Request a Trial

    Your 9-Step Checklist for Loyalty Program Financial Reporting

    Year-end means a lot of things for many people. Holiday music, ice skating, pumpkin spiced lattes.


    For accountants? The fun starts after closing the year-end books.


    With the recent changes in loyalty program revenue recognition standards, this process has come under fresh scrutiny. Loyalty program accountants must now incorporate the new reporting standards ASC 606 and IFRS 15, while still optimizing their financial statements for profitability.


    Rather than get lost in the details (as it’s all too easy to do), we’ve compiled a quick 9-step checklist for loyalty program model financial reporting. As you enter the holiday season, we hope this will speed up your processes and bring better financial insight to your loyalty program model.


    Step 1: Validate data

    Accuracy is everything in accounting.


    Naturally, the first step is to ensure your records are accurate and correct. Good data is essential.


    Each accounting period should be checked to ensure that individual transactional data matches with the total outstanding point balance used in the liability calculation. Underlying data for breakage estimates must match with data used for the books.


    In general, prior period trends should also be consistent. Examine the number of points earned, points redeemed, and points expired each month. Month-to-month point volumes should appear similar when compared to historical years, notwithstanding some exceptions.


    A few exceptions to watch out for include:

    • Flash promotions increasing redemptions
    • Temporary grace periods decreasing point expiration
    • New expiration rule increasing point expiration


    Step 2: Allocate redemptions to points earned

    Accurate breakage estimates require correctly allocating redemptions to actual point earnings.


    Loyalty program point allocation has similarities to inventory valuation. As customers use their points, redemption costs should be allocated to specific point earnings. Much like when physical inventory is sold, revenue and costs of goods sold is applied for each unit sold.


    The industry standard for most loyalty program models is First in First Out (FIFO). Under FIFO, point redemptions are tied to the member’s earliest earned points (first in) that remain outstanding.


    Unlike inventory valuation, there is no required method for point allocation. Some programs might find using FIFO isn’t realistic or advantageous:

    • Programs with expiration rules varying by point
    • Programs whose members choose which points to redeem


    Regardless of which method you follow, a clean system will tie redemptions to specific point earnings.


    Step 3: Update breakage and fair value estimates

    update breakage estimates

    Breakage lies front and center for loyalty program accounting. Your program is optimized for customer engagement and increasing revenue. Breakage is the variable that balances these two goals.


    Breakage drives most of the financial strategy for a loyalty program model. With the new standards, it’s more important than ever to land on an accurate estimate.


    Updating breakage estimates

    Breakage is the percentage of outstanding points that will ultimately go unredeemed. This estimate is used to calculate loyalty program liability.

    Breakage = % of points that go unredeemed

    Loyalty Program Liability = Outstanding points x (1 – Breakage) x CPP

    Cost Per Point (CPP) = Expected cost of each point that will be redeemed

    Revenue Recognition Rate = Deferred revenue / future points expected to be redeemed


    Breakage estimates are updated with each new period, as new customer data rolls in.


    For example:

    Last Period:

    Deferred Revenue Balance = $900

    Points Ultimately Expected to be Redeemed = 1,200

    Revenue Recognition Rate = $900 / 1,200 points = $0.75

    Points Redeemed in Period = 200

    Revenue Recognized in Period = 200 x $0.75 = $150


    Next Period:

    New Deferred Revenue Balance = $900 - $150 = $750

    Remaining Points Expected to be Redeemed Based on Prior Breakage Estimate = 1,200 - 200 = 1,000

    Remaining Points Expected to be Redeemed Based on Updated Breakage Estimate = 950

    Updated Revenue Recognition Rate = $750 / 950 points = $0.79


    Because we now expect fewer points to be redeemed (higher breakage), the revenue recognized with each future point redeemed increases.


    The dangers of inaccurate breakage estimates

    In an ideal world, your breakage estimate is spot on. As members redeem their points, deferred revenue is recognized and your accounts balance out.


    In reality, estimates require continual adjustment. However, if you significantly over or underestimate breakage, significant revisions will be required:

    • Breakage estimate too high and your deferred revenue will be too low, requiring a one-time (potentially) material increase in program liability;
    • Breakage estimate too low and your deferred revenue will be too high, resulting in stuck revenue.


    Accurate breakage estimates require predictive actuarial models

    The consequences of inaccurate breakage estimates can be avoided with robust actuarial modeling.


    Actuaries excel at estimating program liabilities from uncertain cash flows and consumer behavior.


    However, traditional actuarial science methods, such as those used in insurance, are not ideal for loyalty program applications; the loyalty program industry is far more dynamic and fluid than the insurance industry.


    Predictive analytics and modeling is the best solution for estimating accurate breakage rates. These advanced actuarial models can calculate breakage estimates down to the individual member level.


    Fair value per point estimates

    Fair value per point (FVPP) is a component of calculating deferred revenue for a loyalty program. FVPP is a dynamic measure that can change with each period.


    A number of variables can change FVPP:

    • Changes in utilization distribution
    • Changes in award charts
    • Temporary promotional rewards
    • Changes in foreign exchange rates
    • Inflation
    • Seasonality in standalone value of rewards (i.e. flights, hotel nights)


    Assess actual member behavior versus forecasts

    Models and estimates are only worthwhile if they are accurate. Each period, assess actual results to your forecasted values for breakage, FVPP, and redemption patterns.


    Ask yourself questions such as:

    • How did the volume of points redeemed compare to our model predictions?
    • Did members redeemed their points on the award types our model predicted?


    If your answers aren’t quite what you’d hoped, you’ll need to assess and adjust.


    In analyzing your model performance, you’ll be able to identify what’s driving changes in your estimates. This is essential to communicate a clear story to your CFO and auditors. A member-level model is particularly useful for constructing a clear narrative.


    Step 4: Record accounting entries for reporting periods

    record corresponding accounting activity

    Each financial reporting period will require updating key loyalty program accounts. The following items will change and require the corresponding accounting activity:

    • Points earned
    • Points redeemed
    • Points expired
    • Updated breakage estimates


    Points earned

    Any new points earned will require an associated entry to deferred revenue. The value should be based on the relative standalone selling value of the points.


    The amount of deferred revenue recognized should incorporate your latest breakage estimate.


    For example, if breakage = 10%, each redeemable dollar should result in deferring 90 cents.


    Points redeemed

    Points redeemed during the reporting period will result in recognizing new revenue and reducing deferred revenue liability.


    The revenue recognition rate represents the proportion of deferred revenue realized per every redeemable point.


    Let’s take a closer look:


    Beginning of the Period:

    Deferred Revenue Balance = $900

    Points Ultimately Expected to be Redeemed = 1,200

    Revenue Recognition Rate = $900 / 1,200 points = 0.75


    During the Period:

    Points Redeemed =200

    Deferred Revenue Recognized = 200 x 0.75 =$150


    Points expired

    Points expired during the period require no adjustment, as long as the deferred revenue account incorporates point expiration estimates.  


    Final adjustments

    This list is by no means exhaustive. A few noteworthy additional items to adjust include:

    • Adjust deferred revenue balances with latest foreign exchange rates
    • Breakage estimates (with associated updates to the deferred revenue account)


    Member-level predictive analytic models help quantify the magnitude of exchange rate risk, and aggregate results up to a total currency level.


    Step 5: Seek an actuarial opinion

    Actuarial opinion to certify accuracy

    A company’s CFO and auditors are required to certify the accuracy of company financial reporting statements. Given the financial statement ramifications of an inaccurate breakage estimate, actuarial opinions are sought to justify loyalty program liability.


    An actuarial opinion is signed by a credentialed actuary as proof of thorough review and vetting of loyalty program liability assumptions, and provides the following:

    • Support for booked breakage estimate to auditors
    • Peace of mind for the CFO (booked liability is materially significant to financial statements)
    • Protection against key material risk factors (inaccurate estimates of loyalty liability or breakage)


    The opinion provided will usually be presented as a range of reasonable estimates, any of which are actuarial justified for booking purposes. Often, actuaries will present their analysis to the CFO and auditors verbally, in addition to a physical document.


    Step 6: Prepare financial disclosures

    financial disclosure reporting

    There’s already a long list of required disclosures for loyalty programs. After ASC 606 and IFRS 15, the list has only gotten longer.


    Required disclosures Include:

    • Liability change during the year
    • How much revenue recognized in the period is included within opening liability balance
    • When the company satisfies its performance obligations (e.g., when the reward is used)
    • Nature of the goods and services the company has promised to transfer
    • Estimate of the timing to satisfy the liability
    • Significant judgments
    • Method used to determine transaction price and allocate it to performance obligations


    A deeper dive (and examples) into the financial reporting requirements is available here.


    Step 7: Hedge exposure (optional)

    An optional but prudent step is to consider your foreign exchange exposure. If your liability is significantly exposed to foreign exchange risk, your modeling and liability estimate becomes much more complicated.


    An effective currency risk management strategy involving forward contracts can minimize and hedge your exposure to foreign exchange fluctuation risks.


    Step 8: Assess progress against your financial plan for the year

    While Steps 2 through 7 account only for the loyalty program liability, there are additional transactions and measures to track each month. These include:



    Cash Flow Implications

    • Points earned bring in revenue
    • Points redeemed carry a cost


    Forecasting Implications:

    • Forecast liability and cash flow
    • Anticipate year-end financial position
    • Determine budget availability
    • Plan for the medium- to long-term horizon


    Comparing actual transactions and breakage estimates to forecasts will help identify if your program is over- or under-performing. Of course, random fluctuations can be expected, but large variances should be investigated and understood.


    Variances can be examined manually, but will be most effectively assessed through drilling down with member-level models.


    Over time breakage will shift. As frequent customers accumulate more points, they become “power users” (i.e., customers with a larger share of the overall point distribution). It’s worth noting that these power users will tend to push the overall breakage rate down.


    Step 9: Uncover further opportunities to optimize

    identify opportunities to optimize

    Finally, it’s worth remembering that the financial reporting process highlights many metrics that can be optimized for better overall performance.


    Customer lifetime value (CLV) represents another key opportunity. CLV is the present value of all net cash flows expected for each member. This metric can be calculated through implementing a member-level model.


    CLV represents a member-specific metric to focus on for maximizing the profitability of your customer loyalty program. The goal should be to increase CLV for each member each month. This is achieved through a mix of driving customer engagement and purchases.


    By implementing a CLV model, program managers can also identify and target new members with a high CLV-to-acquisition-cost ratio.


    It can be tempting to focus primarily on minimizing your program liability. After all, it’s the only piece of a loyalty program that shows on your financial statements. However, long term profitability and growth depend on maximizing CLV and customer revenue net of cost.



    As the year winds down, deadlines get tighter and deliverables become more urgent. When assessing your next reporting period, give this 9-step checklist a try:


    Step 1: Validate data

    Step 2: Allocate redemptions to points earned

    Step 3: Update breakage and fair value estimates

    Step 4: Record accounting entries for reporting periods

    Step 5: Seek an actuarial opinion

    Step 6: Prepare financial disclosures

    Step 7: Hedge exposure (optional)

    Step 8: Assess progress against financial plan for the year

    Step 9: Uncover further opportunities to optimize


    As we wind down on 2018 and look ahead to 2019, understanding what goes behind each of these steps will help you continue to improve the accuracy of your financial reporting, and provide valuable insight to your company as it looks for new ways to optimize its financial performance.

    New call-to-action


    Len Llaguno

    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.


    Subscribe to email updates