Loyalty programs, gift cards, and other come-ons aimed at keeping shoppers hooked on a particular retailer are spreading faster than word of a fabulous bargain in aisle 5. That's good for consumers because they get better deals, and it's good for retailers because they make more sales. But it may not be so good for investors.
As these programs multiply, investors are finding it harder to size up a retailer's true financial picture. That's because there are no hard-and-fast rules for how retailers should handle the accounting for these incentive programs. Retailers must make assumptions about how many customers they think will use the gift cards they receive or redeem the loyalty points they earn on their purchases. Of course, for retailers, the fewer who do, the better -- and those flexible assumptions can be used to manage earnings. On top of that, retailers are making different calls on where to account for this money in their financial statements. This can distort closely watched measures such as revenues, same-store sales, and profit margins, thereby making comparisons misleading, said Michael C. Gyure, a forensic accountant at FTN Midwest Research, in a report last year.
Compounding the problem, retailers offer scant details on these programs, making it nearly impossible to gauge their impact on results. This concerns investors because the programs are becoming a huge profit center for retailers. Gift-card sales alone are expected to top $95 billion this year, up more than 50% from just $61 billion two years ago, according to Raritan (N.J.) market researcher Pelorus Group. Loyalty programs are harder to track, and analysts say they don't have reliable statistics.
Meanwhile, the Securities & Exchange Commission is investigating at least one retailer over these matters, people close to the agency say. The SEC declines to comment or say which one.
MANY TIES THAT BIND
As the popularity of incentive programs explodes, retailers keep coming up with variations, which further complicate the accounting. In addition to standard gift cards that consumers purchase, there are others that retailers hand out in return for certain purchases, say, one worth $100 for buying a $1,000 TV. Consumer-electronics chain Best Buy Co. (BBY) is one retailer that does this. Similarly, shoppers can get discounts by making purchases that earn them cash-like vouchers they can use for future purchases. Those are offered by youth retailer Pacific Sunwear of California Inc. (PSUN), among others. Then there are a growing number of loyalty programs in which consumers earn points that are good for future discounts. Best Buy rival Circuit City Stores Inc. (CC) added such a program last fall. At the same time clothier Men's Wearhouse Inc. (MW) sharply expanded its Perfect Fit loyalty program, which awards shoppers $50 toward a future purchase for each $500 they spend.
The rapid proliferation of gift cards and reward programs has caught the accounting profession flat-footed. "There is a lot of gray," says Matthew McCann, a senior manager at PricewaterhouseCoopers. The accounting industry's rulemaking body, the Financial Accounting Standards Board, is expected to address this issue as part of a major review it's conducting of how companies account for revenue.
The lack of rules certainly gives retailers plenty of leeway. When Best Buy started its "Reward Zone" incentive plan in 2003, shoppers earned $5 on each $125 they spent, and the money had to be applied to other purchases within 90 days. Because Best Buy had no track record of how many of these dollars would be used, it deducted all of the Reward Zone dollars from revenue in the first quarter of the program. But in the next quarter, Best Buy said it could figure out how many dollars wouldn't be redeemed and cut its liability accordingly. The move added 2 cents a share to the company's before-tax earnings and enabled Best Buy to hit analysts' forecasts of 37 cents a share to the penny. Spokeswoman Susan Busch-Nehring says Best Buy wasn't trying to manage its earnings.
What would better accounting have called for? Charles W. Mulford, an accounting professor at Georgia Institute of Technology's Dupree School of Management, and other accountants say gathering a year's experience before making the adjustment, rather than just one quarter's, would have been more appropriate. That's especially true, he adds, because Best Buy's business is highly seasonal and it had yet to run the program during the peak Christmas quarter. Indeed, for the first quarter of the fiscal year that began on Feb. 29 of last year, Best Buy disclosed that it hadn't set aside enough money for redemptions, forcing it to subtract more from revenue. In October, Best Buy raised the minimum purchase customers must make before earning $5, from $125 to $150, a move that helped earnings for the Christmas season because Best Buy needed to defer less revenue. Best Buy says it was being conservative in its accounting.
Rival Circuit City boosted earnings by adjusting its gift-card liabilities last year. It defers all revenue from gift-card sales. But if a card went unused for two years, the company used to deduct $2 a month from the value of the card. Then, in the quarter ended in February, 2004, it dropped the dormancy fee and began decreasing its liability, based on its record of past redemptions. That added 2 cents a share in a Christmas quarter in which it beat analysts' forecasts by 10 cents. Spokesman William Cimino says the company wasn't trying to manage earnings and that it made the change because of strong opposition to the fees from state governments.
All the same, the change spruces up one of Circuit City's key performance measures. The chain now uses the money it no longer defers to cut expenses, even though a near-consensus in the accounting profession recommends counting that money as revenue instead. "It relates to sales made, not the expenses of running the business," says Georgia Tech's Mulford. Circuit's method helped reduce selling expenses as a percentage of sales for fiscal 2004, one bright spot in a year marred by falling revenues.
A NICE LITTLE BOOST
Loyalty-program accounting also can be all over the map. Talbots Inc. (TLB) counts the liabilities from its Classic Awards program -- in which holders of Talbots credit cards earn $25 for each $500 they spend -- as a selling expense. Talbots' revenue and same-store sales would be lower if it subtracted the liabilities from revenue, especially when it offers double points to drive sales. While both methods result in the same earnings, the Talbots' way does exaggerate revenue. Men's Wearhouse counts the liability as a cost of goods sold. This reduces gross margins but makes revenue and same-store sales higher than they would be otherwise. Neither chain would comment on why they do the accounting this way.
Other retailers apparently agree with accountants that taking the liabilities out of revenue is the best approach. In its most recent quarter, luxury retailer Neiman Marcus Group Inc. (NMG) switched to that method. Previously, it had accounted for its loyalty program the same way Talbots does.
Meanwhile, rival youth retailers Too Inc. (TOO) and Pacific Sunwear print in-house money for their incentive programs, but neither discloses anything about that in its accounting. Shoppers earn $25 in Too Bucks or Pac Bucks for each $50 they spend. But to use that currency, shoppers must drop at least another $50 in the stores within a set period of time. Neither chain fully explained how the accounting is done when asked for further details.
For investors the lesson seems clear: It may be more rewarding to shop in chains with generous incentive programs than to buy into their convoluted accounting.
By Robert Berner in Chicago