Over time, businesses have increasingly embraced customer loyalty programs (CLPs) as an effective marketing tool. Such programs are now quite common, especially among airlines (e.g., "frequent flyer" programs), hotels, casinos, and online retailers.
In many CLPs, a participating customer earns "points" (or some other unit of measurement) for each qualifying purchase that the customer makes from a participating seller. Points can then be used by the customer to obtain free (or discounted) goods or services from the seller in the future. The redemption of points is subject to program-specific conditions that typically require a customer to accumulate a certain minimum number of points before any redemption opportunities are available.
Interpretation 13, Customer Loyalty Programmes, issued by the International Financial Reporting Interpretations Committee (IFRIC) on June 28, 2007, is limited in scope to these kinds of programs. Other programs (such as those providing future cash awards or providing discounts at the time of original purchase) are excluded from the scope of IFRIC 13.
The kinds of CLPs addressed by IFRIC 13 present sellers with a number of uncertainties. These uncertainties raise issues concerning the proper way to account for the granting, redemption, and expiration of program points. For example, sellers will typically not know at the time points are granted (1) whether customers will redeem their points before the points expire; (2) exactly when customers who redeem their points will redeem them; (3) the cost of goods/services that the seller will provide the customer at the time of point redemption; (4) the selling price that the seller will forego in favor of points at the time of redemption.
U.S. GAAP has offered little specific, authoritative guidance on accounting for the many kinds of CLPs that businesses offer today. It offers no specific guidance on accounting for the kinds of CLPs that are within the scope of IFRIC 13.
In September 2000, the FASB's Emerging Issues Task Force (EITF) added Issue No. 00-22, "Accounting for 'Points' and Certain Other Time-Based or Volume-Based Sales Incentive Offers, and Offers for Free Products or Services to Be Delivered in the Future" [http://fasb.org/pdf/abs00-22.pdf] to its discussion agenda. The approach that the IFRIC adopted in Interpretation 13 was originally discussed by the EITF along with potential alternative approaches. But prior to reaching consensus on the portions of Issue No. 00-22 that addressed the kinds of CLPs that IFRIC 13 addresses, the EITF decided at its November 21, 2002 meeting to discontinue further discussion of those portions. The EITF's reasoning was that the FASB-IASB joint project on Revenue Recognition [http://fasb.org/project/revenue_recognition.shtml], which was placed on the FASB's agenda subsequent to the EITF's initial discussions of Issue No. 00-22, would address the issues in a more authoritative and comprehensive way. At this time, the FASB-IASB joint project on Revenue Recognition is many months (possibly years) away from its conclusion.
A related EITF Issue (No. 01-9, "Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products)" at http://fasb.org/pdf/abs01-9.pdf) specifically excludes from its scope the kinds of CLPs addressed by IFRIC 13.
The fundamental issues to be addressed in accounting for the kinds of CLPs addressed by IFRIC 13 are the recognition and measurement of (1) revenues and expenses on the income statement; and (2) related liabilities on the balance sheet. There are two fundamental different approaches that standard-setters have considered for these kinds of CLPs. The different approaches resemble the different ways that different kinds of product warranties are accounted for under U.S. GAAP and IFRSs.
The first approach is known as the "Deferred Revenue" approach. Under this approach, a portion of the price paid for a customer's qualifying purchase is assumed to reflect partial pre-payment for future goods/services that the customer is entitled to obtain through the redemption of points earned from the qualifying purchase. Therefore, the seller does not recognize the full amount of the customer's payment as current-period revenue; the seller defers the recognition of a portion of the customer's payment to a future period when the customer either redeems points or the points expire. At the time of the qualifying purchase, the seller typically debits cash for the full amount of payment received, credits revenue for most of the payment, and credits the difference to a liability account to reflect the amount of goods/services that the seller is obligated to deliver to the customer in the future. The liability will remain on the seller's balance sheet until the customer redeems points or the points expire, at which time the liability will be debited and revenue will be credited (a dubious variation on this approach involves crediting expense at the time of redemption rather than crediting revenue). Thus, applying the Deferred Revenue approach decreases current-period revenues and increases future-period revenues, with a corresponding liability appearing on the seller's balance sheet in the interim. Any incremental cost borne by the seller to fulfill a customer's redemption of points is recognized as an expense in the same period as the deferred revenue is recognized, i.e., the period of redemption. If points expire unredeemed, the seller recognizes the deferred revenue in the period of expiration, debiting its liability account to reflect that it no longer has an obligation to customers.
The second approach is known as the "Incremental Cost" approach. Under this approach, the seller recognizes that it is likely to incur some incremental cost to fulfill its obligations to its customers when customers redeem award points. Consequently, when such cost is reasonably estimable (as it often is), the estimated cost is recognized as an expense by the seller at the time of the original qualifying purchase. The seller debits expense and credits a liability account on the balance sheet to reflect the future cost it expects to bear to satisfy its obligations to customers. When customers redeem award points, the seller will typically credit payables, cash, or inventory to reflect its cost and simultaneously debit the previously-established liability to reflect the satisfaction of its obligations to customers; if the seller estimates the incremental costs of redemption accurately, there will be no impact on revenue or expense at the time points are redeemed. Note that under this approach, the seller recognizes the full payment received from the customer as revenue in the period of the qualifying purchase. If points expire unredeemed, then the seller debits its liability account to reflect that it no longer has an obligation to customers and credits current period expenses to reverse the expense it had presumptively accrued earlier.
Under both approaches, the seller recognizes a liability on its balance sheet between the time points are granted to customers and the time the points are redeemed (or expire). However, the liability accounts would typically bear different labels, i.e., "Unearned CLP Revenue" vs. "Estimated Liability for CLP Redemption Costs."
Under both approaches, the seller's Net Income (NI) in the current period is reduced by the amount of the liability that the seller recognizes in the current period. However, the amount of the liability (and therefore the impact on NI) will typically be larger under the Deferred Revenue approach than under the Incremental Cost approach (assuming that goods/services awarded at redemption normally sell for more than their cost).
Under the Deferred Revenue approach, the seller will typically recognize an increase in NI in the period of redemption due to the deferred revenue recognized at that time typically being greater than the incremental cost that is recognized as an expense at that time. In contrast, under the Incremental Cost approach, the seller typically experiences no impact on NI at the time of redemption (assuming the seller had previously estimated the incremental costs of honoring the redemption accurately).
Under both approaches, the cumulative amount of revenue recognized is the same in the long run; the cumulative amount of expense recognized is the same in the long run; and therefore the cumulative amount of NI is the same in the long run. The only differences between the approaches are in the timing of revenue and expense recognition.
Under both approaches, the liability accrual and corresponding impact on NI are the result of management estimates. This reduces the reliability of reported numbers and can lead to material temporary distortions in financial statements.
Both the Deferred Revenue and Incremental Cost approaches are permissible under current U.S. GAAP and remain permissible under IFRSs until the required adoption of IFRIC 13. Both approaches have been used in practice. For example, Continental Airlines' 2006 10-K [Page 57] discloses that the company uses the Incremental Cost approach for its "OnePass" Frequent Flyer program, whereas Neiman Marcus' 2006 10-K [Page F-15] discloses that the company uses the Deferred Revenue approach for its loyalty programs.
Under IFRIC 13, a sale transaction in which CLP points are awarded to the customer must be accounted for using the Deferred Revenue approach. Specifically, the transaction is accounted for as if it were two transactions: an immediate sale of goods/services for which revenue is recognized at the time of sale, and a pre-payment to be applied to a future "sale" of goods/services for which revenue recognition is deferred.
In theory, the approach required by IFRIC 13 is more conservative than the Incremental Cost approach. But because the IFRIC 13 approach still depends on management estimates, it could end up being less or even more conservative in practice. An overly-conservative application of the approach could be used to fill up a "cookie jar" of deferred revenue that management could dip into to artificially inflate revenue in a future period. A less-conservative approach could be used to artificially inflate current-period revenue.
A challenge in applying the accounting treatment required by IFRIC 13 is determining how much of the customer's payment at the time of the qualifying purchase should be recognized as revenue immediately and how much should be deferred. IFRIC 13 requires that the portion to be deferred be based on the fair value of the points awarded.
The separation of a qualifying transaction two revenue elements as required by IFRIC 13 is not certain to be supported by FASB-IASB joint project on Revenue Recognition. Different treatment could ultimately be required under both U.S. GAAP and IFRSs.
[Last Updated Sep. 25, 2007]
