Home » North America » Viewpoint: What Prepaid Card Issuers Need to Know about Breakage (July 2013)
Print view|Purchase Reprint
07.09.13

Viewpoint: What Prepaid Card Issuers Need to Know about Breakage (July 2013)

By Victoria Blake and Phillip C. Rouse, Card Compliant

The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) are slated to release, in third quarter 2013, Revenue Recognition Standards to provide guidance on accounting for breakage on certain cards, including the use of derecognition to harvest breakage into revenue. For certain card issuers reporting their financial statements under U.S. GAAP (issued by the FASB) or IFRS (issued by the IASB), the derecognition technique for managing prepaid card breakage soon may be a requirement.

Application of derecognition under the proposed accounting standards works well for cards that may be exempt from escheat, such as some types of gift, promotion or incentive cards. It does not work well for cards subject to escheat, such as many GPR cards. The proposed standards apply to closed-loop products, and many believe they extend to open-loop products redeemable only for goods and services as opposed to cards that are readily redeemable upon demand for cash. It’s important, therefore, for issuers to understand what breakage is, the various techniques for managing it and the requirements of the proposed Revenue Recognition Standards.

Breakage in a Prepaid Card Program

“Derecognition often is viewed as a consumer-friendly option for card issuers to manage breakage.”

Card issuers collect funds from consumers at the time of the sale in exchange for a promise to receive goods or services at a later date. Accounting standards call this promise a future performance obligation, which is shown as a liability on the card issuer’s accounting records. The performance obligation remains until the time at which goods or services are provided to the consumer or the duty to perform ceases per the cardholder agreement. Some cardholders, however, do not redeem all or part of a card for goods or services, resulting in unexercised customer rights, commonly referred to as breakage. Although time has now shown that the actual breakage on card programs is lower than was speculated by some in the beginning years of card programs, if not properly managed, accumulating liabilities from stale, unused cards will result in inflated obligations on the issuer’s financial statements. To manage this situation, card issuers utilize a variety of techniques to reduce the breakage amount.

Techniques to Manage Breakage

Many techniques are available to manage breakage in a prepaid program. Historically, card issuers gravitated toward models that utilized fees and/or expiration dates. Back-end fees are charged over time against the underlying liability until it is exhausted. Front-end fees are charged at the time of purchase and are used both as a way to cover the program costs and as a source of revenue to offset anticipated future breakage. Expiration dates cut off the unexercised customer rights, allowing the liability to be converted to income.

In addition to fees and expiration dates, some card issuers use a derecognition technique to manage breakage. Derecognition is an accounting technique of reducing card breakage by reducing the card liability on the balance sheet of a company. The accounting entry typically consists of reducing a liability account and increasing revenue. In programs using fees and/or expiration dates, card balances are reduced to reflect the fees and expiration dates at the time they are applied. In programs using the derecognition technique, card balances are not impacted as a result of derecognition. As such, derecognition often is viewed as a consumer-friendly option for card issuers to manage breakage.

Increasing Trend toward Derecognition

Regulatory pressures and consumer-friendly initiatives have placed pressures on card programs to use the derecognition technique to manage breakage. Commencing in the late 1990s and becoming prevalent in the first decade of 2000, federal and state laws have banned or limited the use of fees and expiration dates. In 2009, the CARD Act placed limits on the use of fees and expiration dates, following about 32 states that already had banned or restricted fees and expirations. In addition, consumer-friendly initiatives mounted against the use of fees and expiration dates in card programs. For example, Target launched a campaign based on the promotional phrase “No Fees, No Expirations, No Kidding” when it eliminated fees and expiration dates from its card program.


History of Derecognition

In 2005, the Securities and Exchange Commission (SEC) addressed derecognition of prepaid card breakage. In a speech delivered at the 2005 AICPA National Conference on Current SEC and PCAOB Developments, the SEC discussed the use of the derecognition technique in limited situations. The speech became the predominant guidance, relied upon by many card issuers, regarding derecognition of breakage.

Proposed Derecognition Standard

The Financial Accounting Standards Board, jointly with the International Accounting Standards Board (collectively the “Boards”), is engaged in a joint project to create uniform accounting standards for the recognition of revenue. This project resulted in the Boards issuing the November 2011 Exposure Drafts (the “ED”) proposing guidance regarding recognition of breakage revenue through use of the derecognition technique.

The ED states a card issuer “should” derecognize breakage if the issuer is reasonably assured of the breakage amount or when otherwise appropriate under the guidance. To apply the “reasonably assured” standard: (1) the entity applying the standard must have experience with similar types of performance obligations and (2) the entity’s experience or other evidence must be predictive. For prepaid card programs this means the transaction data used to forecast the breakage amount for the card portfolio must be regarding similar cards and must be predictive in nature.

Proportionate and Remote Methods

The ED provides for two methods by which derecognition of breakage should be implemented: proportionate and remote. If the “reasonably assured” standard is met, the entity should recognize the expected breakage as revenue “in proportion to the pattern of rights exercised by the customer.” The Boards decided that the proportionate approach “represents the most appropriate pattern of revenue recognition for breakage.” However, if the “reasonably assured” standard is not met, the entity should recognize the expected breakage as revenue when the “likelihood of the customer exercising its remaining rights becomes remote.” The term “remote” is not defined; however, statistical support will likely be needed to support the determination.

Under the remote method, breakage is taken to revenue in a lump sum amount at a specific time, such as after two years of issuance; while under the proportionate method, the breakage is amortized over the course of the two years. In other words, breakage would be taken to revenue in proportion to the pattern of rights exercised, likely over the same two-year period.

The Escheat Factor

The guidance in the ED is consistent with the premise that cards subject to escheat cannot be derecognized as the liability is owed to the state when the cards reach presumed abandoned status under an unclaimed property law. If the card must be escheated, it cannot be taken to revenue. Issuers must take appropriate steps to determine if the breakage is escheatable property before using the derecognition technique.

Conclusion

The march toward using derecognition as a tool to manage breakages continues with its recognition in the proposed Revenue Recognition Standards to be issued by the FASB and the IASB. The new standards provide direct guidance on application of the technique in a wide array of prepaid card programs.

CPA Tori Blake leads Card Compliant’s accounting technologies and operations teams. She holds a BS in accounting from Kansas State University and an MS in accounting from the University of Missouri, Kansas City. Previously, she was an auditor at Ernst & Young.

Chuck Rouse has practiced extensively in the area of regulatory compliance and breakage management for stored value card products. He is chairman of StoreFinancial Services LLC and Card Compliant LLC. StoreFinancial is a full-service transaction processor and administrator of open-loop and restricted authorization network (RAN) prepaid card programs, managing 400+ card programs in the United States, Canada and Europe. Card Compliant is a compliance specialty company serving the prepaid and stored value card industry, providing technology supported and processed solutions to regulatory compliance challenges encountered in administering card programs.

In Viewpoints, prepaid and emerging payment professionals share their perspectives on the industry. Paybefore endeavors to present many points of view to offer readers new insights and information. The opinions expressed in Viewpoints are not necessarily those of Paybefore.

Comment

Your email address will not be published. Required fields are marked *

By clicking below, I acknowledge that my contact information will be shared with the companies whose files I am accessing on Pay Connect so they can contact me directly about their products or services. Please refer to their privacy policies for details on how your information will be used. Paybefore uses cookies to store this data so you will not need to re-enter it.

To sign up for Paybefore e-newsletters and announcements, click here.  http://paybefore.com/enewsletter-subscriptions/

  • This field is for validation purposes and should be left unchanged.
X