Points, Miles, and Balance Sheets: How Loyalty Programs Keep Accountants Up at Night

Loyalty programs are integral to a company's marketing and customer engagement strategy, offering customers rewards in exchange for their continued patronage. In industries such as airlines, hospitality, retail, and financial services, loyalty programs are designed to create long-term relationships with customers, incentivising repeat business and fostering brand loyalty. However, while these programs generate significant value, they also introduce complex accounting and financial challenges. Managing loyalty liabilities, recognising revenue, and determining the fair value of unredeemed points/miles are critical aspects that organisations must address to ensure compliance with international financial reporting standards.

In this article, I will try to provide a comprehensive overview of the accounting framework for loyalty programs, with a particular focus on IFRS 15/IND AS 115 standards, which govern the recognition of revenue from customer contracts. We also explore the financial implications of loyalty program economics, covering topics such as cost per mile, breakage, and liability management. By offering a detailed examination of these factors, I will try and provide insights into how organisations can manage their loyalty programs to achieve both compliance and profitability.

A. Understanding the Core Financial Components of Loyalty Programs

Loyalty programs typically consist of several core financial components that impact the overall profitability of the program and the organisation's financial statements. These components can be broadly categorised into

1. Profit and Loss (P&L)
2. Balance sheet items
3. Cash flow management.

Each category presents unique challenges and requires careful consideration to ensure that the financial health of the loyalty program is accurately reflected.

1. Profit & Loss (P&L) Considerations:

The profit and loss statement for a loyalty program includes both revenues generated from the program and the associated costs of running the program.

Key elements include:

• Revenue Recognition: Revenue from loyalty programs can be generated through several channels, including: Partner Revenue: This includes the revenue earned by the program host from the sale of points/miles to customers or partners. When customers earn points/miles on purchases, the program host recognises revenue based on the sale of these points/miles. Redemption Revenue: Revenue is also recognised when a customer redeems points/miles for rewards. The value discharged from the balance sheet liability reflects as redemption revenue in the P&L. Subscription and Service Fees: Some loyalty programs charge subscription fees for premium membership tiers. Additionally, service fees, redemption fees, and ancillary revenues from the sale or transfer of points/miles contribute to the program's revenue. Breakage Revenue: Breakage refers to points/miles that are issued but never redeemed, either due to expiration or non-usage. Breakage is a crucial revenue stream, as it allows organisations to reduce their liability for unredeemed points and recognise this reduction as revenue.
• Cost Structure: The cost structure of a loyalty program typically includes: Cost of Redemptions: This represents the expenses incurred when customers redeem points/miles for rewards. Redemption costs vary depending on the type of reward (e.g., flights, merchandise, services) and the agreed-upon transfer pricing mechanism with partners. Operating Costs: Loyalty programs incur various operational costs, such as technology infrastructure, marketing expenses, and administrative overhead. These costs are aggregated to determine the total cost per mile/point issued. Tier Benefits and Bonuses: Loyalty programs often offer incremental benefits to customers based on their tier status. These benefits come with additional costs, which must be factored into the program's overall cost structure.

2. Balance Sheet Considerations:

The balance sheet is critical in managing the liabilities associated with unredeemed points/miles. The key balance sheet items related to loyalty programs include:

• Accrued Liabilities for Points/Miles: Loyalty programs accrue liabilities for points/miles issued to customers but not yet redeemed. These liabilities are recorded on the balance sheet as deferred revenue and are based on the fair value of the points/miles issued. Liability Management and Adjustments: The loyalty liability is subject to periodic adjustments based on changes in the redemption profile, earn rate, and breakage rate. If the estimated breakage rate increases (i.e., more points/miles are expected to expire without being redeemed), the liability is reduced, and the reduction is recognised as revenue. Fair Value Calculation: The fair value of a point/mile is a key metric in determining the deferred revenue and liability associated with unredeemed points/miles. Fair value is calculated based on the expected redemption cost and is adjusted annually to reflect changes in customer behaviour, redemption trends, and seasonal patterns.

3. Cash Flow Implications:

Cash flow management is essential to the financial sustainability of a loyalty program. Cash inflows and outflows related to the program are directly influenced by the issuance and redemption of points/miles.

• Cash Inflows: Cash inflows from a loyalty program come from various sources, including: Subscription Fees: Premium membership tiers often charge subscription fees, which generate cash inflows. Service Fees and Ancillary Revenues: Loyalty programs generate additional revenue through service fees for point/mile transfers, redemptions, and the sale of points/miles to customers or partners. Partner Contributions: Loyalty programs that involve partners (e.g., airlines, hotels, retailers) receive cash inflows when partners purchase points/miles for their customers.
• Cash Outflows: Cash outflows occur primarily due to the costs associated with redemption and program operations: Redemption Costs: When a customer redeems points/miles, the program incurs a cost based on the value of the reward. This cost is reflected as a cash outflow. Operational Costs: The day-to-day running of a loyalty program, including technology, marketing, and administration, results in cash outflows.

B. Accounting Standards Governing Loyalty Programs (IFRS 15/IND AS 115):

The financial reporting and accounting treatment of loyalty programs are governed by IFRS 15 (Revenue from Contracts with Customers) and its equivalent Indian standard, IND AS 115. These standards provide a framework for recognising revenue from customer contracts, including loyalty programs.

1. Key Elements of IFRS 15/IND AS 115:

Under IFRS 15/IND AS 115, revenue is recognised based on the satisfaction of performance obligations within a contract. Loyalty programs fall under this framework because the issuance of points/miles represents a performance obligation on the part of the company (the program host) to provide rewards to the customer in the future.

• Identifying the Contract: A loyalty program contract is established when a customer earns points/miles from purchasing goods or services. This contract creates enforceable rights and obligations for both the program host and the customer.
• Identifying the Performance Obligations: The key performance obligation in a loyalty program is the company’s promise to provide rewards to the customer in exchange for points/miles earned. Each distinct good or service provided as a reward is treated as a separate performance obligation.
• Determining the Transaction Price: The transaction price in a loyalty program is the value that the company expects to receive in exchange for the goods or services promised. This transaction price is allocated to the performance obligations based on the fair value of the points/miles issued.
• Allocating the Transaction Price: Once the transaction price is determined, it is allocated to each performance obligation (i.e., the rewards) based on their fair value. The fair value of a point/mile is a crucial factor in this allocation.
• Revenue Recognition: Revenue is recognised when the performance obligation is satisfied. In the context of a loyalty program, this occurs either when a customer redeems points/miles for rewards or when points/miles expire (i.e., breakage).

2. Fair Value Determination and Deferred Revenue:

A key aspect of accounting for loyalty programs under IFRS 15/IND AS 115 is the determination of the fair value of points/miles. The fair value represents the cost the program will incur when points/miles are redeemed for rewards. This fair value must be calculated regularly to reflect changes in customer redemption behaviour, seasonal trends, and cost structures.

The deferred revenue is recognised as a liability on the balance sheet, representing the obligation of the program host to provide rewards in the future. This liability is reduced as points/miles are redeemed or expire, with the corresponding revenue recognised in the P&L. A point to keep in mind is that the Balance sheet liability is revenue waiting to be recognised or what we call banked revenues. Discharge of Liability is as Revenueu to the P & L either due to redemptions or due to breakage.

3. Breakage and its Impact on Revenue Recognition:

Breakage plays a critical role in revenue recognition for loyalty programs. Breakage refers to the portion of points/miles that are issued but never redeemed, either due to expiration or non-usage. Under IFRS 15/IND AS 115, companies must estimate breakage rates based on historical data and forecast trends. Breakage allows companies to reduce their deferred revenue liabilities and recognise the corresponding revenue.

C. Program Economics: Cost Per Mile, Breakage, and Liability Management

The economics of a loyalty program are shaped by several key factors, including the cost per mile, breakage rates, and the management of loyalty liabilities. Understanding these factors is essential for maintaining the financial viability of a loyalty program.

1. Cost Per Mile:

The cost per mile is a critical metric that determines the overall cost of running a loyalty program. It is calculated by aggregating all program costs, including the cost of redemptions, partner payouts, and overheads, and dividing these costs by the total number of miles/points issued.

The cost per mile includes the following components:

• Cost of Redemptions: The primary expense in a loyalty program is the cost incurred when customers redeem their points/miles for rewards. This cost varies depending on the type of reward (e.g., airline tickets, hotel stays, merchandise) and the transfer pricing mechanism agreed upon with partners.
• Partner Redemptions: In programs with multiple partners, the cost of redemptions is often shared between the program host and the partners. Partner redemptions are typically costed at the partner’s transfer pricing rate.
• Overheads: Loyalty programs incur various overhead costs, including technology infrastructure, marketing, and administration. These costs are factored into the overall cost per mile.

The cost per mile is a key metric that loyalty program managers use to monitor and control program costs. Programs can flex this cost up or down by managing the key drivers of costs, such as redemption rates, overheads, and partner agreements.

2. Breakage:

Breakage is a vital element of loyalty program economics. It refers to the percentage of points/miles that are issued but never redeemed. Breakage occurs when points/miles expire or are forecasted to never be used. Accurately estimating breakage is crucial for several reasons:

• Revenue Recognition: Breakage allows companies to recognise revenue for points/miles that will never be redeemed. This reduces the program’s liability and contributes to immediate revenue recognition.
• Liability Management: Reducing the liability for unredeemed points/miles through breakage helps improve the financial position of the program by lowering deferred revenue on the balance sheet.

The estimation of breakage rates is based on historical data and customer behaviour patterns. Loyalty programs must continuously monitor and update these estimates to ensure that revenue recognition and liability management reflect the latest trends in customer redemption behaviour.

3. Liability Management:

Managing the liability associated with unredeemed points/miles is one of the most important aspects of running a loyalty program. The loyalty liability is the financial obligation of the program host to provide rewards for outstanding points/miles. This liability is recorded on the balance sheet as deferred revenue and must be carefully managed to avoid excessive financial burden.

The value of the loyalty liability is directly tied to the fair value of points/miles and the redemption profile of customers. As the fair value of points/miles fluctuates based on redemption trends, customer behavior, and cost structures, loyalty programs must regularly revalue their liabilities to ensure accuracy.

When the fair value of points/miles changes, the corresponding impact on the program’s liability is reflected in the financial statements. If the fair value decreases (e.g., due to a lower redemption rate), the liability is reduced, and the reduction is recognised as revenue. Conversely, if the fair value increases, the liability rises, impacting the program’s profitability.

Loyalty programs are powerful tools for enhancing customer engagement and driving brand loyalty, but they also pose significant accounting and financial challenges. By adhering to IFRS 15/IND AS 115 standards, organisations can ensure that their loyalty programs are both compliant and financially sustainable. The careful management of key metrics such as cost per mile, breakage, and fair value is essential for maintaining profitability and reducing financial liabilities.

Loyalty program managers must also remain vigilant in monitoring the program’s economics, including redemption trends, customer behaviour, and seasonal variations. Regular updates to fair value estimates and breakage rates are necessary to ensure that revenue recognition and liability management reflect the latest trends in customer behaviour.

Ultimately, the success of a loyalty program depends not only on its ability to attract and retain customers but also on its ability to manage its financial obligations and accounting requirements effectively. By applying the insights and best practices outlined in this article, organisations can navigate the complex landscape of loyalty program accounting and achieve long-term success.

In the ever-changing playing field of the aviation industry, the role of loyalty programs has grown beyond mere customer engagement tools to become critical drivers of revenue, profitability, and free cash flow. These programs, rich in customer data and engagement opportunities, present untapped potential for strategic enhancement and monetisation. The advent of challenges such as the COVID-19 pandemic has underscored the resilience and financial significance, proving them to be indispensable assets within the organisations broader business model.

?We are Customer Capital, specialists in crafting and monetising customer experiences. The collaboration with us will serve as a catalyst for creating new or transforming existing loyalty programs into dynamic, profitable, and customer-centric entities. Our vast experience in Captive Commerce across industries and continents as well as a deep understanding of customer engagement strategies, can unlock new dimensions of value creation.