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Fasten Your Seatbelts

IFRIC 13 could lead to turbulent times

We should all be familiar with the customer loyalty programs that airlines use to build brand loyalty, retain their valuable customers and increase sales volumes.

The potential benefits and strategic importance of having a successful Frequent Flyer Program (FFP) are well documented. Some commentators would even argue that the FFP is one of the primary value drivers for many airlines given the vast sums of money third parties (e.g. financial institutions) are willing to pay airlines to allow them to offer redemption opportunities through their own sales channels and clients.

The benefit of having a successful FFP has always come at a price to airlines – the on-balance sheet liability to recognize the cost of future redemptions. However, in the past many airlines would contend that such a cost was not significant given that the estimate of the liability was based on the marginal cost of carriage. The airlines’ sophisticated yield and revenue management systems ensured that frequent flyer redemptions rarely, if ever, displaced a fee paying passenger and in the case where a redemption occurred, the cost to the airline was considered to be marginal e.g. the cost of an extra meal or wash pack.

IFRIC 13 will change all of this as it requires airlines to measure the FFP award with reference to fair value being the amount that it could be sold separately, for example the fair value to the holder of the award. The impact on the quantum of the liabilities could be massive which in turn could lead to an adverse impact on book equity values and accounting profit. Are you sufficiently prepared or can you expect turbulent times ahead?

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By Roger Williams, Managing Partner, Consulting, Airline Information

Today’s loyalty programs have achieved great market success by developing their own private currencies, most notably in the form of points or miles. They have moved beyond customer relationship management, because currency-based reward programs create an excellent opportunity for businesses to earn valuable ancillary revenues by selling their loyalty currency to partners.

If you are an operator of one of the myriad of loyalty programs that issues points that can be exchanged for “free” items or services, I congratulate you for embracing a practical approach to CRM. However, the resulting quagmire of liability management and point valuation just got more complicated with the introduction of new international accounting standards, mainly IFRIC 13 and IAS 18.

The International Financial Reporting Standards (IFRS) are standards and interpretations adopted by the International Accounting Standards (IASB). Worldwide it is estimated by the IASB that 100 countries use, or in some manner, coordinate with these standards. To better understand this paradigm, you could consider how electricity is used in different countries or regions. It’s all electricity, but there are many accepted voltages and plugs.

(Source: IASB)

The countries or groups of countries that run on IFRS “electricity”, if you will, include the European Union, Australia, and South Africa. Some countries are stricter than others, requiring all companies to adhere to IFRS, while others exercise a more laissez-faire approach and coordinate their own standards to be similar.

Going back to our electricity analogy, if you travel to another country that operates on different electrical standards, it is probably not a good idea to force your laptop’s power cord into a non-concurrent socket. Well the IASB has recognized that precisely correct adapters are required for every region, and is diligently working on creating global partnerships with some of the most influential accounting standard establishments.

In North America, accountants and even some astute loyalty marketers, are familiar with the GAAP (Generally Accepted Accounting Principles,) brought to you by yet another ominous sounding acronym the FASB (Financial Accounting Standards Board). Both IFRS and U.S. GAAP differ conceptually on a number of points, but the main divergence is that IFRS were crafted to be a more principles-based set of standards rather than the rules-based approach of U.S. GAAP.

A special alert for my American colleagues that tell me time after time that IFRS does not apply to them- the IFRS are coming! Even the Securities Exchange Commission recently embraced the need to adopt these standards. This could mean many late nights for both accounting and business management at American mega-loyalty point programs, especially airline frequent flyer programs.

For loyalty programs and operating/host companies, the core of the IFRS matter is as follows:

Cash Flow, can you afford to physically accrue points earned by customers? Meaning, can you put aside, in cash, the hard cost of every point accrued?

The Fair Valuation method recommended by IAS 18 leaves quite a bit to interpretation and could possibly place a downward pressure on the price of points sold to partners demanding parity valuation.

Corporate Governance, and “fair trade” implications of IFRS could be numerous. This for a business practice (loyalty programs) that has historically come under fire from government regulators and watch dog groups.

The bulk of the IFRS standards that will affect loyalty programs are contained in the new IFRIC 13 Customer Loyalty Programs that became mandatory for annual reporting periods beginning on or after 1 July 2008. This thirteenth interpretation was issued by the (IFRIC) International Financial Reporting Interpretation Committee on 28 June 2007.

The main directive of IFRIC 13 states that any operator of a loyalty program will need to recognize credits, points or miles that it awards to customers as part of a sales transaction as a separately identifiable component of revenue, which would be deferred at the date of the initial sale. This is the physical accrual part that I mentioned earlier, which brings along with it the controversial “Fair Valuation” of points.

Loyalty managers need to be aware that Fair Valuation could lead to the development of parity valuation that will detrimentally affect lucrative loyalty partnerships. Mitigating currency parity valuations among multiple partners is one of several business-related issues that loyalty professionals will now have to contend with.

The strategic upside of IFRS standards, I would argue, is the crossover of issues between accounting and marketing. The need to examine the operational, market and replacement costs of loyalty points; and physical cash accruals, only enhance the value of points which are more often than not treated as “free money”. The venerable lesson, nothing is life is free, certainly applies here. Ultimately IFRS will affect change in the right direction enhancing the responsible development of ancillary revenue generating loyalty marketing programs.

Customer Loyalty Programs: New Accounting Rules or the

Half Billion Dollar Impact?

By Michael Smith, Managing Director, SeaMountain & Moderator, FFP Seminar

1 July 2008 signalled a major change for loyalty programs in many parts of the world with the adoption of several new accounting standards. But, you have never heard about this and might be thinking: “What do these new rules have to do with my loyalty program?”  Well, the accountants have been working behind the scenes to ensure that Customer Loyalty Programs properly account for miles, points and other forms of loyalty currency. Many marketers and their colleagues running Customer Loyalty Programs generally don’t have much to do with their finance departments when it comes to accounting rules. However, this one is different on a major scale! 

To put it into perspective, these new rules are already a reality in Australia and so Qantas Airlines complied with them. The impact on Qantas’s bottom line for doing so was a downward restatement of its profits by a staggering AUS$508.4m (As reported in its Annual Report and Accounts for the half-year ended 31 December 2007, the link to which you can find at the end of this page.)

One Aussie dollar is almost the equivalent of a U.S. Greenback, so it is a sizeable sum in any currency. Implementing these rules can also impact what banks and partners pay you for your loyalty currency, meaning that Loyalty Program Managers, just as much as Accountants, must prepare for these changes.

What are these new rules?
The new rules in essence mean that if you run a Customer Loyalty Program, then you must value whatever loyalty currency (miles, points, etc.) that you issue at “fair value.” This means that they can no longer be held on the balance sheet at marginal value. So what is “fair value?” This is where things become both complicated and interesting.

The rules body hasn’t defined what it means by this and so it is open to some interpretation. Qantas has already decided what this means to it and Qantas has taken a major financial hit as a result. If all of these terms and numbers have you reaching for the headache medicine, then fear not. Help is at hand! It is not all bad news or doom and gloom.

Some good news and some bad news
The good news is that these rules only apply to you if you are a public company. If you are a privately held company, then you can, perhaps (but not necessarily), breathe a sigh of relief, as they do not directly apply to you. If you are in the U.S. or Canada (even if you are a public company) they don’t directly apply to you either- at least for now, but Canada will adopt them in the next couple of years. In the U.S., the accounting bodies hope to adopt the same principles. However, even if the rules don’t directly apply to you, this doesn’t necessarily mean that you should not be thinking about their impact. Many of the new rules are sensible in their own right. Plus, if you are a U.S.-traded company, the analysts will be looking at how other companies in your industry are responding and may (or may not) view your company more or less favourably as a result.

An overview of the new rules
Maybe it is time to get that headache medicine after all! Although these new rules, on many levels, are sensible and may be easy to follow if you spend your day doing P&L’s and accruals, they are less straightforward if your lexicon is dominated by a different set of accruals – those relating to earn and burn and loyalty currency sales to third parties! So where do you start? First, we will look at who has made these rules and what authority they have to do this. Then we’ll move on to whom they apply before finally giving an overview of what the rules actually are. Often it is worthwhile to look at something from the perspective of why something has come about, or the grand vision driving the change.

Wouldn’t it be nice if…?
In a global world it makes a lot of sense if there is one set of generally accepted accounting practices. It makes the financial statements easier to read, if they are all based on the same set of rules, which is the main thinking behind these global accounting standards. The body that was formed to oversee all of this is the International Accounting Standards Committee. This is a non-profit foundation based in London. It is made up of 22 trustees from around the world and they oversee the work of the International Accounting Standards Board (IASB) which takes soundings on the areas that need rules. They produce the drafts, which are then interpreted by IFRIC (the International Financial Reporting Interpretations Committee). These, in turn, become the IFRS rules – International Financial Reporting Standards.

Why are there rules for Customer Loyalty Programs?
When the IASC started work, it identified and prioritised a number of areas where it felt there were issues with how accounting standards were being used. One area they identified was the fast growing area of companies running loyalty programs. Their website provides a lot of useful information and this section is taken directly from it as it neatly explains why the rules are being implemented and the likely effect:

http://www.iasb.org/Home.htm

Impact of IFRIC 13
IFRIC 13 is based on a view that customers are implicitly paying for the points they receive when they buy other goods or services, and hence that some revenue should be allocated to the points. IFRIC 13 requires companies to estimate the value of the points to the customer and defer this amount of revenue as a liability until they have fulfilled their obligations to supply awards. IFRIC 13 will standardise practices and ensure that entities measure obligations for customer loyalty awards in the same way as they measure other obligations to customers, i.e. at the amount the customer has paid for them.

Fair Value
At the heart of the new rules is “fair value,” although the rules don’t state how to determine what fair value is. There are, potentially three main interpretations:Interpretation 1: the amount for which the award credits could be sold separately – “exit value strategy” (IFRIC 13) Interpretation 2: the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction (IAS 18) Interpretation 3: the amount which a Willing Buyer is prepared to pay a Willing Seller – “standard Fair Value interpretation”

Valuation Methods:
With “Fair Value” in mind, there are several possible valuation methods, each with different advantages and disadvantages:

Note: One of the links in the section below takes you to a document recently produced by the accounting firm, KPMG, which gives an excellent overview of valuation methods.

 How will these impact your program?
What could be the impact for your program?

If you are running a program in the US or are a private company you can breathe a sigh of relief as the rules don’t apply to you. However, if you take the approach that Qantas has, then there is a big impact coming to your company’s bottom line. In their case it was over AUS$500m. The approach that QF is taking may be driven by their desire to spin of their FFP and follow the lead of Air Canada.

Here’s what Qantas said in their report and accounts about the change in their accounting standards:

“The previous accounting policy created a provision for the cost of the obligation to provide travel rewards to members arising from travel on points earning services. This provision excluded the costs of an estimation of the number of points that were expected to expire. The provision was calculated as the present value of the expected incremental direct cost (being the cost of meals and passenger expenses) of providing the travel rewards.

The new Qantas Group accounting policy requires revenue received in relation to points earning flights to be split. The allocation between the value of the flight and the value of the points awarded is undertaken at fair value. The value attributable to the flight is then recognised on passenger uplift, whilst the value attributed to the awarded points is deferred as a liability until the points are ultimately utilised.

The value attributed to the points that are expected to expire is recognised as revenue as the risk expires i.e. based on the number of points that have been redeemed relative to the total number expected to be redeemed.” (QF Report and Account half year to end December 31st 2007)

What this doesn’t tell you is how they calculated “fair value” although it gives some insights in to their approach. It also shows that if you are doing what Qantas used to (and many airlines around the world are using this method) then, if you country is signed up to the new rules, you will need to change your approach.

Using the average selling price
One easy way, at first glance, might be to use the price that you sell miles to your non air partners. You and they qualify as willing buyers and sellers and using a weighted average of those prices would give you a “fair value” that should qualify under IFRIC13. It also has the advantage in making the liability for miles sold externally or internally the same.

However, thinking through the impact of this leads to several conclusions. The miles you award for flying to your own FFP members can suddenly become very much more expensive (unless, of course, you are paying the same price as your non air partners?) They are no longer held at a marginal cost on your balance sheet – or in some cases not even recognised at all until the member has enough miles for a flight.

Another potential impact of this approach is that your ancillary partners will get a greater insight into the prices you are charging others. As you can see it is vitally important that to understand the impact of all the methods that detailed discussions take place with finance colleagues as well as the auditors of the business.

A few “bigger” ideas
In the first IFRIC 13 workshop, it’s coordinator, Allan Carson of the South African firm Promethian, offered some other “bigger” options for Loyalty Programs to deal with the IFRIC 13 changes.

- Shutting your program down (Which you probably don’t want to do!)
- Outsourcing your program to a third party for a set fee (Think Aeroplan!)
- “Selling” your program’s current liability (See the link below to presentation on this subject by RBH Financial.)

Useful Related Websites:

International Accounting Standards Board website: Has all details about the body, what it does and why.  It also has details about the various standards that apply to Customer Loyalty Program accounting:

http://www.iasb.org/Home.htm  

Qantas’ Report & Accounts: Australia adopted the IFRIC13 rules recently and as a result Qantas is compliant and this link shows the dramatic impact compliance had on Qantas: (The information relating to IFRIC 13 is on page 17.)

http://www.qantas.com.au/infodetail/about/investors/2007HYResults.pdf

KPMG’s outline of IFRIC 13’s potential impact for airlines: Since auditors will have to agree with loyalty programs their “fair value” methodology, understanding KPMG’s approach is worthwhile: http://www.kpmg.com/SiteCollectionDocuments/IFRIC%2013%20Fasten%20your%20seatbelts.pdf

“FFP Expo” Conference presentations (13-14 May 2008, Dallas, Texas):

Variety of loyalty-related presentations, including a request form for the workshop materials from the first IFRIC 13 Workshop and RBH Financial’s presentation “Cost Savings through Innovative Liability Management” on selling your liability to 3rd parties:

http://www.airlineinformation.org/conferences/2008_annual_ffp/FFP2008EXPO_agenda.html

“FFP Conference” presentations (11-12 March, Istanbul, Turkey): Variety of loyalty-related presentations:

http://www.airlineinformation.org/conferences/2008_annual_ffp/FFP2008_agenda.html