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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.
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:
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:
Still, despite these piecemeal improvements, U.S. GAAP guidance had two primary shortcomings:
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:
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.
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:
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.
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.
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.”
Goals of the new standard are more comprehensive:
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.
ASC 606 requires additional disclosure obligations for customer contracts, including:
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.
Due to the collaboration with the FASB, the IFRS 15 standard objectives are very similar to ASC 606:
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:
In the interest of providing more relevant information to investors, additional quantitative and qualitative information is required:
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.
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:
Don’t leave millions stuck in accounting limbo.
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.
Founder and managing partner of KYROS Insights. I'm an analytics nerd and recovering actuary. I use machine learning to help loyalty programs predict member behavior so they can identify their future best customers, and recognize and reward them today.