Breakage definition
/What is Breakage in Accounting?
Breakage is that amount of revenue generated from unclaimed prepaid services or unused gift cards. The amount of breakage is difficult to estimate in advance, which can complicate the related accounting. Breakage results in pure profit for retailers, since there is no offsetting cost of goods sold. However, state governments sometimes claim breakage revenue under their escheatment laws; under these laws, the company forwards the unused funds to the government, from which customers can then make claims.
How to Estimate Breakage
A seller can estimate breakage by analyzing historical redemption patterns and applying statistical modeling to predict the percentage of prepaid services or gift cards that will remain unused. This process typically involves reviewing past data on similar offerings to determine the proportion of customers who never redeem their balances. Companies may also segment customers based on behavior, such as purchase frequency or average transaction size, to refine their estimates. Additionally, sellers often use a probability-based approach, recognizing breakage revenue over time as it becomes increasingly unlikely that the remaining balances will be used. Regular updates to breakage estimates are necessary to reflect changes in customer behavior and ensure accurate financial reporting.
Dormancy Fees
Some retailers who issued gift cards used to charge a small annual “dormancy fee” on the unused balances stored on these cards. By doing so, they were able to gradually recognize the unused amounts as fee revenue. However, the Federal Trade Commission has sued several companies for this practice, on the grounds that the fees were not properly disclosed to customers.
Example of Breakage
A mother buys a $100 gift card for her daughter. The seller receives $100 from the mother in exchange for the card, which is essentially an obligation of the seller to provide goods to the daughter at a later date. She then uses the card to make purchases totaling $96, after which she discards the card. The unused $4 on the gift card represents breakage for the seller.