Before learning the accounting, let’s understand what are customer loyalty programs? Companies often use these special programs or schemes with the aim to achieve customer loyalty and customer retention i.e., encouraging repeat purchases and trying to make regular customers.
Customer loyalty programs offer rewards to customers based on the purchases made. These rewards can be of various forms such as awarding loyalty points, coupons, vouchers etc. to the customers that entitle them to get discounts and free products in future.
Let’s think about the customer loyalty programs from an accountant’s perspective
If a company gets $1,000 from selling a product to its customer, and rewards the customer loyalty points worth $20, i.e., he will get a discount of $20 on future purchase from any of the outlets of the company. An accounting brain should now start to ponder on whether to record sales revenue of full $1,000 and ignore the future discount, or there should be some impact of the loyalty points on the amount of revenue recognition? One can also say that $1,000 has a part related to the purchase price of product bought and a part that is a kind of prepayment for future goods.
All these questions are relevant, but the good thing is that we have the International Financial Reporting Standards to refer. IFRS 15 – Revenue from contracts with customers guides us on how to account for the customer loyalty programs.
Accounting of customer loyalty programs
When the sale of a product gives a reward in the form of an option that the customer can acquire additional good or service free of cost or at a discounted price, the first thing to do is to evaluate whether the sale contract gives MATERIAL RIGHT to the customer.
What is a material right? As per IFRS 15, a material right is a right that gives the customer an option to acquire an additional good or service at a price that is lower than its stand-alone selling price. Further, the customer would not receive this right without entering into the initial sale contract.
So, if the answer to the above question is “NO”, then the accounting is simple. You’ll ignore the loyalty program and record the full amount of sales revenue at the time of selling the main product. However, if the answer to the above question is “YES”, then the material right needs to be accounted for separately.
If a sale contract awards some loyalty points to the customer that constitute a material right, stand-alone selling price of the loyalty points is estimated. This estimation includes the benefit given through loyalty points along with the likelihood of the customer exercising or using these points. Based on the stand-alone selling prices of loyalty points and the main product, sale price of the contract is allocated between the sale of the product and loyalty points.
The portion allocated to the sale of main product is recorded as revenue at the time of sale, whereas the portion of loyalty points is recorded as a contract liability (a kind of advance payment from customer). In future, this contract liability is settled, and corresponding revenue is recorded either when the customer uses loyalty points, or the loyalty points are expired.
Confusing? No worries! following example will help you understand the accounting of customer loyalty programs.
Example – Customer loyalty program
An electronics company has introduced a customer loyalty program awarding 10 loyalty points for every $100 worth of purchases made in year 20X0. Each point is equivalent to $1 and the customers can use these points in future purchases from the company till 31 December 20X1. After this date, any unutilized points will be expired.
During the year ended 31 December 20X0, the company sold its products for $800,000 and as a result, awarded 80,000 loyalty points ($800,000 x 10 points/$100) to its customers. It means that $800,000 is the transaction price that needs to be allocated on the following:
- Sale of products (revenue)
- Loyalty points (contract liability)
Based on the historical trends, the company expects 85% redemption of these points. So, the stand-alone price of one loyalty point can be calculated as follows:
Stand-alone price of one point = $1 x 85% = $0.85
Stand-alone price of 80,000 points = $0.85 x 80,000 points = $68,000
Based on the stand-alone prices of the products sold and loyalty points awarded, the transaction price of $800,000 is allocated as shown below.