“Accounting for customer loyalty programs” by Dhonabee B. Señeres (December 12, 2011)

SUITS THE C-SUITE By Dhonabee B. Señeres
Business World (12/12/2011)

Stiff, cut-throat 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 a 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 participates in a program run by a third party), and the source of credit (e.g., from single or group of purchase or 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 two main approaches which have evolved in practice — the marketing expense approach and the deferred revenue approach. Under the marketing expense approach, the cost of supplying goods or services in the future related to the loyalty award credit is recognized as an expense at the time of selling the goods or service (initial sale). Under the deferred revenue approach, the award credit is treated as a separate component of the sales transaction that requires delivery in the future.

To address this divergence in practice and to improve consistency and comparability, the International Financial Reporting Interpretation Committee (IFRIC) issued IFRIC Interpretation 13, Customer Loyalty Programmes. For annual periods beginning on or after 1 July 2008, IFRIC 13 requires the use of the deferred revenue approach, which entails apportionment of the consideration received or receivable from customers for the initial sale between the: (a) award credit and (b) other components of the sale (goods or services sold). The amount allocated to the award credit is deferred and recognized 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).

For companies which have adopted the interpretation, the difficulties they 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 had to be reconfigured, or the company had to employ a new system for tracking grants, redemptions, expiration 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 previously using the marketing expense approach. Instead of recognizing marketing expense and the corresponding liability (representing the expected cost of settlement of the award) when the award credit is earned by customers, revenue is reduced (or deferred) and a liability is recognized (representing the obligation to render services or deliver goods in the future when the award credit is 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.

On the other hand, companies that have been using the deferred revenue approach but changed the valuation method (e.g., from residual fair value to relative fair value) upon adoption of IFRIC 13 need to account for this as a change in estimate (i.e., the effect of adoption is taken prospectively). As IFRIC 13 does not prescribe a specific method for estimating the fair value of the award credit, management would have to choose an appropriate method and apply the selected method consistently.

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, retail 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 program 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.

Dhonabee B. Señeres is a Partner of SGV & Co.

This article was originally published in the BusinessWorld newspaper. It 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 SGV & Co.