Gift Cards Keep Giving to Retailers

When retailers say gift-card sales have been a boon to their profits, they aren’t kidding. Given the loose accounting rules for the cards, they can easily be used to goose the bottom line.

That’s because merchants have lots of leeway in deciding when to count the cash from gift card sales as revenue on their income statements.

They can base their decisions on such metrics as how many customers will actually use their cards in full and how quickly that could happen.

As a result, gift cards can distort a merchant’s finances and be used to manage earnings, something that securities regulators are starting to crack down on.

Gift cards have ballooned in popularity in recent years. The National Retail Federation estimates that $18.5 billion in cards will be sold this holiday season, up more than $1 billion, or 6.6%, from a year ago.

In fact, they are the No. 1 gift choice for many shoppers, with two-thirds of consumers expected to buy on average almost five gift cards this holiday season, according to an October survey of about 17,500 consumers by Deloitte & Touche.

Yet even though the cards are given as gifts, that doesn’t mean they are always used in full. The Deloitte survey found that respondents had an average of two unused cards from last year, and only 48% had used up all the cash on the cards they received as gifts. The survey also found that nearly 4% of gift cards were more than 5 years old.

Retailers do what they can to get shoppers to spend their gift-card dollars in full -- like setting expiration dates or charging service fees when they haven’t been used within a certain time frame. But that still doesn’t spur some shoppers to buy.

This presents a tricky predicament for retailers. They get paid when gift cards are purchased, but technically they still owe something to consumers. That means merchants can’t officially book that revenue at the time of sale but have to carry a liability on their balance sheets until the status of the cards changes.

But when is it appropriate to wipe out the liability on unused portions of the cards, which is known as “breakage” in accounting circles, and shift that money to the income statement?

During a recent accounting conference in Washington, Securities and Exchange Commission accounting fellow Pamela Schlosser said that should happen when the cards were redeemed or expired, when redemption became remote or when the company could “reasonably and objectively” estimate what percentage of its card sales would go unredeemed.

That gives companies some wiggle room. As Bear, Stearns & Co. accounting analyst Pat McConnell points out, estimates could be based on historical experiences, but a lot will depend on the circumstances of each company.

In addition, state laws could also affect how and when companies can make such reversals.

Companies also don’t have to say how they come up with their reversal figures, or why the “breakage” is taking place at a given time.

“Disclosure of gift card accounting methods is typically sketchy and general in nature based on our review of SEC filings,” McConnell said in a recent note to clients.

All this matters because if the accounting rules are inconsistent and give companies lots of discretion, that means they can tap that “breakage” money when they might need it most.

The hope is that companies will do the right thing, but investors should know to watch what companies are doing and when.

For instance, consumer electronics retailer Best Buy Co. reported Dec. 13 that it got a nice lift to its fiscal third-quarter earnings by reducing its liability from gift cards purchased from 1995 through 2003. That totaled $29 million on a pretax basis, or 4 cents a share after taxes.

The good news for investors is that this issue is on the SEC’s radar. Schlosser noted during her talk that the agency had recently dealt with an issue of a company too quickly shifting part of the liability off its books. The SEC declined to name the company.