Chapter 8 — Step 5: Determine When to Recognize Revenue

8.8 Customers’ Unexercised Rights — Breakage

ASC 606-10

55-46 In accordance with paragraph 606-10-45-2, upon receipt of a prepayment from a customer, an entity should recognize a contract liability in the amount of the prepayment for its performance obligation to transfer, or to stand ready to transfer, goods or services in the future. An entity should derecognize that contract liability (and recognize revenue) when it transfers those goods or services and, therefore, satisfies its performance obligation.

55-47 A customer’s nonrefundable prepayment to an entity gives the customer a right to receive a good or service in the future (and obliges the entity to stand ready to transfer a good or service). However, customers may not exercise all of their contractual rights. Those unexercised rights are often referred to as breakage.

55-48 If an entity expects to be entitled to a breakage amount in a contract liability, the entity should recognize the expected breakage amount as revenue in proportion to the pattern of rights exercised by the customer. If an entity does not expect to be entitled to a breakage amount, the entity should recognize the expected breakage amount as revenue when the likelihood of the customer exercising its remaining rights becomes remote. To determine whether an entity expects to be entitled to a breakage amount, the entity should consider the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration.

55-49 An entity should recognize a liability (and not revenue) for any consideration received that is attributable to a customer’s unexercised rights for which the entity is required to remit to another party, for example, a government entity in accordance with applicable unclaimed property laws.

Paragraph BC397 of ASU 2014-09 notes that the FASB and IASB decided to include in ASC 606-10- 55-46 through 55-49 (paragraphs B44 through B47 of IFRS 15) specific implementation guidance on the accounting for breakage (i.e., “situations in which the customer does not exercise all of its contractual rights” to goods or services in the contract) in contracts for which there is only a single performance obligation. The boards note that in other arrangements (i.e., those with multiple performance obligations), breakage is generally addressed by the guidance on accounting for a material right (see Chapter 11) and the allocation guidance in step 4 (see Chapter 7 for further discussion). In light of this, the next sections take a deeper dive into the application of the revenue standard’s implementation guidance on breakage.

8.8.1 Accounting for Sales of Gift Certificates That May Not Be Redeemed

Gift certificates sold by a retailer can be used by the holder to purchase goods up to the amount indicated on the gift certificate. Typically, they represent a nonrefundable prepayment to an entity that gives the customer a right to receive goods or services in the future (and obliges the entity to stand ready to transfer the goods or services). Under ASC 606, revenue should be recognized when (or as) an entity satisfies a performance obligation by transferring a promised good or service to a customer. In this case, the retailer satisfies its performance obligation when the customer redeems the gift certificate and the retailer supplies the associated goods or services to the customer. Accordingly, upon receipt of a prepayment from a customer, the retailer should recognize a contract liability for its performance obligation to transfer, or to stand ready to transfer, the goods or services in the future. The entity should derecognize that contract liability (and recognize revenue) when it transfers those goods or services and, therefore, satisfies its performance obligation.

Customers may not exercise all of their contractual rights for various reasons. ASC 606 states that such unexercised rights are often referred to as breakage. Under ASC 606-10-55-46 through 55-49, breakage can be recognized in earnings before the vendor is legally released from its obligation in certain circumstances. For example:

ASC 606-10-55-48 states, in part, “If an entity expects to be entitled to a breakage amount in a contract liability, the entity should recognize the expected breakage amount as revenue in proportion to the pattern of rights exercised by the customer” (emphasis added). Under this approach, the estimated value of gift certificates that an entity expects will not be redeemed would be recognized as revenue proportionately as the remaining gift certificates are redeemed. For example, assume that a retailer issues $1,000 of gift certificates and, in accordance with ASC 606-10-32-11 through 32-13, expects that $200 of breakage will result on the basis of a portfolio assessment indicating that 20 percent of the value of all gift certificates sold will not be redeemed. Therefore, the proportion of the value of gift certificates not expected to be redeemed compared to the proportion expected to be redeemed is 20:80. Each time part of a gift certificate is redeemed, a breakage amount equal to 25 percent (20 ÷ 80) of the face value of the redeemed amount will be recognized as additional revenue (e.g., if a gift certificate for $40 is redeemed, the breakage amount released will be $10, such that the total revenue recognized is $50).
Entities should not recognize breakage as revenue immediately upon the receipt of payment, even if there is historical evidence to suggest that for a certain percentage of transactions, performance will not be required. As noted in paragraph BC400 of ASU 2014-09, the FASB and IASB “rejected an approach that would have required an entity to recognize estimated breakage as revenue immediately on the receipt of prepayment from a customer. The Boards decided that because the entity has not performed under the contract, recognizing revenue would not have been a faithful depiction of the entity’s performance and also could have understated its obligation to stand ready to provide future goods or services.”
For an entity to determine whether it expects to be entitled to a breakage amount, the entity should consider the requirements in ASC 606-10-32-11 through 32-13 on constraining estimates of variable consideration. The entity should use judgment and consider all facts and circumstances when applying this guidance.
ASC 606-10-55-48 also states, “If an entity does not expect to be entitled to a breakage amount, the entity should recognize the expected breakage amount as revenue when the likelihood of the customer exercising its remaining rights becomes remote” (emphasis added). For example, assume that a retailer issues $1,000 of gift certificates and applies the guidance in ASC 606-10-32-11 through 32-13 but concludes that it does not expect to be entitled to a breakage amount. Each time part of a gift certificate is redeemed, revenue will be recognized that is equal to the face value of the redeemed amount. Later, after $800 has been redeemed, the entity may determine that there is only a remote possibility that any of the outstanding gift certificate balances will in due course be redeemed. If so, the entity will release the remaining contract liability of $200 and recognize revenue of $200 at that time.

8.8.2 Changes in Expectation of Breakage After Initial Allocation of Revenue

Although the breakage guidance in ASC 606-10-55-48 specifically refers to the section on constraining estimates of variable consideration (the “constraint” in ASC 606-10-32-11 through 32-13), breakage is not a form of variable consideration because it does not affect the transaction price. In the absence of variable consideration, the requirement in ASC 606-10-32-14 to reassess the transaction price at the end of each reporting period does not apply. Therefore, a change in the estimate of breakage will not cause the original amount allocated to the expected breakage to be amended. However, the expected breakage could affect the timing of recognition of revenue because an entity that expects to be entitled to a breakage amount is required under ASC 606-10-55-48 to “recognize the expected breakage amount as revenue in proportion to the pattern of rights exercised by the customer.”

The example below illustrates how changes in expected breakage could affect the timing of revenue recognition.

Example 8-18

Entity M sells a product to Customer H and, as part of the same transaction, awards H a specific number of loyalty points that can be redeemed at a future date as and when the customer purchases additional products from M. The sale is made for cash consideration of $100, and no refund is available to the customer for unused loyalty points.

In accordance with ASC 606, M is required to allocate the revenue between the product sold and the loyalty points (material rights) that can be redeemed in the future. On the basis of a relative stand-alone selling price method (which would include expectations related to the level of loyalty points that will not be redeemed [i.e., “breakage”]), M determines that the appropriate allocation is $80 to the product sold and $20 to the loyalty points.

Because breakage is not a form of variable consideration (in this example, M always remains entitled to the original cash consideration of $100), the requirement in ASC 606-10-32-14 to reassess the transaction price at the end of each reporting period does not apply. Therefore, a change in the estimate of breakage will not cause the original allocation of $80 to the product and $20 to the points to be amended.

The expected breakage could, however, affect the timing of recognition of revenue with respect to the $20 allocated to the loyalty points. This is because M is required under ASC 606-10-55-48 to “recognize the expected breakage amount as revenue in proportion to the pattern of rights exercised by the customer.”

Similarly, if M sells gift cards on a stand-alone basis, the transaction price will be fixed at the amount paid by the customer irrespective of the expected breakage amount. Thus, the expected breakage affects only the timing of revenue recognition, not the total amount of revenue to be recognized, and therefore is not a form of variable consideration.

See Section 8.8.1 on accounting for sales of gift certificates that may not be redeemed.

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This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.