IFRS valuations for Customer Loyalty Programs

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IFRS valuations for Customer Loyalty Programs

• 18 June 2009

Gautam Kakar Business Leader - Retirement, Risk
and Finance Consulting Email gautam.kakar_at_mercer
.com Phone [phone]
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Agenda

• What is Customer Loyalty Program?
• IFRIC 13
• Implication on Companies
• Results of Analysis
• How Mercer can help?
• Q A

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What is a Customer Loyalty Program ?

• Customer Loyalty programs are structured
  marketing efforts that reward, and therefore
  encourage, loyal buying behaviour behaviour
  which is potentially of benefit to the firm
• Tool for rewarding customers who have repeat
  purchases
• The program usually specifies a minimum
  requirement to receive the incentive
• e.g. purchase 10 coffees and receive the 11th
  coffee free
• Award credits commonly known as miles or points
• Common examples supermarkets, airlines, hotels,
  credit card providers, petroleum distribution
  companies

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Issues ?

• Commercial use of the personal data collected as
  part of the programmes has the potential for use
  /misuse
• Loyalty program discount goods to people that are
  buying their goods anyway, and that the expense
  of doing these programs may not pay
• Additional implied employee benefit - An employee
  who needs to buy something (such as a hotel room
  or an airline flight) for a business trip but who
  has discretion to decide which airline or hotel
  chain to use has a powerful incentive to choose
  the payment method that provides the most credit
  card rewards or loyalty points instead of
  minimizing cost for the organization.

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International Accounting StandardsIFRIC 13
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International Financial Reporting Interpretation
Committee Interpretation 13 (IFRIC 13)

• Aims to standardise how Customer Loyalty Programs
  recognise, measure and disclose in financial
  statements obligations that arise from providing
  customers with free or discounted goods or
  services.
• Applies to award credits, from a Customer Loyalty
  Program, that are part of a sales transaction and
  require other qualifying conditions.
• Revenue from the sale of award credits is
  deferred until the obligation to provide awards
  is met.

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IFRIC 13

• IFRIC 13 has mandated that paragraph 13 of IAS 18
  applies
• ..in certain circumstances, it is necessary to
  apply the recognition criteria to the separately
  identifiable components of a single transaction
  in order to reflect the substance of the
  transaction. For example, when the selling price
  of a product includes an identifiable amount for
  servicing, that amount is deferred and recognised
  as revenue over the period during which the
  service is performed.

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Application

• What is the revenue to be deferred?
• Fair Value of the points issued
• What is Fair Value?
• The price payable if the award credits could be
  sold separately
• Weighted average of the fair value of awards
  allowing for award credits expected not be
  redeemed

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IFRIC 13 in Asia Pacific

• Australia, New Zealand, Singapore, Hong Kong
• Accounting Years beginning 1 July 2008
• India 1 April 2011
• Japan No later than 1 July 2011
• Korea in draft stage implementation expected 1
  January 2011
• Thailand Currently moving towards IFRS
• Malaysia currently in draft, for period
  beginning 1 Jan 2010
• Indonesia unclear but moving towards IFRS
• Taiwan unclear but moving towards IFRS
• Philippines unclear but moving towards IFRS

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Implication on Companies
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Implications on Companies having Customer Loyalty
Programmes

• Need to estimate how long a member holds their
  points/miles before they are redeemed for an
  award, the probability of redemption or expiry
  for the balance (or current outstanding points)
  at a point in time for example the accounting
  date
• Need to estimate the probability that a point
  issued tomorrow will be redeemed, this can help
  in pricing when selling points to other retailers
  etc.
• Require help of Actuaries to do the valuation or
  review the valuation they have performed. Audit
  companies recommend that an actuary should
  calculate the probability of a point expiry.
  Actuaries let the data tell members behavior and
  also look at future plans of the program while
  setting assumptions

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Implications on Companies having Customer Loyalty
Programmes

• IFRIC 13 may change the design of the Customer
  Loyalty Programme, for e.g.
• If the company does not want to hold liability
  for long in their books, it would have strict
  rules for expiry of the points, awards available
  in small denominations of points
• If a company like for e.g. a credit card company
  wishes the customers to have multiple
  transactions instead of single transaction, it
  might put upper cap on the numbers of points one
  can earn is a single transaction

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Results of Analysis
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Analysis
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Analysis
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Case Studies
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Case Study 1.Awards supplied by the Entity

• A grocery retailer operates a customer loyalty
  program. It grants program members loyalty points
  when they spend a specified amount on groceries.
  Program members can redeem the points for further
  groceries. The points have no expiry date. In one
  period, the entity grants 100 points. Management
  expects 80 of these points to be redeemed.
  Management estimates the fair value of each
  loyalty point to be one currency unit (CU1), and
  defers revenue of CU100.

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Case Study 1.Year 1

• At the end of the first year, 40 of the points
  have been redeemed in exchange for groceries,
  i.e. half of those expected to be redeemed.
• The entity recognizes revenue of
• (40 points / 80 points)CU100 CU50.

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Case Study 1.Year 2

• In the second year, management revises its
  expectations. It now expects 90 points to be
  redeemed altogether.
• During the second year, 41 points are redeemed,
  bringing the total number redeemed to 4041 81
  points. The cumulative revenue that the entity
  recognises is (81 points / 90 points)CU100
  CU90.
• The entity has recognised revenue of CU50 in the
  first year, so it recognises CU40 in the second
  year.

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Case Study 1.Year 3

• In the third year, a further nine points are
  redeemed, taking the total number of points
  redeemed to 81 9 90.
• Management continues to expect that only 90
  points will ever be redeemed, i.e. that no more
  points will be redeemed after the third year. So
  the cumulative revenue to date is
• (90 points / 90 points)CU100 CU100.
• The entity has already recognised CU90 of
  revenue (CU50 in the first year and CU40 in the
  second year). So it recognises the remaining CU10
  in the third year.
• All of the revenue initially deferred has now
  been recognised.

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Case Study 2.Getting the most out of your
loyalty program

• Client situation
• A retailer was looking to fundamentally re-launch
  its customer loyalty program by introducing a
  number of changes to invigorate the program to
  increase customer loyalty and grow their customer
  base. These changes were expected to have a
  material dollar impact on profit, especially in
  the long term. Quantification of the impact was
  beyond the modelling capabilities of the customer
  loyalty program manager.
• Client needs
• The client needed a series of what if scenarios
  to determine the dollar cost impact and the
  change to customer redemption rates. Having this
  information was vital to help shape the new
  look program.

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Case Study 2.Mercer action

• Mercer worked with the client to acquire a
  detailed understanding of the program and was
  able to build a robust, refined and accurate
  valuation model. Through use of this model,
  Mercer was able to test
• The impact of various levels of increased
  customer points accrual over a number of years
• The introduction of non-expiry of points for
  those who accrue more than a specified number in
  a month
• The impact of targeted rewards for low point
  balance members
• The impact of introducing annual limits on the
  number of points earned

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Case Study 2.Results

• Mercers actuarial modelling and analysis in
  partnership with the client resulted in a number
  of benefits to the client
• A greater understanding of the financial outcomes
  from the timing of expiration of points, customer
  spending patterns and impact from the various
  what if scenarios due to the increased accuracy
  and management of data
• Ability to assess possible strategies based on
  the model outcomes and choose the optimal option
• Ability to relaunch their customer loyalty
  program with confidence understanding the long
  term financial impact on the program.

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Case Study 3.

• Client situation
• An airline client was seeking to adopt the new
  international accounting interpretations for the
  valuation of their frequent flyer program in
  their financial statements. One key statistic,
  mile expiry (known as breakage) had been
  previously derived internally based on historical
  program experience for miles at the balance date.
  Under the new accounting interpretation, the
  client needed to change the methodology for
  measuring breakage to be based at the time of
  issue. Quantification of breakage on this basis
  for audit purposes was beyond the modelling
  capabilities of the clients internal resources.
• Client needs
• The client needed ratification of current and
  previous breakage statistics, and an estimate of
  the breakage statistics into the future.

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Case Study 3.Mercer action

• Mercer worked in tandem with the clients
  internal team to acquire a detailed understanding
  of the operation of the frequent flyer program.
  Based on this knowledge, Mercer then aggregated
  very large volumes of data to create summaries
  based on an accurate representative sample that
  enabled appropriate analysis of redemption and
  expiry experience.
• Through the analysis of the redemption and expiry
  experience Mercer was able to build a robust
  forecasting model.
• This model was able to reconcile the historic
  breakage statistics with the forecast breakage.

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Case Study 3.Results

• Mercers modelling and analysis in partnership
  with the client resulted in a number of benefits
  for the client
• Flexible tools that allow prompt assessment of
  the impact of potential changes aimed at
  invigorating the program and promoting membership
  engagement
• External verification of key statistics that
  formed part of the clients published financial
  statements
• Transition to the new accounting interpretation
  occurred with confidence that later adjustments
  were not required
• Better understanding of the drivers of breakage
  and redemption, therefore assisting in
  quantifying the impact of decisions regarding
  program development
• Ability to consider program refinements to manage
  costs as well as customer appeal.

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How Mercer can help?
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Valuing customer loyalty programs

• Mercer is one of the leading global providers of
  customer loyalty program valuations with over a
  decade of loyalty program valuation experience.
  We have developed actuarial and financial
  techniques to help you quickly and efficiently
  assess the impact on your loyalty program.
• Mercer is currently working with some of the
  largest customer loyalty program providers to
  assist them in dealing with the new IFRIC 13
  accounting changes. These changes require
  businesses to value customer loyalty programs in
  a consistent, precise and transparent manner.
• Our analysis covers the key requirements of IFRIC
  13 and includes
• The probability of redemption or expiry of a
  point/mile.
• The market value of each point/mile.
• Disclosure information to allow the client to
  meet its IFRIC 13 obligations (i.e. quantity of
  revenue to defer and to release).

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Other Mercer loyalty program services

• Mercer can also provide
• Sensitivity analysis Quantifying the immediate
  and future financial impacts associated with
  changing a programs terms and conditions. This
  enables providers to make informed decisions
  regarding marketing strategies and optimizing the
  impact of any changes to their customer loyalty
  program in their financial accounts quickly.
• Analysis of financial drivers to a program
• Financial governance and risk management

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