Breakage

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• deferred revenue
• liability
• revenue recognition
• accounting standards
• financial reporting
• profit margins
• liquidity
• cash flow
• balance sheet
• financial statements
• unclaimed property
• escheatment
• consumer protection
• economic incentives
• intangible assets

What Is Breakage?

Breakage refers to the portion of a prepaid service or product, such as a gift card, loyalty program points, or service contract, that goes unused or unredeemed by the customer. In financial accounting, breakage represents revenue for a company because the initial payment for the product or service has been received, but the corresponding good or service is never delivered. This concept falls under the broader financial category of revenue recognition and impacts a company's financial statements. Companies often record the initial sale as a deferred revenue and later recognize breakage as revenue once it's deemed highly probable the customer will not redeem the outstanding balance.

History and Origin

The concept of breakage has existed as long as pre-paid services and goods have, but it gained significant attention with the proliferation of gift cards and loyalty programs. Before widespread regulation, companies often benefited substantially from unredeemed balances and even expiration dates or inactivity fees that effectively reduced the value over time.

For instance, companies like Starbucks have reported substantial amounts in unredeemed gift card balances, which translates into breakage revenue. In 2021, Starbucks recognized $155 million in profit from unused loyalty and gift card money.²¹ The practice, while legal and common, has faced scrutiny, with some groups alleging that payment platforms are designed to encourage customers to leave unspent money.²⁰

The rise of consumer protection laws, particularly concerning gift cards, has influenced how breakage is handled. A federal law enacted in 2010 stipulated that most gift cards cannot expire for at least five years from the purchase date, with some states imposing even longer periods.¹⁹ This legislation aimed to curb the practice of companies benefiting excessively from unused balances by setting short expiration terms.

Key Takeaways

• Breakage represents unredeemed or unused portions of prepaid products or services.
• It is recognized as revenue by companies once the likelihood of redemption becomes remote.
• Common examples include unspent gift card balances and unused loyalty points.
• Breakage can significantly impact a company's profit margins and overall financial reporting.
• Consumer protection laws have been enacted to regulate aspects of breakage, particularly regarding gift card expiration.

Formula and Calculation

The calculation of breakage is not a precise formula applied universally, but rather an estimation based on historical data and company-specific assumptions. Companies estimate the portion of prepaid balances that they expect will never be redeemed.

One common method involves calculating the estimated breakage rate and applying it to the total outstanding prepaid balance:

Where:

• Total Prepaid Balance represents the aggregate value of outstanding gift cards, loyalty points, or other prepaid services.
• Estimated Breakage Rate is the percentage of the prepaid balance that the company anticipates will go unredeemed, typically derived from historical redemption patterns and statistical analysis.

Companies often link their estimated breakage rate to the historical behavior of similar prepaid programs. This estimation is a critical component of accounting standards for revenue recognition.

Interpreting the Breakage

Interpreting breakage involves understanding its implications for a company's financial health and business model. A higher breakage rate generally means more revenue for the company without the corresponding cost of goods or services delivered, positively impacting cash flow. For example, Starbucks generated $212 million in revenue from breakage in 2022.¹⁸ This effectively represents "free money" for the company.¹⁷,¹⁶

However, companies must carefully balance the benefits of breakage with the risk of customer dissatisfaction. While some unredeemed balances are due to genuine forgetfulness, excessively high breakage might also signal that a product or service is not being fully utilized or that consumers find it difficult to redeem. Regulators and consumer advocates closely monitor breakage, particularly concerning consumer protection issues, to ensure fair practices.

Hypothetical Example

Consider "GymCo," a fictional fitness chain that sells annual memberships. Each membership costs $500, and GymCo sells 10,000 memberships in a year, totaling $5,000,000 in sales. Based on historical data, GymCo has determined that approximately 5% of its members do not fully utilize their memberships or cancel early without a refund, leading to breakage.

At the time of sale, GymCo initially records the $5,000,000 as deferred revenue on its balance sheet because the service has not yet been fully delivered. As the year progresses, GymCo will recognize the revenue proportionally as members use the gym or as the membership period passes.

However, after analyzing past trends, GymCo estimates that 5% of these memberships will remain unused.

This $250,000 represents the estimated breakage revenue that GymCo can recognize over the membership period, as it becomes highly probable that these services will not be rendered. This additional revenue directly boosts the company's profitability.

Practical Applications

Breakage has several practical applications across various industries and financial contexts:

• Gift Cards and Prepaid Cards: This is arguably the most common and visible application of breakage. Retailers and service providers often generate significant income from unused gift card balances. A survey by Bankrate found that nearly half of U.S. adults had at least one unspent gift card or voucher with an average value of $187, totaling $23 billion.¹⁵,¹⁴
• Loyalty Programs: Unredeemed points in customer loyalty programs (e.g., airline miles, hotel points, retail rewards) also contribute to breakage. Companies record these points as a liability until they are redeemed, and any points that expire or are not used become breakage revenue.
• Service Contracts and Subscriptions: In some service-based businesses, a portion of prepaid service contracts or subscriptions might go unused. For instance, prepaid phone cards or unused sessions in a personal training package can lead to breakage.
• Regulatory Compliance: Due to the financial implications, breakage is subject to regulatory oversight. The Federal Trade Commission (FTC) provides consumer advice regarding gift cards, emphasizing that gift cards are for gifts and not for payments, particularly in the context of scams.¹³,¹² Moreover, unclaimed property laws in many states may require companies to remit unredeemed balances to the state as unclaimed property after a dormancy period.¹¹,¹⁰,⁹

Limitations and Criticisms

While breakage can be a significant source of revenue for businesses, it also faces limitations and criticisms. One primary concern revolves around the ethics of profiting from unused customer funds. Critics argue that companies might have economic incentives to make redemption difficult or to encourage small, unredeitable balances. For instance, some companies have been accused of structuring their payment platforms in ways that make it challenging for customers to fully zero out their balances.⁸

Another limitation is the potential for negative consumer perception. If customers feel that companies are unduly profiting from their unused balances, it can lead to a loss of trust and reputational damage. While federal laws dictate that gift cards must be valid for at least five years, some states allow inactivity fees after a certain period, which can erode the card's value.⁷,⁶

Furthermore, the accounting for breakage relies on estimates, which can be subject to manipulation or error. Companies use historical data to project future redemption rates, but significant shifts in consumer behavior or market conditions could impact the accuracy of these projections. In some cases, states may require companies to turn over unredeemed gift card balances to state unclaimed property programs through a process known as escheatment.⁵,⁴,³ This can reduce the amount of breakage revenue a company can ultimately recognize.

Breakage vs. Unclaimed Property

Breakage and unclaimed property are related but distinct financial concepts, both dealing with unutilized customer funds. The key difference lies in the ultimate recipient of the funds and the legal framework surrounding them.

Breakage refers to the portion of prepaid value (like gift cards or loyalty points) that a company estimates will never be redeemed by the customer. This unredeemed portion is eventually recognized as revenue by the company. It's essentially a business's profit from services or products that were paid for but never delivered.

Unclaimed property, on the other hand, refers to financial assets that have been abandoned or forgotten by their rightful owners for a specified period, as defined by state law. Examples include dormant bank accounts, uncashed checks, forgotten utility deposits, or even the cash value of unredeemed gift cards that have passed a dormancy period. These assets are eventually remitted to state governments, which then attempt to reunite them with their owners. The National Association of Unclaimed Property Administrators (NAUPA) is a key organization in this process.²,¹

The confusion often arises because unredeemed gift card balances, which contribute to breakage, can eventually become unclaimed property if they remain unused for a prolonged period and are subject to state escheatment laws. However, a company's ability to recognize breakage revenue is typically based on its internal estimates and historical data, while the obligation to remit funds as unclaimed property is a legal requirement enforced by state regulations.

FAQs

How do companies account for breakage?

Companies typically record the initial sale of a prepaid item, such as a gift card, as a deferred revenue or liability on their balance sheet. As the probability of redemption decreases over time, or after a certain period determined by historical patterns, the estimated unredeemed portion (breakage) is recognized as revenue. This process adheres to specific accounting standards and principles related to revenue recognition.

Is breakage legal?

Yes, breakage is generally legal. Businesses are allowed to recognize revenue from unredeemed prepaid balances. However, the recognition of breakage is subject to various regulations, particularly regarding expiration dates and dormancy periods for gift cards. Many jurisdictions have consumer protection laws that dictate how long gift cards must remain valid and whether inactivity fees can be charged. After a certain period, some unredeemed balances may also become subject to state unclaimed property laws.

What happens to unused gift card money?

When a gift card is purchased, the money is typically held by the issuing company as a liability or deferred revenue. If the gift card is not fully redeemed, the unspent portion can eventually become breakage revenue for the company, particularly if the company determines it's highly unlikely to be redeemed. In some cases, if the gift card remains unused for a long period as defined by state law, the funds may be turned over to the state as unclaimed property through the process of escheatment, and the state will then try to locate the rightful owner.