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How To Account For Customer Loyalty Incentives

November 10, 2020 Strategy

Implementing a customer rewards program at your business is a highly effective way to secure loyalty, strengthen CLV, and increase sales. But issuing rewards points and keeping your loyalty members engaged is only one half of the financial equation…

How To Account For Customer Loyalty Incentives

Implementing a customer rewards program at your business is a highly effective way to secure loyalty, strengthen CLV, and increase sales. But issuing rewards points and keeping your loyalty members engaged is only one half of the financial equation…

The first half, that is. Your store offers its loyalty members a "valued currency", i.e. "points" for every unit of a real-world dollar-amount spent. This is the essence of your loyalty program and it addresses the first half of the financial equation. As part of your program, this could mean allocating 50 rewards points for every $25 dollars spent, or it could be structured so that the loyalty member earns 5 "Nugs" for every 10 bottles of CBD oil they purchase. Either way, there is a real dollar value assigned to every "point", and that association is up to you.

If the first half of this financial equation starts with determining the value of your rewards points and getting your loyalty members to earn and redeem as regularly as possible, the second half has to do with accounting for those rewards points within your bookkeeping. 

Loyalty rewards programs, whether earned points are redeemed or outstanding, have a direct impact on your business's financial statements, both your P&L and Balance Sheet. Because of this, it's critical to evaluate your rewards program and make sure it is being accurately represented in your financial accounting and properly reported in your Year-End tax returns.

Yes, the government expects accuracy. In 2014, a formal accounting standard on booking and reporting rewards "points" was determined as a result of the U.S. Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) reaching an agreement. What we have today, based on the Accounting Standards Codification (ASC) Topic 606: Contracts with Customers, is referred to as the IFRS-15 Accounting Standards.

If you're a store owner who recently launched a loyalty rewards program, if you're a marketing specialist that's promoting a store, or if you're one person wearing both of those hats, you might feel beyond intimidated right now by the prospect of venturing into the bookkeeping and accounting side of your customer loyalty rewards program. You might have even resigned yourself to hire a specialized accountant already. Whether you have or haven't, this article will equip you with a broad-based understanding of where, why, and how rewards points need to hit your financial statements.

IFRS-15 Accounting Standards both changed how rewards "points" hit a business's accounting books and mapped out how to record those transactions. Prior to the issuance of these accounting standards, a lot of retail stores were booking "points" incorrectly, associating outstanding points as liability that, once redeemed, showed up in an expense category. There were many problems with this method, the most glaring of which was that it simply wasn't accurate. But a secondary problem with this method was that it was also being used for ordinary store sales that were not a part of the rewards points system or loyalty program. In other words, the books weren't differentiating between store sales and rewards points, even though the two are very different promotions.

In order to help you fully understand this difference, and in turn grasp how you--or your bookkeeper and accountant--must record your loyalty program within Quickbooks, Quicken, Peachtree, MAS90, or whichever bookkeeping software your POS exports into, let's first define the differences.

SALES DISCOUNTS

Even prior to the advent of official loyalty programs, stores have been using traditional sales discounts as a way to incentivize customers into buying more than they had originally planned. This incentive method involves simply reducing the price of select goods and services by either a certain percentage or amount. For accounting purposes, the original sales price is fixed within the books, i.e. it does not change to reflect a lower price. While the customer pays a reduced price at the checkout register, the bookkeeping will reflect the original price, less the discount, so that two-line items within the journal entry are recorded. Remember, the discount is allocated as cost.

If an item or service had no sales discount, the books would appear to debit Cash and credit Sales. When an item or service has a sales discount due to your current promotion, the books require two separate Journal Entries, as follows:

JE #1

Debit Cash at a value of Selling Price minus Discount

Debit Discount at the value of the Discount

Credit Sales

JE#2 (relevant to COGS)

Debit Cost of Goods

Credit Inventory

A real-world example of the above equations might look like this, a bottle of nail polish retails at $10. There is a discount currently being offered on this item, which has a $2 value.

JE#1

Debit Cash $8

Debit Discount $2

Credit Sales $10

As you can see, within our first Journal Entry, we are recording a full $10 collected on the sale of the nail polish even though the customer only paid $8 at the register. But the $2 booked to Discount as a debit will offset the overall Sales figure on the P&L and the Balance Sheet.

Let's move on to the second Journal Entry for our nail polish example. What was the wholesale value of the nail polish bottle? That amount factors in here, since COGS detracts from Gross on the P&L. Let's say the nail polish bottle wholesales at $4.

JE#2

Debit Cost of Goods $4

Credit Inventory $4

Bear in mind, your P&L Income Statement will reflect the additional cost of $2 that you accrued when your customer took you up on the discount promotion. This $2 will ultimately unite with the $4 COGS, so that the $10 figure you've recorded in Sales gets pulled down.

Now, in terms of your accounting, it's also crucial to differentiate Sales Discounts that any customer can receive versus Sales Discounts that only your loyalty members are eligible for, meaning you must differentiate between the two within your books.

PROMOTIONAL & COMPLIMENTARY SALES

Promotional and complimentary sales, also referred to as "giveaways", could also occur because of a regular promotion that all customers have access to, or it could occur because of a loyalty program campaign. As we mentioned regarding Sales Discounts, you'll need to differentiate your giveaways within your books as either associated with your loyalty program or part of a regular incentive that any customer can participate in.

Unlike Sales Discounts, however, these types of giveaway promotions imply that the customer receives the associated goods or services for free. So, what happens when you give away a product for free that has a COGS amount? Afterall, you paid a wholesale cost to obtain the product. Even if you're giving away a service for free, you're likely paying the employee who is literally providing the service, like a hairdresser if you're running a promotion at a salon.

In this case, the value of the product or service can be written off as an overhead expense. Be mindful, though, that the overhead account cannot be Cost, as was the case with Sales Discounts. Alternatively, you can debit the value of the product or service into a clearing account where it can sit until you journal it out to its final destination later. In either option, you will also have to record the applicable Sales Tax or Value-Added Tax (VAT), which complicates matters for some.

Of course, the bookkeeping accounting side of recording "giveaways" must ultimately reflect the reality, which is that your company is incurring a loss whenever it gives away goods or services. Let's take a look at the Journal Entries for this type of free promotion, and remember, you'll need to record whether your promotional and complimentary sales are associated with your loyalty program or not.

JE#1 for Cash Sales to allocate the Selling Price

Debit Cash

Credit Sales

JE#2 Complimentary Sales

Debit Complimentary Sales Expense

Credit Sales

Debit Cost of Goods

Credit Inventory

You might notice that for Journal Entry #2, the first two-line items balance the Selling Price, while the second two balance the Cost Price (COGS). What you might find unusual with these Journal Entries is that #2 will hit your Income Statement as Revenue even though the item is given away at $0.

The reason for this is because the item or service is still a Sale, regardless of the value it is sold at--a value of $0 is still a value. While you do not earn cash for these free promotional giveaways, they aren't a loss since you are instead earning customer loyalty and the increased chance that the customer will shop with you more exclusively, or truly exclusively, which would be an asset.

CUSTOMER LOYALTY REWARDS POINTS

Here we get into the nitty-gritty of accurately recording the earned and redeemed rewards points within your bookkeeping. As we mentioned in the sections above, your rewards program can have any number of particular promotions, including those that are relevant to sales discounts and giveaways.

When setting up your customer loyalty program promotions within the Chart of Accounts of your books, you'll want to include separate categories for each promotional type. You can get as detailed as you like, noting the various promotions you have been running. However, we don't automatically recommend this, since this level of detail is already being compiled within the loyalty program software in the first place. You can view and analyze that data at any time. The most productive option is to set up the line items of your Chart of Accounts for your loyalty program in such a way that you can get a snapshot P&L of the different promotional types whenever you like. This way, at a glance you will be able to see if your gamified promotions are making more or less profit than your tiered promotional incentives, for instance.

To reiterate the outmoded accounting treatment of rewards points, most businesses used to book loyalty rewards credits as a "marketing expense" or "promotional expense". Because of the IFRC-15, this is no longer acceptable. Now, the discount or giveaway must be treated as a separate component of the sales transaction, as we've shown in our Journal Entry examples.

Let's dive into further detail and take a look at Deferred Revenue, which is what accrues when your loyalty members purchase goods or services that earn them rewards points. As those rewards points rack up, and prior to their redemption, they must accrue within your books as liability. What would that sales transaction look like within your books as a Journal Entry?

JE #1

Debit Cash (Purchase Amount)

Credit Sales Revenue (Purchase Amount minus Loyalty Credit)

Credit Deferred Revenue (Loyalty Credit)

A practical example of this would include offering customers 5 points every time they spend either $5 or buy one item, let's say a tube of hand cream valued at $5. First, you would have to understand the value of 5 points within your customer loyalty rewards program, but for the sake of this equation, we'll make 5 points equivalent to $1. The following is how you would record the sale of one tube of hand cream.

Debit Cash $5

Credit Sales Revenue $4 ($5 minus 5 points or $1)

Credit Deferred Revenue $1 (5 points or $1)

As you can see, the Journal Entry clearly separates the collected revenue from the deferred revenue. What does this mean? In terms of your bookkeeping and accounting, recording your Journal Entries in this manner means that you are acknowledging the future redemption value at the time of the sale, as well as recording the discount. Even though the customer handed you $5 for the hand cream, your bookkeeping will reflect the future potential of that sales transaction causing a loss of $1 when the customer redeems those 5 points.

A more complex representation of recording earned rewards points at the time of sale with the same tube of hand cream example:

JE #2

Debit Cash $5

Credit Sales Revenue $5

Debit Customer Loyalty Component of Sales $1

Credit Deferred Revenue $1

Many business owners, as well as bookkeepers and accountants, prefer the second journal entry to the first, since it shows a clear balance between Cash and Sales Revenue, and Customer Loyalty Component of Sales and Deferred Revenue. By neatly matching the figures, it's visually easier to see where these figures will show up within the Chart of Accounts.

Your Journal Entries can get even more complex if you'd like to reflect the various promotion types you're offering at your store. But we won't get into the myriad possibilities here. Just know, the possibilities are endless if you choose to reflect real-life promotions within your books.

Let's look at the other side of the rewards points program. We just reviewed how to record earned points at the time of the sale. Now, let's take a look at recording redeeming those points when the customer does so in the future.

JE#1

Debit Deferred Revenue 5 points or $1

Credit Sales Revenue 5 points or $1

As you can see, when recording the redemption of the points, only the value of the points being "burned" is reflected. You will also need to make Adjusting Journal Entries within your books at the time the rewards points that have not been redeemed expire. Unredeemed rewards points should be "released" as follows:

JE #2

Debit Deferred Revenue $1

Credit Sales Revenue $1

You may have noticed that both Journal Entries are identical, and you're right.

At any given time of year, you may want to understand the real-dollar value of the rewards point’s liability at your store. Hypothetically, if every customer with outstanding points suddenly redeemed them on the same day, your business would take a hit. While this is unlikely to occur, it's wise to have a grasp on the actual value of the liability of your program, which means that you'll need to know how to calculate that liability.

CALCULATING REWARDS PROGRAM LIABILITY

As you now understand, rewards points that are outstanding, i.e. have not yet been redeemed by the customer, are always a liability for your company. But just because you may know that there are a total of 1 million unredeemed rewards points, for example, you still need to figure out what that means as a dollar value.

The formula below will assist you in calculating that precise figure, though your POS export to your accounting software should spit out the same figure. But that would be the case if and only if your loyalty rewards program was properly integrated into your POS system wherein the rewards point to dollar value was accurately set up, too. Bear in mind when using the formula that rewards program liability is also equal to deferred revenue.

Defining those terms above, the Outstanding Points refers to the "points" that have been issued to the customers but not yet redeemed by them, nor have those "points" expired. In other words, they are pure liability. The Cost Per Point refers to the expected cost of each point that will eventually be redeemed. An oversimplified example of this would be if your rewards program was set up so that 1 point was equal to $1. Finally, the Redemption Rate refers to the probability that a point will be redeemed. Calculating the Redemption Rate is by far the trickiest aspect of this equation, because it's not possible to predict the future with 100% accuracy. However, by reviewing the true redemption rate of prior years and taking an average, you can gain a good sense of what the future will hold.

Representing your customer loyalty rewards program within your bookkeeping software can be a complicated endeavor, but not impossible. While this article only scratched the surface, by now you should have a foundational understanding of what goes into accurately recording and reporting your rewards program so that it meets IFRC-15 guidelines.

That being said, grasping the particulars of the Journal Entries we went over won't do you much good if your loyalty rewards program software isn't exporting seamlessly and accurately into your accounting software. And this is where Loyal~n~Save comes in. Our loyalty rewards program does more than incentivize enrollment, increase sales, and succeed at branding and marketing your business. Our developers and strategists have kept your Year-End planning in mind, and our solutions are tailored to simplify your life while accurately recording your accounting to meet IFRC-15 Standards.

If you would like Loyal~n~Save to work for you, please Contact Us today.

This article was written by Loyal~n~Save, an omni-channel customer loyalty solution for retailers looking to increase customer retention and new customer acquisition.
Mira Gibson
Mira Gibson

Mira Gibson is a Loyalty Strategist at Loyal~n~Save where she develops innovative marketing strategies for small businesses. She is a content machine and advocates that marketing consistency and frequency is tantamount to success. She’s a passionate writer, avid reader, and she also manages a political blog in her spare time.