price,” of these performance obligations would be less than the face value or maximum possible performance under the contract.
Proponents of view B might additionally note that there is precedent in practice for selling gift cards on a standalone basis at 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. In order to apply view B, management must be able to support the assertion that they would sell the gift card (or other performance obligation) at a price less than the face value on a standalone basis. For example, if an entity can show that the gift card was given with the intent of improving customer loyalty, it may be able to make the case that the standalone selling price of the gift card should be reduced by the breakage amount.
In cases with no standalone sales, applying view B could be difficult in light of the requirement to “maximize observable inputs,” when estimating standalone selling price. Proponents of view B would not necessarily argue that all performance obligations should use the standalone selling price of the performance obligation reduced by breakage, only that it would often be appropriate to do so. The approach in view B allocates less consideration to the performance obligation with expected breakage, and would probably accelerate revenue recognition in most cases.
Both views have logical arguments for and against their positions, and both are probably defensible. We believe that generally, view A will be preferable, because it reflects the amount of consideration theoretically available to the customer, and it also avoids understating the liability that the company has to provide future performance. However, view B could be appropriate in some situations as well. An entity should consider the nature of the performance obligation, and possibly management’s intent in contracting for the performance obligation with breakage, in determining which allocation method is most appropriate.
Comparison to 605
Breakage was not specifically addressed under ASC 605, so practice had developed based on a Securities and Exchange Commission (SEC) speech from 2005. In practice, vendors recognized revenue either when the vendor’s legal obligation had passed (such as on an expiration date), or when the probability of the customer exercising its right had become remote. Recognizing revenue when the probability of the customer exercising its right had become remote required that an entity have a large population of homogenous transactions. It further required the entity to be able to objectively estimate both the amount and timing of breakage. Breakage subject to escheat laws was recognized as a liability.
These practices are similar to the guidance under ASC 606, but more restrictive. Entities that do not expect breakage are allowed to continue recognizing revenue when the probability of each customer exercising its rights becomes remote. Entities that expect breakage will probably now recognize revenue earlier, except in cases where the entity already met the criteria outlined above.
It is also worth noting that many vendors, especially those in the retail industry, currently recognize breakage as a contra-expense in SG&A. This practice started because companies felt that breakage was not an earnings event, and recognizing breakage as revenue would improperly overstate gross margins. This treatment has not been objected to by the SEC in the past, but ASC 606 appears to require that breakage be recognized in revenue rather than as a contra-expense.
Treatment for breakage was not directly addressed by ASC 605, so practice had developed in industry. These practices are similar to the application of the requirements of ASC 606, but ASC 606 should be less restrictive about recognizing revenue for breakage amounts in situations where the entity expects some customer rights to go unexercised. Whereas practice had relatively restrictive requirements in such situations, entities are now allowed to make reasonable estimates of the breakage amount, and recognize revenue related to breakage in proportion to the actual satisfaction of that performance obligation.
- ASC 606-10-55-47 to 55-49.
- ASU 2014-09: “Basis for Conclusions.” BC 396-401.
- Deloitte, Revenue From Contracts With Customers: “A Roadmap to Applying the Guidance in ASU 2014-09.” February 2015. Section 7.6 “Customers Unexercised Rights.”
- EY, Financial reporting developments: “Revenue from contracts with customers.” Revised August 2016. Section 7.8 “Breakage and prepayments for future goods or services.”
- KPMG, Issues In-Depth: “Revenue from Contracts with Customers.” May 2016. Section 10.5 “Customers’ unexercised rights (breakage).”
- PWC, “Revenue from contracts with customers.” August 2016. Section 7.4 “Unexercised rights (breakage).”