Quarter-end reporting can be an incredibly stressful time for any loyalty program accountant. It goes without saying that accuracy and efficiency in completing reporting requirements is of the utmost importance.
Add to this the stress of fielding questions from management, completing precise and timely reporting, and ensuring adherence with the SEC and auditors, and it’s easy to see how even the most seasoned accountants can get overwhelmed.
Understandably so, the balance between accurate loyalty program accounting and the proper recognition of deferred revenue has come under ever more scrutiny with the new revenue recognition standards ASC 606 and IFRS 15.
Compliance with the new revenue recognition standards jointly issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) in 2014 is now required for public companies.
No matter what industry your company is in, if it generates a profit from contracts with customers, you need to change the way you account for revenue. This is especially true if your company has a loyalty program, as you’ll need to alter the way you account for program revenue and liability.
The impact this new standard has on your loyalty program will be felt throughout your organization: from greater revenue deferral to alterations in balance sheet liabilities, to additional disclosure obligations in your company’s financial statements.
Shockingly, a significant number of companies are not prepared for the major changes in accounting and business operations required by the new revenue recognition standard.
In this post, we’ll discuss the new standards, their improvements, how this will affect your accounting program and its estimates, and the key focus for loyalty program accountants going forward.
A history of revenue recognition standards
U.S. GAAP: ASC 605 and SAB 104 Accounting
Prior guidance with U.S. GAAP originally fell within ASC 605, and was later modified by SAB 104: Revenue Recognition.
For years, ASC 605 was the only guidance for revenue reporting in the U.S. Initially, the revenue recognition guidance was nonspecific. However, it was later clarified by SEC Staff Accounting Bulletin No. 104 (which, coincidentally, was only applicable to public companies; private companies still lacked clear guidance).
The revenue recognition principle from ASC 605 was simple but vague: recognize revenue once realized or realizable and earned.
SAB 104 established the criteria list. When all four criteria were met, revenue could be recognized:
- Persuasive evidence of an arrangement exists (e.g., written contract or electronic evidence)
- Delivery of goods or services has been completed
- Seller’s price to the buyer is fixed or determinable
- Collectibility is reasonably assured
Because these SAB 104 accounting guidelines offered no specifics for loyalty programs, the FASB formed an Emerging Issues Task Force (EITF) to develop guidance that led to two dominant modeling methods:
- The incremental cost model, where companies recognize revenue at time of purchase and a liability is recorded to cover the cost of future point redemption; and
- The deferred revenue / multiple element model, in which companies defer the portion of revenue directly related to the earning of loyalty points until the customer redeems them, or the points expire. The deferral amount is calculated using a fair value approach.
Still, despite these piecemeal improvements, U.S. GAAP guidance had two primary shortcomings:
- Revenue recognition concepts remained too broad
- Over 200 industry-specific guidelines were excessive
IFRS: IFRIC 13
International accounting standards followed a more specific approach under interpretation IFRIC 13, issued in reporting year 2008. This provided guidance to entities that grant loyalty rewards points to customers that can be exchanged for goods or services.
While its focus was on the treatment of loyalty program liabilities, IFRIC 13 provided additional guidance for the treatment of deferred revenue by introducing two key concepts:
- Deferred revenue / multiple element model: Revenue related to the sale of a good or service is recognized immediately; revenue allocable to the value of the loyalty points must be deferred until points are either redeemed or forfeited.
- Deferred revenue must be based on the fair value of points to the customer or relative fair value (this was previously optional with ASC 605).
In comparison to the old U.S. GAAP and IFRS standards, IFRIC 13 is more closely aligned with the new standards — though it lacks the prescriptive deferred revenue valuation.
The new standards, summarized
For over 16 years, the IFRS and FASB have worked together to create the newly developed standards, ASC 606 and IFRS 15. Fundamentally, these new standards require companies to accurately recognize revenue as the value anticipated to be received from the transfer of goods or services.
This involves a five-step process:
- Identifying the contract with the customer
- Defining the performance obligations in the contract
- Determining the transaction price
- Allocating the transaction price to the performance obligations
- Recognizing revenue when (or as) the entity satisfies a performance obligation
In other words, companies will have to defer revenue for most loyalty programs.
This means that not only will companies that previously used the incremental cost model see later revenue recognition, but that the new model has made certain concepts of loyalty program accounting identical for both the U.S. GAAP and IFRS.
New standard ASC 606: Revenue from Contracts with Customers
Accounting Standards Codification (ASC) 606, titled “Revenue from Contracts with Customers”, became effective for public company reporting periods beginning after December 15, 2017. For 2018, the new standards are applicable and must be reported. The effective date for all other entities begins after December 15, 2018.
Objectives & improvements
The new standards aim to improve the financial reporting of revenue from contracts with customers. Previously, highly specific industry guidelines made comparability difficult, which have been simplified with ASC 606.
The standard now provides guidance on many transactions — specifically service transactions — that were previously lacking (non-public entities had to rely on the SEC and other entities for guidance).
The new scope applies to contracts with customers, which are defined as:
“A party that has contracted with a company to obtain a good or service that is an output of the company’s ordinary activities in exchange for consideration.”
- Lease Contracts
- Insurance Contracts
- Financial instruments
Goals of the new standard are more comprehensive:
- Remove inconsistencies in revenue reporting
- Create a more robust framework for addressing recognition issues
- Improve comparability of revenue recognition practices across reporting entities and industries
- Provide more useful financial statement information
- Simplify financial statement preparation
Recognition & measurement guidance
This applies the new accounting standards to any business that recognizes revenue with the transfer of goods or services in exchange for consideration.
Specifically, if a company enters contractual agreements with a customer (such as through a loyalty program), the company makes a promise of performance obligations. These obligations must now be accounted for separately, and quantified at an estimated or actual transaction price. As the company satisfies its performance obligations, revenue is recognized in an amount equal to the performance obligation.
New disclosure requirements
ASC 606 requires additional disclosure obligations for customer contracts, including:
- Revenue recognized from customer contracts (and categorized appropriately)
- Contract balances (contract assets and liabilities)
- Performance obligations and program rules
- Significant judgments
New standard IFRS 15: Revenue from Contracts with Customers
The International Accounting Standards Board (IASB) first issued IFRS 15 Revenue from Contracts with Customers in May 2014, after collaboration with U.S. GAAP. The mandatory date for adherence was January 1, 2018. Its focus: developing a high-quality global accounting standard for revenue recognition.
Objectives & improvements
Due to the collaboration with the FASB, the IFRS 15 standard objectives are very similar to ASC 606:
- Address inconsistencies with and weaknesses in prior standards
- Improve inadequate disclosure requirements
- Improve the comparability of contract revenue reporting
- Provide more clear and comprehensive guidance for revenue recognition issues
- Enhance disclosures for consumers of financial information
Revenue recognition model
The model establishes a thorough framework for determining when to recognize revenue and how much to recognize:
“An entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”
To implement this framework, companies should apply a five-step process:
- Identify the contract with the customer
- Define the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations
- Recognize revenue when (or as) the entity satisfies a performance obligation
New disclosure requirements
In the interest of providing more relevant information to investors, additional quantitative and qualitative information is required:
- Revenue recognized from customer contracts (and categories)
- Contract balances (including assets and liabilities)
- Performance obligations
- Significant judgment in applying standards
- Assets recognized from costs to obtain/fulfill customer contracts
How will these standards affect loyalty program liability accounting?
For loyalty programs, the key issue becomes one of allocating revenue between the initial transaction in which the customer earned the points or rewards, and the standalone selling price of the option to acquire goods or services in the future through the redemption of the loyalty reward obligation. The standalone selling price is representative of deferred revenue.
The underlying purchase and the subsequent transaction involving the redemption of points for products or services are separate performance obligations, and the recognition of revenue from those separate obligations will be separate in substance (and timing).
Specifically, the sum allocated to the loyalty rewards is recognized as a contract liability, and revenue will need to be deferred and recognized when the rewards are redeemed or expire.
Each loyalty program has different nuances. A simple method for identifying deferred revenue, on a monthly basis is reflected in the following:
Monthly Deferred Revenue = [Points earned in a month] x (1 - [continuing breakage]) x FVPP
Fair Value Per Point (FVPP) = expected fair value of each point that will be redeemed
While the change brought by the new revenue recognition standards might result in more short-term financial decision making, the long-term economics of loyalty programs should see no effect.
New revenue recognition standards increase the importance of accurate breakage estimations
Determining the standalone selling price of the points or rewards necessary for compliance with the new standard can be a challenging exercise.
A standalone selling price is the price at which a company would sell a promised good or service separately to a customer.
In the context of rewards programs, determining this price will involve some degree of estimation that takes into consideration potential customer discounts, variability or changes in costs, and most critically, breakage.
When businesses estimate too much breakage, they fail to defer enough revenue. Conversely, when companies underestimate breakage, they will defer too much revenue and depress it more than they need to.
Deferring too much revenue can build up to a significant pile of "stuck revenue."
Stuck revenue occurs when breakage estimates are insufficient. An excess of deferred revenue becomes “stuck”, remaining allocated in loyalty program liability accounts.
Only by updating breakage estimates can this be corrected. However, many companies rely on vintage-based models (e.g., join year development models) with simplistic forecasts. This leads to underestimating actual levels of breakage, potentially leaving millions in revenue locked up in liability accounts.
An ideal breakage estimate model incorporates:
- Predictive analytics
- Comparison of monthly breakage actuals versus forecasts
- Quicker updates
- Quantifies model estimation uncertainty
Don’t leave millions stuck in accounting limbo.
Are you prepared for the new revenue recognition standards?
For companies that currently account for their loyalty reward revenues using the multiple-element model, the new standard may not change current practices all that much.
However, those businesses that use an incremental cost model under GAAP standards will likely see later revenue recognition for a portion of the transaction price when the new SAB 104 accounting rule is applied.
In other words, the new revenue recognition standards will change the landscape of loyalty program accounting, and SAB 104 accounting reducing the amount of revenue received at the moment of transaction and making it necessary for companies to insure against the coming wave of member redemptions with reasonably estimated deferred revenue.