What it means
Retailers, airlines, telecoms companies, restaurants, software providers and anyone else who takes money in advance for something to be delivered later accumulate a pool of customer prepayments. Some of that pool will never be drawn down.
Cards are lost, forgotten, given to someone who does not shop at the store, or partly used with a small balance abandoned. Historically, companies varied widely in how they treated this: some recognised nothing until a card legally expired, some took the whole balance to income after a fixed period, and some never released it at all.
Current revenue standards (IFRS 15 and ASC 606) set a single approach. If the company expects to be entitled to a breakage amount, meaning it has reliable historical data showing that a predictable proportion goes unredeemed, it recognises that breakage as revenue in proportion to the pattern of rights exercised by customers.
In plain terms: if experience shows that 10% of gift card value is never used, then as customers redeem the other 90%, the company recognises breakage revenue alongside each redemption, so that when redemptions are complete the full amount has been released. If the company cannot estimate breakage reliably, it waits until the likelihood of redemption becomes remote, usually at legal expiry.
Two constraints limit breakage. First, in many jurisdictions unclaimed property or escheat laws require unredeemed balances above certain thresholds to be paid to the state after a period of dormancy; that portion is not the company's to recognise as revenue and must remain a liability until remitted.
Second, consumer protection rules in some places prohibit expiry of gift cards or limit fees on dormant balances, which changes the redemption pattern and the estimate. Breakage matters financially because prepaid pools can be very large.
A big retailer may carry hundreds of millions in gift card liabilities, and a breakage rate of a few percentage points is a material profit item. It also matters for cash: gift card sales are cash received today for goods delivered later, an interest-free loan from customers, and breakage is the portion of the loan that is never repaid.
Loyalty programmes work the same way: points issued create a deferred revenue liability, and the expected proportion that will expire unused is released as members redeem. Because the estimate drives revenue, it must be reviewed regularly against actual redemption data, and changes in customer behaviour (a new app that makes balances visible, an economic downturn, a change in expiry policy) change the rate.
Auditors focus on the historical data supporting the rate and on the consistency of the pattern used.
In practice
Real-world examples.
Example
An airline estimates that 12% of loyalty miles will expire unused and recognises that proportion as revenue as members redeem the rest.
Example
A software company with prepaid usage credits that expire annually recognises the expected unused credits over the year in line with consumption.
Example
A theatre with unclaimed ticket refunds and unused vouchers reviews its breakage rate after a new app cuts the forgotten-balance rate from 9% to 5%.
Think of it
“Breakage is money from gift cards people never use-revenue from unredeemed stored value.
Formula
Calculation
Expected Breakage = Total value issued x Expected breakage rate
Breakage Revenue in period = Redemptions in period / Expected total redemptions x Expected breakage
Worked example. A restaurant group sells $2,000,000 of gift cards in December. Historical data over five years shows that 8% of gift card value is never redeemed, and that redemptions follow a stable pattern: 50% within three months, 30% in the next three, 15% in the following six, and the remaining 5% over the next two years.
- Expected redemptions = $2,000,000 x 92% = $1,840,000
- Expected breakage = $2,000,000 x 8% = $160,000
- On sale: debit cash $2,000,000, credit gift card liability $2,000,000. No revenue.
First quarter: customers redeem $920,000 (50% of expected redemptions). Breakage recognised in proportion = 50% x $160,000 = $80,000.
- Revenue recognised = $920,000 (meals delivered) + $80,000 (breakage) = $1,000,000
- Liability remaining = $2,000,000 minus $1,000,000 = $1,000,000
Second quarter: redemptions $552,000 (30% of expected). Breakage = 30% x $160,000 = $48,000. Revenue $600,000. Liability $400,000.
After two and a half years, when redemptions total $1,840,000, all $160,000 of breakage has been recognised and the liability is nil. The company has recognised $2,000,000 of revenue in total: $1,840,000 for meals actually served and $160,000 for meals that will never be claimed. Had it waited for legal expiry, the $160,000 would have arrived in one lump in year three, distorting both years.
If the state's unclaimed property law required 60% of unredeemed balances to be remitted after three years, the company could recognise only 40% of the unredeemed value as breakage ($64,000) and would hold $96,000 for remittance to the state.Case study
Seen in the real world.
A national coffee chain had for years recognised unredeemed gift card balances as revenue in full after two years of inactivity. The amount had grown with the business and reached $14 million in the latest year, all recognised in the fourth quarter. When the group adopted the current revenue standard, its auditors required a change to proportional recognition based on the redemption pattern.
Analysis of six years of card data showed a stable breakage rate of 7.5%, most of it on cards with balances under $5. The switch spread breakage across the year in line with redemptions and, on transition, required a one-off adjustment to retained earnings for the breakage that would previously have been recognised later. It also exposed that the chain had been recognising breakage on balances that, under the unclaimed property laws of eleven states, it was required to remit; the company had to set aside $3.2 million and file returns for prior years.
The finance team now tracks breakage by card type, balance band and state, reviews the rate every quarter, and reports the gift card liability, expected breakage and escheat obligation separately. The chief financial officer noted that the old method had made the fourth quarter look better every year for reasons that had nothing to do with selling coffee.
Watch out
Common mistakes.
- Recognising breakage revenue on balances that unclaimed property laws require to be remitted to the state.
- Recognising breakage without reliable historical data, or applying a single rate to card types with very different redemption behaviour.
- Taking breakage to income in a lump at expiry when a redemption pattern exists, which front-loads or back-loads profit and fails the proportional requirement.
Questions
People also ask.
Is breakage a form of revenue or a gain?
Under current standards it is revenue, recognised as part of the contract with the customer, not a separate gain.
What if we cannot estimate breakage?
Recognise nothing until the likelihood of the customer exercising the right becomes remote, typically at legal expiry.
Does breakage apply to deposits and prepayments?
It applies to any customer prepayment where some of the value is expected to go unclaimed, subject to the legal position on refunds and unclaimed property.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%