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.
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:
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:
Regardless of which method you follow, a clean system will tie redemptions to specific point earnings.
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.
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.
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:
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 (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:
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:
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.
Each financial reporting period will require updating key loyalty program accounts. The following items will change and require the corresponding accounting activity:
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 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 during the period require no adjustment, as long as the deferred revenue account incorporates point expiration estimates.
This list is by no means exhaustive. A few noteworthy additional items to adjust include:
Member-level predictive analytic models help quantify the magnitude of exchange rate risk, and aggregate results up to a total currency level.
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:
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.
There’s already a long list of required disclosures for loyalty programs. After ASC 606 and IFRS 15, the list has only gotten longer.
A deeper dive (and examples) into the financial reporting requirements is available here.
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.
While Steps 2 through 7 account only for the loyalty program liability, there are additional transactions and measures to track each month. These include:
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.
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.