As global markets have become progressively more entwined, it’s become crucial to standardize the accounting rules by which companies record and report revenue.
The world of loyalty program accounting has not been spared this need for congruence, and as a result, recent changes have been made by both the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). These changes have been instated as part of a larger measure to synchronize American loyalty accounting practices with those of its global counterparts.
So what do these changes mean for accounting departments? Primarily, they represent a paradigm shift in the way that revenue from loyalty program members is recorded.
No longer can a loyalty program member’s transactions be regarded as a singular occurrence, where revenue is recorded the moment the transaction occurs. Instead, loyalty program transactions must be treated as a chain of separate-but-related performance obligations whose revenue is noted only when their rewards are either satisfied or reach their contractually-defined expiration date.
In other words, until performance obligations are met, revenue must be deferred to absorb accompanying loyalty program liability.
How much revenue a company defers in anticipation of its loyalty program liability can have serious consequences on the business’ finances. For example, if a corporation defers too little revenue, it’s possible that all of the revenue will be recognized before the performance obligations have been met. This can even lead to companies having to adjust their income statements.
Conversely, when the amount of revenue set aside exceeds the scale of the liability, a phenomenon known as “stuck revenue” can come into play.
It’s imperative that your company have a robust model for accurately forecasting breakage rates. Continue reading to discover why the new accounting standards signal a heightened emphasis on top-tier breakage models and what your company can do to ensure its models make the grade.
What the new accounting standards represent
No longer will it be considered standard practice for companies to immediately register revenue earned at the point of purchase without deferring some of those funds towards neutralizing the potential loyalty program liability incurred. Instead, revenue must now be deferred upfront and reintegrated into income statements only upon the satisfaction of the related performance obligations.
Broadly speaking, a performance obligation is a promise to deliver a good or service. Within transactions involving the issuance of loyalty points, the performance obligations will consist both of delivering the initial good or service purchased (e.g., the flight or hotel stay), as well as the rewards for which accrued loyalty points can be redeemed.
Since purchases by loyalty program members will have at least two performance obligations attached to them, loyalty program accountants must defer enough revenue upfront to absorb the costs of potential redemptions.
However, not all outstanding points are redeemed. In fact, the disparity between how many points are issued versus how many are used is one of the primary components of the deferred revenue calculation for loyalty programs. In order to capture the revenue created by this incongruence under the new accounting standards, however, companies must take careful efforts to ensure that they do not defer the incorrect amount.
In order to ensure that the amount your company defers the correct amount, you'll need to have a reliable breakage estimate. Breakage refers to the amount of outstanding points that go unredeemed.
A canonical example of companies leveraging breakage correctly to improve their profit margins can be observed at the beginning of every year. Motivated by New Year’s resolutions and a seasonally-inspired sense of optimism, thousands sign up for gym memberships offered at slimmed-down prices.
Of course, if all who sign up actually participate as intended, gyms would find their facilities overtaxed and under-compensated. However, because of high breakage rates, the tidal wave of New Year's enrollees hits the gym with only a trickle, and gym owners end up capturing a massive profit from their unused memberships.
Breakage must be estimated correctly
Incorrect breakage forecasts can have debilitating effects on a company, however. If your company defers too little money, it might find itself unable to satisfy the cost burden of redemptions. This can lead to serious consequences, such as a revenue true-up and restatements of income.
In contrast, deferring too much revenue can bring about “stuck revenue,” which is revenue caught in a purposeless limbo.
It's important to remember that despite the immediate profits occasioned by high breakage rates, such conditions also indicate a low rate of customer engagement. As a result, it's more beneficial to focus on customer lifetime value, which puts the breakage rate into the correct context.
The bottom line
The new accounting standards have redefined the way loyalty program transactions are interpreted. These transactions must now be seen as a chain of connected performance obligations — where revenue cannot be logged until its accompanying obligation is satisfied. In the case of purchases by loyalty program members, revenue must be deferred upfront and only reintegrated upon the redemption of outstanding rewards points.
By using breakage estimates garnered through granular-level insights and powerful predictive analytics that forecast the behavior of individual members, your company can correctly anticipate how much revenue to defer to absorb loyalty program liability and successfully negotiate the new accounting standards.
This article has been republished from Kyros Insights.
Len Llaguno is the founder of Kyros Insights, a leader in loyalty program liability solutions. Kyros helps loyalty programs predict member behavior and manage complex financial reporting of program liabilities.