Why Gift Cards Expire

Local retailers commonly issue gift certificates. You pay the retailer some money, and the retailer gives you a piece of paper with the amount you paid written on it. You can give the certificate to someone else, and they can use it to buy things from the retailer.

Over the last 20 years, many local retailers have been supplanted by big-box category-killer retail chains. Retail chains don't issue gift certificates: they sell gift cards. Conceptually, gift cards work the same as gift certificates: you give the retailer money in exchange for the card; then you can use the card to buy merchandise from the retailer. Physically, gift cards are a bit slicker than gift certificates

Expiration date

There is one other significant difference between gift certificates and gift cards: Gift cards expire.

Typically, a gift card retains its full value for a year or two. After that, a "service charge" or "maintenance fee" kicks in. Each month, the card loses a few dollars or a few percent of its value, until it becomes worthless.

It's isn't obvious why companies do this; it hardly seems worth the bad PR

Alternately, if you think it is obvious—they're greedy—then it isn't obvious why local retailers don't do it: a retailer can as easily write an expiration date on a gift certificate. As it turns out, the big companies aren't specially greedy, and the local retailers aren't specially virtuous. In fact, it's an accounting problem.

Accounting

There are two fundamentally different kinds of accounting: cash and accrual.

Cash

Cash accounting is pretty much what it sounds like: you keep track of your cash All that matters is how much cash you have.

Small businesses—like local retailers—typically use cash accounting. When a customer buys a gift certificate from a small business, the business has more cash, which is good. Someday, the customer may redeem the gift certificate for merchandise. That's fine: the store is full of merchandise, and redeeming the certificate doesn't reduce the store's cash position. Or the certificate may be lost, or forgotten, and never redeemed. That's fine too: the store still has the cash.

In short, local retailers issue gift certificates that never expire, because once they have the cash, they don't much care if the certificate is ever redeemed or not.

Accrual

Big companies—and especially, publicly traded companies—can't use cash accounting.

One reason is that there is more to know about a company than how much cash is in the drawer. Companies have

and all of these things have to be accounted for in order to get an accurate picture of the company's finances.

Another reason is that cash is volatile. A company's cash position changes every time a check clears, and the bigger the check, the bigger the change. For a company doing millions of dollars in business, a cash accounting would fluctuate so wildly and rapidly as to be useless.

Big companies use accrual accounting. In accrual accounting, you keep track of your assets and liabilities. Furthermore, you account for things not when they actually happen, but at the point in time when you know they will happen.

Buying inventory

For example, suppose a company buys $1,000,000 of inventory. When they take delivery, they get They have the inventory, so they enter it on their books as an asset. They haven't paid the invoice yet, but they are obligated to pay it, so they enter it on their books as a liability. The asset and the liability are equal, so the company's net worth is unchanged.

Eventually, the company pays the invoice. This removes $1,000,000 of cash from the company's books, and it also removes the invoice from the books. Since the amount of the cash and the amount of the invoice are the same, the company's net worth is again unchanged.

Selling gift cards

Now watch what happens when a company sells a $20 gift card So far, it looks just like the local retailer who uses cash accounting. But for a company that uses accrual accounting, it doesn't stop there. The gift card obligates the company to deliver $20 of merchandise to the customer at some time in the future. To represent that fact on its books, So a $20 gift certificate, sold by a local retailer who uses cash accounting, puts $20 of cash into the retailer's drawer. But a $20 gift card, sold by a company that uses accrual accounting, doesn't add to the company's revenue, because it's offset by the pre-paid sales liability.

Eventually, the customer redeems the gift card for merchandise. Then

Only after the pre-paid sales liability goes away can the company recognize the $20 of revenue, and any associated profit. If the gift card isn't redeemed—if it's lost or forgotten—then the company can never remove the liability from their books.

Recognizing revenue

You can imagine how annoying this must be. They can see the money; it's sitting in their bank account. But they can't report it as revenue: as long as the pre-paid sales liability remains on their books, they can't say that the money is theirs. Granted, this pre-paid sales liability is an accounting fiction, but it's a fiction that matters. It matters to accountants, and auditors, and investors: to the people who determine the company's stock price and reward its executives.

So companies that issue gift cards find ways to make them expire. When a gift card loses value to a "service charge", the company isn't actually performing a service for you; when a card loses value to a "maintenance fee", there isn't any actual maintenance being done on it. All that's happening is that the company is removing some of the pre-paid sales liability from its books, so that it can recognize the money you paid for the card as revenue.

When gift cards expire, accounting trumps public relations, customer good-will, and common sense.


Notes

keys the card into the retailer's database
So the value of the card is stored in the database, not on the card itself. For an application where this makes a big difference, see How Disney made the gray market in multi-day passes evaporate.
pre-paid sales
The term "pre-paid sales" refers to the fact that the customer has paid for merchandise but hasn't yet received it.

Steven W. McDougall / resume / swmcd@world.std.com / 2004 Aug 17