Loyalty Points Liability Management: Balancing Finance and Freebies

by Sean Ogino |

Loyalty Points Liability Management: Balancing Finance and Freebies

Loyalty programs gave birth to a new currency–points. At this point, points-based programs have been around for a while, and they’ve always been treated as liabilities, since they constitute a promise for future service. However, many companies never thought too much of it until Delta Airlines announced that at the end of 2015, its loyalty points liability amounted to roughly $3.9 billion. It was about 10% of its total liabilities.

Moreover, the recent changes in accounting rules have made it compulsory for firms to adhere to the basic and inherent liable nature of the loyalty points. According to the International Financial Reporting Standard (IFRS) 15, which will become mandatory in the U.S. in 2018, a firm is required to treat every point issued in connection with a cash sale as a separate component of the sale. As it’s akin to deferred revenue, it’s bound to decrease the firm’s profits upon the initial sale. Of course, the firm can recognize a corresponding amount from its deferred revenue liabilities once the points are redeemed or expire, and it proportionally increases the profit. But the moot point that IFRS 15 guidelines have stipulated is that loyalty points‘ value should be reflected in revenue amounts. What it denotes is from now on, the actual value of a firm’s loyalty program’s deferred revenue will be the sum of three terms: the total number of outstanding points, the value of a point, and the probability that the point will be redeemed. Suddenly, loyalty points liability management has become a much more important issue.

Striking a Balance with Loyalty Points Liability

It’s quite understandable that any finance department wants to minimize this liability. But marketing teams often want to maximize loyalty points in order to increase customer engagement, repeat purchases, and average order value through redemptions. Redemption is a sound indicator of healthy customer satisfaction and engagement. This 2016 Loyalty Report has found that members who have recently redeemed for rewards have 2.5X higher program satisfaction levels compared to members who have never redeemed. Though it makes a strong case for brands to encourage redemption, it also opens up a can of worms for the finance department.

Remember that rewards-oriented expenses are incurred when the points are issued, not when they’re redeemed. As soon as the loyalty points are issued to members, the costs associated with the “potentially redeemable” points are incurred immediately. It also sets up the reserve account to cover future redemptions. Practically speaking, this entry is going to affect the cost of the loyalty program. The liability reserve will get converted into cash only after the actual redemption happens.

Moreover, redemptions that took place were previously expensed when the points were issued. Accounting books have already recorded those costs months or even years ago. Even though your redemptions have efficiently converted reserve liabilities into cash, it may make your CFO frown. It may not be an ideal outcome from their perspective, as every CFO wants to retain cash as long as possible and not have to pay off the liability. Nobody wants to pay off an interest-free debt early. As it proves that higher redemption rate doesn’t push the CFO towards their aim of reducing liabilities, other ways need to be formulated by maintaining proper synergy between your finance and marketing departments. Proper loyalty points liability management is impossible without this equilibrium.

Reducing Loyalty Points Liability

When a CFO asks CMO to reduce points liabilities, they mean to reduce the impact of the factors that bring points liabilities. There are two such main factors.

The first factor is accrual rate, which is the percentage of issued points expected to be redeemed during members’ lifetime. The second factor in reducing your loyalty points liability is the cost per point.

A reduction in the accrual rate directly means anticipating an increase in the breakage rate. Breakage is the percentage of issued points that are expected to never be redeemed by members.  CMOs vehemently hate the idea of increasing the breakage rate, as it entails that users aren’t engaged or seeing value in the program. It may help a company in getting rid of the current liability for the short term. But it’s not going to do well in the future, as it will have to increase the percentage of issued points going into its liability reserve.

Naturally, the only option that the CMO can think of is to reduce cost per point. But if they want to continue with their redemption campaign, then the efficacy of this option depends upon the cost of the lower-end rewards. Besides, the CMO will be able to reduce the average cost per point if and only if rewards are offered at a lower cost per point than everyday program reward offerings. The flip side of this scenario is this will enable the CMO to reduce the cost per point on a temporary basis. But if cost per point must be lowered on a permanent basis, they has to think about rewards realignment and communications of various rewards options.

The synthesis of the above discussion makes it clear that bringing CMOs and CFOs on the same page in the context of points redemption is very hard. Both the departments get affected differently. But the lesson is that while deciding redemption strategy, care should be taken to compare the benefits that it brings, such as lower customer churn, and higher spend with the inherent cost of points liability that such rewards carry. That’s the kernel of loyalty points liability management!

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