Small business owners are crazy busy during the holidays and many are hitting a year-end rush. This often means being a bit more behind on the books and that's okay. It can get a little messy, however, if you are not sure HOW certain transactions affect your accounting.
One of the more complex issues for retailers and small business is the sale of gift cards in lieu of services or merchandise. When you sell a gift card, you sell a promise to deliver something in the future which may or may not even get redeemed. Accounting for this becomes complicated. Do you book the income when you sell the gift card or when it is redeemed?
There are two ways to do this based on your business’s accounting method:
Cash basis businesses recognize income when they receive the cash and expenses when they pay. Therefore, you would record sales of gift cards when they are purchased. Most businesses use the cash basis if they make less than $26M a year in revenue and don’t have inventory.
Gift card sale under Cash Basis:
This is basically a normal sale transaction.
The challenge here is that you may not recognize the income in the same year you incur the related expenses. Let's say you run a nail salon. Someone buys a gift certificate for their mom for Christmas in December. The mom redeems the certificate in January. The issue here is that you are paying a nail techs in January for revenue you earned in December. Therefore, you may not be able to have the costs and revenue offset in the same year. This is not necessarily a problem, but should be taken into consideration when opting of offer gift cards or certificates.
Accrual basis taxpayers recognize income when they perform the service to earn it or when they receive the benefit of their expenses. This involves spreading out recognition of these transactions over time. If you’re an accrual basis business, you would recognize the gift card income when you perform the service and it is redeemed. This is a bit more complicated and tough to measure. It also means you may never see the revenue hit your books. Instead of revenue, you book a liability called Deferred Revenue. This shows up on your balance sheet until you provide the service.
Gift card sale under Accrual Basis:
CR Deferred Revenue
When it is Redeemed:
DR: Deferred Revenue
This also means if you are a cash basis business selling a lot of gift cards in 2021 that are redeemed in 2022 means accelerating revenue into 2021 and therefore more in taxes. You are more likely to match revenue and expenses in the same year, but you may have to wait a long time to recognize the revenue.
Neither of these options is necessarily bad, but when you understand how and when income hits your books, it makes you more powerful and strategic as a business owner.
Are you looking to implement gift cards in your business? Text Shannon at 860-609-6374 if you need help implementing this.