Competition in the global market and intense rivalry prompt companies to devise creative marketing strategies to keep ahead of competition. A popular and effective initiative is to introduce a customer loyalty program to reward previous purchases and offer incentives to encourage repeat purchases.
Customer loyalty programs range from simple ones that offer for example, a free coupon for a certain number of visits or volume purchased to complex ones such as an airline’s frequent flyer program or telecom operator’s loyalty awards.
These programs also differ, among others, on the manner of redemption (e.g. redeemable upon grant vs. those requiring accumulation) who operates (e.g. the company itself vs. outsourced to third party or the company participants in a program run by a third party) and the source of credit (e.g. from a single purchase or group of purchases over a specified period of time).
Credits can also be earned by buying products or services from another entity who is not necessarily participating in the program, or awards can be redeemed for products or services of the company or of another entity. A good example is an airline alliance mileage program where loyalty miles can be earned from one airline but may be used to fly another airline within the alliance.
As loyalty programs vary, so do their accounting treatment. In general, there are several approaches which have evolved in practice. The most common method of revenue recognition is to recognise the total revenue at the inception of the transaction, and any products and services offered for loyalty points are recognised as marketing costs at the time of redemption of such points. Some companies recognise revenue upfront, and set off the costs on redemption of reward points against revenue at the time of redemption.
To address this divergence in practice and to improve consistency and comparability, the International Financial Reporting Interpretation Committee (IFRIC) issued IFRIC 13, Customer Loyalty Programs. IFRIC 13 requires the use of deferred revenue approach, which entails apportionment of the consideration received or receivable from customers for the initial sale between the : (a) award credited and (b) other components of the sale (goods or services sold).
The amount allocated to award credits is deferred and recognised as revenue only upon redemption or usage, expiration or in some cases when the entity revises its expectations of the number of award credits expected to be redeemed.
IFRIC 13 also requires that the award credit be measured at fair value – the amount for which the award credit could be sold separately (not the cost to the entity when the award is redeemed by the customer)
In adopting the interpretation, the difficulties the companies have encountered in transitioning to and complying with IFRIC 13 generally revolve around (1) the estimation of the fair value and the redemption rate of the award credits and (2) the availability of data.
The degree of difficulty depends on the extent of alignment between the entity’s accounting treatment and the requirements of IFRIC 13. In some of the cases, the company’s information system will need to be reconfigured, or the company may have to employ a new system for tracking grants, redemptions, expirations and inputs to estimate the fair value of the award credits.
The challenge here is balancing the level of detail of the data to be tracked in the system to ensure compliance with the interpretation (and provide management with information to evaluate the effectiveness of the program), against the related costs (e.g. acquisition or development and maintenance of the system). In any case, the system implication of transitioning to or implementing IFRIC 13 should be anticipated and continually assessed as the company’s loyalty program evolves.
In terms of financial reporting, adopting IFRIC 13 would mean a change in accounting policy for companies resulting in reduced revenue and recognition of deferred revenue in the balance sheet, representing the obligation to render services or deliver goods in the future when the award credits are redeemed.
Additionally, the interpretation requires the change in accounting policy to be taken retroactively and reflected in the financial statements since the earliest period presented. This poses a challenge particularly when information or systems for the comparative prior periods are nonexistent. Given these requirements of IFRIC 13, it can potentially impact the company’s top line performance and debt ratios.
Over the years, the use of customer loyalty programs to boost sales has been employed successfully by various industries (airline, telecommunications, hotels, retails and consumer credit are but a few).
These programs will continue to evolve as market demands change. The key challenge for management therefore is to keep the company’s loyalty programs responsive to customer preferences and to establish an information system or process that can flexibly respond to these changing demands, while complying with the reporting requirements at a minimal cost.
(The writer is a Partner of Ernst & Young. This article is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of Ernst & Young.)