Fred’s Makes An Aggressive Change In Accounting

Fred’s Inc (NASDAQ: FRED), the regional discount retailer, released its Q2 results yesterday in a Form 10-Q. Revenue was up 1.9% compared to the prior year, but restructuring charges led to a net loss of over $(16.4) million, compared to net income of about $3.3 million for the same period last year. On a GAAP basis, diluted EPS came in at a $(0.45), compared to income of $0.09 for the prior period.

In their press release announcing the quarter’s results, the company backed-out the reorganization expenses, and noted a non-GAAP net loss of $(7.1) million or $(0.19) per share. This was in line with the company’s guidance, which was pegged between $(0.15) and $(0.20).

Interestingly, an accounting change that benefitted earnings by a not-insignificant amount was not mentioned in either the press release or the earnings call. In the Critical Accounting Policies section of the MD&A, the company made the following disclosure:

In the second quarter of 2014, the Company made a change to the revenue recognition policy concerning gift card breakage….

Utilizing 10 years of gift card data provided by third party vendor Bank of America, a clear redemption and breakage trend emerged. Fred’s gift cards hit their redemption peak of approximately 87% by the end of third year of activation, resulting in a 13% breakage trend. In addition, Fred’s gift card liability is governed by Tennessee’s escheat laws which state that gift cards issued after 1998 are not considered abandoned property. Therefore, the Company has changed the estimate of gift card breakage revenue during the second quarter of 2014 and recognized $0.9 million of gift card revenue, or $0.02 per share. Going forward, the balance on gift cards activated at least 36 months will be considered to represent gift card breakage and the liability balance on those cards will be recognized as part of revenue.

This change in revenue recognition related to gift card breakage, while less than 1% of revenue, improved net loss and diluted EPS by about 5%. Further, coincidentally, $0.9 million bump from the change, the company would have missed its own guidance projections, instead of falling just within its projected range.

What can we read into here? Many companies recognize gift card breakage and it is generally accepted as a valid accounting policy. But a quick analysis of some of Fred’s peers tells a slightly different story, perhaps.

The chart below shows the breakage policy of other discount retailers.

Freds Peers Breakage

Dollar General (NYSE: DG) doesn’t recognize any gift card breakage. Dollar Tree (NASDAQ: DLTR) doesn’t disclose any information about breakage, nor does Family Dollar (NYSE: FDO). Big Lots (NYSE: BIG) recognizes breakage after four years, but doesn’t say what the redemption rate is by that point. Further, the amount of breakage Big Lots recognizes as a percentage of sales and income is infinitesimal compared to the amount recognized by Fred’s.

Based on this analysis, we would conclude that Fred’s change in its revenue recognition policy is an aggressive change, and a red flag.

That said, even though the change is aggressive, it is fairly immaterial, and the long-term health of the company will depend much more on the success of its reorganization plan than on what may be considered an accounting gimmick.