Understanding the handling of prepaid items in a business acquisition

November 29, 2023

Picture of a gift card

Understanding the handling of prepaid items in a business acquisition

When a business changes hands, it is important to address the handling of prepaid items such as gift cards and coupons as these items represent a future liability for the buyer.

Prepaid items such as gift cards, coupons, and similar commitments represent both a business asset and a liability. Many small businesses incorrectly treat these funds as revenue. However, when a customer purchases a gift card, the business receives cash, which should be recorded on the balance sheet as an asset. Simultaneously, this event creates a potential liability, as the business is now obligated to provide goods or services in the future. Therefore, it is necessary to record a corresponding liability on the balance sheet. Once the gift card is redeemed the funds and expenses can move to the profit and loss statement and the liability can be removed.

Impact on Business Acquisition

In the event of the sale of the business, these prepaid items assume significant importance. Typically, the seller compensates the buyer for the liability associated with the outstanding prepaid items. The extent of this compensation should be addressed in the initial negotiation, as it directly impacts the final sale price. Addressing this upfront ensures that the buyer is not unduly burdened with obligations for which the seller has already received payment.

Accounting for Unredeemed Items

In calculating the appropriate compensation, it is important to consider historical redemption rates. It is estimated that between 10 and 20% of gift cards go unredeemed and that 47% of Americans have a gift card they have not used. Historical data can play a vital role in this calculation. The seller can provide documentation to determine the actual redemption rate is for the subject business. An accurate estimation will help in arriving at a fair and equitable settlement.

The author Anthony John Rigney is the broker and owner at Quorum Business Advisors, an Industry leading firm in the field of business brokerage and M&A firm. As always. we remind you of the importance of seeking legal advice when acquiring a business.
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