Customer Loyalty Programmes. Implementation Guidance of IFRIC 13 for Telecommunications Operators. Telecommunications Accounting Updates:

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1 GLOBAL TELECOMMUNICATIONS CENTER FEBRUARY 2008 Telecommunications Accounting Updates: Customer Loyalty Programmes Implementation Guidance of IFRIC 13 for Telecommunications Operators

2 Telecommunications Accounting Updates This is a series of publications by Ernst & Young s Assurance and IFRS professionals, which summarises the latest changes in accounting policy and how they are implemented within the global telecommunications sector. For more information, please contact your local Ernst & Young representative or refer to Global Telecommunications Center The Ernst & Young Global Telecommunications Center is part of our continued commitment to the telecommunications industry. The Center, located in Paris with antennas in Beijing, Delhi and San Antonio, is dedicated to offering insight on assurance, risk, tax, transactions and The Center links client service professionals from Ernst & Young member to Ernst & Young clients. A supplementary publication industry, should be read in conjunction with Ernst & Young Global s publication, Customer Loyalty Programmes: Implementation Guidance, which can be obtained via

3 Customer Loyalty Programmes Contents 1 Introduction 2 2 Transition and effective date 2 3 Scope of IFRIC Challenges 4 5 Illustrative fact pattern 5 6 Initial recognition 6 7 Subsequent accounting 10 8 Potential impacts on information systems 12 Ernst & Young 1

4 Customer Loyalty Programmes 1 Introduction Many telecom operators use customer loyalty programmes to reward customers for their past purchases and provide incentives to make further purchases. Typically customers are granted loyalty awards, often points, based on their usage of services (airtime services, content) or the purchase of goods (handsets and modems). Services and goods might be sold separately or in bundles. Loyalty awards can be accumulated and redeemed to obtain or from other parties. IFRIC published an Interpretation on accounting for customer loyalty programmes (hereafter referred to as IFRIC 13 or the Interpretation ) on 28 June This publication addresses some of the complexities associated with the practical application of IFRIC 13 within the telecommunications industry. It provides guidance on the Interpretation and includes practical application issues through the analysis of an illustrative fact pattern. We trust this publication will help both preparers and users in understanding the implications of IFRIC Transition and effective date An entity shall apply this Interpretation for annual periods beginning on or after 1 July Earlier application is permitted; however, if an entity applies the Interpretation for a period beginning before 1 July 2008, it must disclose this fact. We believe that the application of IFRIC 13 will most likely be a change in accounting policy for most telecommunications operators, as industry practice was to recognise the loyalty programmes as a cost. Changes in accounting policy shall be accounted for in accordance with IAS 8. Companies will therefore be required to determine an approach to identify the fair value at inception of all existing loyalty awards credits as at the transition date, accounting for potential changes in redemption rate estimates since their grant date, in order to determine the appropriate deferred revenue. However, when an entity has previously accounted for the programme as an element of a sales transaction, but needs to change its valuation methodology in light of the requirements of IFRIC 13, this is likely to be a change in estimate. At the date this paper was prepared, this IFRIC has not been endorsed by the European Union. 2 Ernst & Young

5 Implementation Guidance of IFRIC 13 for Telecommunications Operators 3 Scope of IFRIC 13 IFRIC 13 addresses the accounting of loyalty awards, granted as part of a sale transaction, that customers can redeem in the future for free or discounted goods or services, provided other qualifying conditions are achieved. IFRIC 13 covers the accounting of awards by the grantor and not by the grantee. To fall within the scope of the Interpretation, a loyalty award should therefore (1) result from a past transaction (for example, vouchers given for free are not considered in this Interpretation) and (2) The obligation may require a positive act from the customer: the customer formally enrols into included in the airtime service contract) and the way award credits are earned and can be redeemed Loyalty awards may also be implicit and embedded into offers. For example, an offer whereby an operator grants free minutes when their customers reach a certain level of usage is a loyalty programme within the scope of IFRIC 13, since it creates for the customer a contractual right to On the other hand, operators loyalty programmes can also be out of the scope of IFRIC 13 when they do not provide rights for customers. Operators often use internal scoring systems to identify their high-value customers and offer them, on a discretionary basis, rebates or free goods when they renew their subscriptions. These awards, even if (among other factors) they are determined based on past purchases, are not in the scope of IFRIC 13 because criteria (2) mentioned above is not met. Ernst & Young 3

6 Customer Loyalty Programmes 4 Challenges Loyalty programmes in the telecommunications industry are usually programmes granting points that allow customers to obtain a discount on their handset when renewing their airtime contract. Due to the way they have been built, these programmes usually do not allow customers, unless their usage is very high, to buy a handset at a better price than new customers. However, the inconvenience of losing their phone number was usually an incentive for customers to use their points and to accept having to pay more for a new handset than new customers. The introduction of number portability, and the pressure from regulatory bodies to make the portability fast and easy for customers, changes customers without the inconvenience of changing their phone number. Therefore, in order to maintain churn rate 1 at an acceptable level, it is likely that loyalty programmes will, in the near future, allow Impact of introduction of number portability on loyalty programmes Price of handset for new customer Price of handset for customer renewing airtime contract Loyalty discount from points Value of not losing current phone number Perceived value of handset upon renewal Price of handset for new customer Price of handset for customer renewing airtime contract Loyalty discount from points Value of not losing current phone number Perceived value of handset upon renewal Anticipated evolution of loyalty programmes Price of handset for new customer Price of handset for customer renewing airtime contract Loyalty discount from points Price of handset upon renewal This paper discusses loyalty programmes that allow customers to earn a discount on the handset upon renewal of a contract. The illustration above clearly explains why these types of programmes this is likely to become material in the future and we believe telecommunications operators should be prepared to deal with the accounting implications of such programmes. The examples that are presented in this document illustrate some of the complexities relating to the implementation of IFRIC 13. 1: Churn rate is the ratio of the net number of subscribers who disconnect over a period of time, as compared to the number of active subscribers in the system over the same time. It is typically calculated on a monthly basis and expressed in percentage form (eg, 1.2% churn rate means that 1.2 customers disconnected for each 100 customers who subscribed). Source: Ernst & Young and On Line Communications Dictionary, 20 December 2007, 2007 Althos Publishing 4 Ernst & Young

7 Implementation Guidance of IFRIC 13 for Telecommunications Operators 5 Illustrative fact pattern Key assumptions The assumptions detailed below will be used in examples 1, 2 and 3 presented further in this document. On 01/10/20Y1, a mobile operator launched a loyalty programme whereby all post-paid customers will earn one loyalty point for each euro spent on airtime services. These points have a current face value of This face value is not necessarily communicated to the customer and may change at the operator s discretion. They can be used only to obtain a discount on a new handset if and when the customer renews the airtime contract. A new customer gets a handset for 50 and an airtime service contract. On renewal, an existing customer is offered the same handset for 80 (before taking into account accumulated loyalty points) with the same airtime service contract. Each point accumulated will provide a discount of 0.03 (eg, its nominal value). Therefore if the existing customer has accumulated more than 1,000 points, he will be able to buy the same handset at a better price than the new customer. He will Points granted and redeemed are as follows: 31/12/20Y1 31/03/20Y2 30/06/20Y2 75,000,000 points granted in Q4 Y1 and not yet redeemed as of 31/12/20Y1 Points granted in Q1: 40,000,000 Points (Q4 Y1) redeemed during Q1: 25,750,000 Points (Q1 Y2) redeemed during Q1: 11,000,000 Points granted in Q2: 50,000,000 Points (Q4 Y1) redeemed during Q2: 25,000,000 Points (Q1 Y2) redeemed during Q2: 15,000,000 Points (Q2 Y2) redeemed during Q2: 10,000,000 Points granted during year Y2 will have to be used by the customer before the end of year Y5 otherwise they will lapse. Ernst & Young 5

8 Customer Loyalty Programmes 6 Initial recognition The Interpretation has retained a deferred revenue model. The credit award is therefore accounted for as a separate component of the sales transaction in which it has been granted. This component is then deferred until either: The credit awards are redeemed by the customer The obligation is passed on to another entity The probability that unused award credits will be redeemed becomes remote The credit awards reach an expiry date (if applicable). The consideration initially allocated to the award credits shall be measured by reference to their fair even if not directly observable, the fair value of the awards granted must be estimated. IFRIC 13 does not specify whether the consideration allocated to the awards should be equal to their fair value (irrespective of the fair value of the other components of the sale the residual fair value method) or to a proportion of the total consideration based on the relative fair value of the award credits compared to the fair value of the other components of the sale (the relative fair value method). The selection of one of these methods is therefore left to the management. In the telecommunications industry, customers usually automatically join loyalty programmes when they subscribe to an airtime contract, therefore there is unlikely to be a difference between the two methods. Should this not be the case, we invite the reader to refer to paragraph 3 of Ernst & Young Global s publication, Customer Loyalty Programmes: Implementation Guidance, which can be obtained via When the fair value is not directly observable, the fair value of award credits can be estimated by reference to the fair value of the awards for which they could be redeemed. The fair value of the award credits must be reduced to take into account two elements: 1. Discounts that would otherwise normally be granted to customers who have not earned award credits from an initial sale eg, to new customers 2. The proportion of award credits that are expected to be forfeited. 6 Ernst & Young

9 Implementation Guidance of IFRIC 13 for Telecommunications Operators 6.1 Calculating the fair value of the award the fair value of each unit to apply to the face (ie, nominal) value of award credits, since the operator has to determine the value of discount that would be offered to its customers that do not participate in the loyalty programme. In other words, what discount would be available to existing customers if they were to buy the same goods or services as the ones for which the award credits can be redeemed? The example below is an illustration of the steps that can be applied for determining such fair value. Example 1 At 31/03/20Y2, the operator will need to determine the fair value of the award granted to its customers. The following information is available to the operator for the three-month reference period : Number of clients that have redeemed their points 25,000 Clients that have earned a lower discount than new customers 2 1,800 Clients that have earned a higher discount than new customers 23,200 Points used by those 23,200 clients 35,000,000 Points used by those 1,800 clients 1,750,000 Number of points necessary to earn a higher discount than a new customer over 1,000 The overall discount granted to customers that have earned a higher discount than new customers amounts to 1,050,000 (being 35,000, ). If those customers were new customers, they would have been entitled to a discount of 696,000 (being 1,000 23, ). to 354,000. By dividing this amount above by the total number of points redeemed over the period, the fair value of each award, based on the assumption that 100% of points will be redeemed, is (being 354,000 36,750,000). 2: Number of customers that have redeemed their points but that have accumulated less than 1,000 points and, therefore, Ernst & Young 7

10 Customer Loyalty Programmes Key points from Example 1: The fact that subscribers acquisition costs on average are higher than subscribers retention their points. Then an appropriate segmentation of customers that have earned an incremental The example demonstrates that the threshold has a key impact on the calculation of the fair value of award credits. does not have any impact on the accounting treatment. fair value of the award. Catalogues presenting discounted products that can be obtained with loyalty points may sometimes show loyalty awards at a pre-discount price that is higher than the price that would be offered to a new customer. The example demonstrates that each point granted will potentially allow the customer telecommunications industry, this incremental approach will be especially challenging, due to the large panel of bundle offers available to customers, to the changes to these offers as time passes and also due to the complexity of the existing loyalty plans. and should be carefully monitored: rate and changes in commercial offers). 8 Ernst & Young

11 Implementation Guidance of IFRIC 13 for Telecommunications Operators 6.2 Calculating the value of the award building in expected redemption rates Frequently, loyalty programme members do not accumulate the minimum number of award credits required to redeem the credits for free, or discounted handsets or services. Additionally, members services to which they are entitled. IFRIC 13 requires consideration of the redemption rate of points when determining the amount to be initially deferred. Example 2 Based on historical trends and experience, the operator has been able to document that 10% of the loyalty points granted to customers will never be used. Over Q1 Y2, the operator granted 40,000,000 points. Therefore, deferred revenue amounts to 360,000 (40,000, ). Key points from Example 2: Under a deferred revenue model, the amount is not re measured if assumptions change. Changes in assumptions will only affect the timing of the release of the deferred revenue. In other words, the effect of changes in the expected redemption rate will be recognised in revenue over the period in which other award credits are redeemed and is accordingly neither deferred until actual expiry, nor recognised as a cumulative catch-up. The estimation of the redemption rate is often the most challenging aspect of measuring the fair value of award credits. In particular, the following factors may affect the estimated redemption rate: Changes in the popularity of the programme over the years Changing patterns in the redemption rates relating to factors such as the age of customers, their geographical location and their past buying pattern Requirements for customers to build up a minimum level of credits before they can be used, which may mean a number of customers will not be able to redeem their credits The absence of historical experience with similar types of awards programmes or the inability to apply such experience because of changing circumstances. The operator s capacity to determine and document the redemption rate is therefore critical. If an operator cannot make a reasonable estimate of the redemption rate, through internal or external studies, internal marketing models and benchmarks, the deferred revenue will have to be based on the assumption that 100% will be exercised. Ernst & Young 9

12 Customer Loyalty Programmes 7 Subsequent accounting The deferred revenue is recognised in income as loyalty points are used or when they expire. The rule to calculate the amount of revenue recognised in any one period is made on a cumulative basis according to the formula below: Award credits redeemed to date Total award credits expected to be redeemed Total revenue allocated to the award credits Revenue recognised to date Example 3 This example presents how the revenue allocated to the credit awards granted in Q4 Y1 and Q1 Y1 is recognised during the different periods. Additional assumptions: Fair value of points granted in Q4 Y1 assuming 80% redemption rate: Deferred revenue balance as at 31/12/ 20Y1: 450,000 Redemption rate estimates for each period: Redemption rate for points Estimation date granted in: 31/12/20Y1 31/03/20Y2 30/06/20Y2 Q4 Y1 80% 80% 85% Q1 Y2 90% 85% Q2 Y2 85% Assumptions regarding points granted and redeemed are those presented in the illustrative fact pattern section. The calculation below presents how revenue related to loyalty points granted in Q4 Y1 will be recognised in Q1 Y2 and Q2 Y2. At the end of Q1 Y2, 25,750,000 points granted in Q4 Y1 have been redeemed. Therefore the revenue to be recognised amounts to 193,125 (being (25,750,000 (75,000,000 80%)) 450,000). At the end of Q2 Y2, 25,000,000 points granted in Q4 Y1 have been redeemed, bringing the total award credits redeemed to date to 50,750,000. However, management has changed its redemption rate estimate from 80% to 85%. Therefore the revenue to be recognised amounts redemption rate had not changed, the revenue recognised in Q2 Y2 would have been 187,500. The calculation below presents how revenue related to loyalty points granted in Q1 Y2 will be recognised in Q1 Y2 and Q2 Y2: As calculated in Example 2, an amount of 360,000 has been deferred at the end of Q1 Y2. At the end of Q1 Y2, 11,000,000 points granted during Q1 Y2 have been redeemed. Therefore the revenue to be recognised amounts to 110,000 ((11,000,000 (40,000,000 90%)) 360,000). At the end of Q2 Y2, 15,000,000 points granted in Q1 Y2 have been redeemed, bringing the total award credits redeemed to date to 26,000,000. However, management has changed its redemption rate estimate from 90% to 85%. Therefore the revenue to be recognised amounts rate had not changed, the revenue recognised in Q2 Y2 would have been 150, Ernst & Young

13 Implementation Guidance of IFRIC 13 for Telecommunications Operators Key points from Example 3: a revenue model and not a balance sheet stock-based approach. of deferred revenue. A decrease in the redemption rate will result in a more rapid release of deferred revenue. A change in the redemption rate might also lead to a provision for an onerous contract if such a change leads to unavoidable costs to supply the awards higher than the revenue deferred and the revenue receivable for them (additional consideration that might be received when the loyalty member redeems their points). We believe this will rarely be the case in the telecommunications industry, since loyalty awards are usually associated to a contract renewal and overall loss on a contract is unlikely. However, if loyalty awards are given without a renewal of the airtime contract, it is possible that unavoidable costs to provide the award will become higher than the deferred revenue (for example, if the redemption rate assumptions have been overestimated). Ernst & Young 11

14 Customer Loyalty Programmes 8 Potential impacts on information systems to be tracked, such as detailed history of customer loyalty awards, including various elements used to calculate these awards. This new requirement for information and the required level of detail may result in complex information systems developments, which should be anticipated. An impact analysis on information systems should be performed jointly by controlling, accounting and IT departments to determine information to be tracked in the systems. As IFRIC 13 allows several ways to calculate the various amounts to be posted, this impact analysis should aim at balancing (1) the level of detail of data to be tracked in the systems, in order to apply the standard and (2) the complexity and workload of information systems development. IFRIC 13 issues regarding information systems should mainly concern IT applications supporting: Loyalty awards tracking system Price list master data Controlling and accounting systems which monitor: Award churn rate Deferred revenue. IT consequences of the adoption of IFRIC 13 should therefore be anticipated as soon as possible. 12 Ernst & Young

15

16 Contacts Vincent de La Bachelerie Global Telecommunications Leader Tel: vincent.de.la.bachelerie@fr.ey.com Richard Addison Global Telecommunications IFRS Leader Tel: raddison@uk.ey.com Jean-Yves Jegourel Global Telecommunications Assurance Leader Tel: jean-yves.jegourel@fr.ey.com Thomas Queme Senior Manager Global Telecommunications Center Tel: thomas.queme@fr.ey.com Ernst & Young About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 130,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve potential. For more information, please visit Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor EYGM Limited. All Rights Reserved. EYG No. EF0016

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