Financial Reporting Update

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1 Financial Reporting Update December 2007 Issue 38 KPMG IN HONG KONG HK(IFRIC) Interpretation 13, Customer loyalty programmes In this issue: Background and IFRIC's consensus 1 Application of HK(IFRIC) 13 - Scope 3 - Identifying the amount of consideration to be allocated to award credits 4 - Revenue recognition 6 Effective date and transitional requirements 10 Common abbreviations defined: HKICPA - Hong Kong Institute of Certified Public Accountants (previously known as Hong Kong Society of Accountants) HKAS - Hong Kong Accounting Standard HKFRS - Hong Kong Financial Reporting Standard The HKICPA has recently issued a new interpretation, HK(IFRIC) Interpretation 13, Customer loyalty programmes, which is effective for annual periods beginning on or after 1 July 2008 with early application permitted. HK(IFRIC) 13 is a copy of IFRIC 13, issued by the IASB, with the same effective date and transitional provisions. HK(IFRIC) 13 describes "customer loyalty programmes" as programmes under which entities grant award credits as incentives to customers to buy their goods or services. Common examples are airline and hotel loyalty schemes and credit card reward schemes. HK(IFRIC) 13, however, does not seek to address all forms of customer loyalty programmes. Instead, its scope is limited to the accounting by entities that provide their customers with award credits as part of a sales transaction. It therefore does not cover the accounting for incentives granted outside a sales transaction (such as freely distributed discount vouchers) or arrangements where customers are granted financial assets (such as cash-back arrangements). This FRU takes a closer look at this Interpretation. If at any time you would like further assistance, please talk to your usual KPMG contact. Background and IFRIC's consensus Customer loyalty programmes that fall within the scope of HK(IFRIC) 13 are widespread, being offered by businesses as diverse as supermarkets, airlines, telecommunications operators, hotels and credit card providers. The key features of these schemes are generally as follows: IASB - International Accounting Standards Board IFRS - International Financial Reporting Standard IAS - International Accounting Standard IFRIC - International Financial Reporting Interpretations Committee FRU - Financial Reporting Update issued by KPMG Hong Kong Customers are awarded the credits when they buy goods or services (the "initial sales transaction"). Commonly the entity keeps an electronic record of these credits by customer name, but the system could be as simple as giving the customer discount coupons or stamps which the customer collects until they have accumulated enough to claim an award. The customer can redeem the award credits for free or discounted goods or services. Commonly, the customer is permitted to choose from a range of goods and/or services, but it could be that the award credits may only be redeemed for a single specified item. The goods/services may be provided directly by the entities that granted the award (such as waiver of next year's annual credit card fee by a credit card company) or by third parties (such as specified stores or restaurants honouring retail vouchers obtained through redemption of credit card points). 1 FRU issue 38 (December 2007)

2 Generally, the award credits have an expiry date i.e. if they are not redeemed by a certain date they become worthless. Alternatively, the credits may only be capable of redemption "while stocks last" and therefore they effectively expire when stocks of the award items run out. In some cases no expiry date or other condition has been set on the timing of the redemption. Unredeemed award credits represent an incomplete transaction so long as they have not reached their effective expiry date. The issue that IFRIC addressed was whether this incomplete transaction should be accounted for: by taking an accruals approach in accordance with paragraph 19 of IAS 18, Revenue (equivalent to HKAS 18) i.e. by recognising the initial sales transaction at its full sales value, but increasing expenses (for example "marketing expenses") by setting up a liability for the expected costs that would arise as and when the customer chooses to redeem the credits; or by taking a multiple sales approach in accordance with paragraph 13 of IAS 18 i.e. by deferring some of the revenue received from the initial sales transaction, to be recognised as revenue as and when the entity provides the goods or services promised under the loyalty programme. IFRIC concluded that customer loyalty programmes should be recognised as a revenuegenerating activity, to be recognised as and when the entity has fulfilled its obligation towards the customer IFRIC concluded that entities are required to apply the second approach to customer loyalty programmes within the scope of IFRIC 13. That is, IFRIC concluded that paragraph 13 of IAS 18 applies if a single transaction requires two or more separate goods or services to be delivered at different times, thereby ensuring that revenue for each item is recognised only when that item is delivered. In contrast, IFRIC concluded that paragraph 19 of IAS 18 applies only if the entity has to incur further costs directly related to items already delivered, e.g. to meet warranty claims. Having decided that the appropriate approach to customer loyalty programmes is to allocate revenue between multiple components of the sales transaction, IFRIC then considered the related issues of: how to allocate the consideration receivable from the initial sales transaction between the award credits and the other components of the sale; when to recognise any amount deferred in respect of the customer loyalty programme; and when and how to measure revenue if a third party supplies the awards. These issues are looked at below, after first considering more closely which arrangements fall within or outside the scope of HK(IFRIC) 13. HK(IFRIC) 13 only needs to be applied where the effect would be material Materiality may depend on one or more of the following factors: - the value of the award items relative to the value of the initial sales transaction - the extent to which the award items are dissimilar from the items supplied under the initial sales transaction - whether the entity is acting as principal or agent in the customer loyalty programme - whether the accounting for the initial transaction and the award redemption fall into different financial reporting periods NB In the discussion below, we have included a number of simplistic examples to illustrate HK(IFRIC) 13's principles. However, it should be noted that in practice, entities need only apply HK(IFRIC) 13 to customer loyalty programmes in existence if the effect would be material. This would depend on the facts and circumstances from one entity to the next. However, the presence of one or more of the following factors increases the likelihood that application of the principles of HK(IFRIC) 13 could have a material impact on an entity's performance reporting: the award items available to customers have a significant fair value, for example where customer can receive free air tickets by redeeming airline points (as opposed to, for example, low value novelty items which may be the subject of supermarket stamp collection programmes); the goods/services supplied under the loyalty programmes are significantly different from those in the initial sales transaction, such that they would be presented as different classes of revenue in the entity's financial statements; even though third parties are supplying the awards, the entity is acting as a principal in the customer loyalty programme (as opposed to acting as an agent to a third party supplier of the awards) and therefore has to record the revenue from the redemption of awards under the programme on a gross basis (rather than simply recording an agent's fee equal to only the margin earned from the transaction); and/or FRU issue 38 (December 2007) 2

3 there is a significant period of time between the initial sales transaction in which the award credits were granted and the time when they were redeemed, for example where a customer needs to accumulate a large number of points before being eligible for any awards, when that time period may fall across two financial reporting periods. Even when accounting for material loyalty programmes, it may be necessary to make generalisations and assumptions. Care should be taken to ensure these are reasonable It should also be noted that when applying HK(IFRIC) 13 to such material programmes, entities would generally need to make a number of assumptions and generalisations in order to allocate and recognise amounts, particularly where there are a large number of participants in the programmes and/or a considerable variety of awards on offer. Such assumptions and generalisations are acceptable provided they are reasonable, for example, they can be supported by reference to historical data obtained by the entity on the pattern of customer behaviour and are materially consistent with HK(IFRIC) 13's principles. Application of HK(IFRIC) 13 Scope HK(IFRIC) 13 addresses accounting by entities that provide their customers with incentives to buy their goods or services by providing award credits as part of sales transactions HK(IFRIC) 13 addresses the accounting by the entity that grants award credits to its customer. It applies to customer loyalty award credits that: an entity grants to its customers as part of a sales transaction, i.e. a sale of goods, rendering of services or use by a customer of entity assets; and subject to meeting any further qualifying conditions, the customers can redeem in the future for free or discounted goods or services. (HK(IFRIC) 13.3) The entity may operate the customer loyalty programme itself or may participate in a programme operated by a third party. The awards offered may include goods or services supplied by the entity itself and/or rights to claim goods or services from a third party (HK(IFRIC) 13.2). HK(IFRIC) 13 does not apply to customer loyalty programmes that grant customers financial assets The Interpretation does not apply to customer loyalty programmes that grant customers financial assets (such as cash back arrangements). This kind of benefit is similar to a discount on the initial sale transaction as it does not require any further purchases for the value of the credit to be obtained by the customer. It should therefore be deducted from the revenue recognised on the initial sale. Are money-off vouchers inside or outside the scope of HK(IFRIC) 13? Money-off vouchers fall within the scope of HK(IFRIC) 13 if they were obtained in a sales transaction Freely distributed money-off vouchers are outside the scope of HK(IFRIC) 13 but may be onerous to the entity, in which case HKAS 37 should be applied Vouchers that are of a specified monetary value (such as $100 supermarket gift vouchers or coupons which give the holder "$1 off" the cost of a specified item) are not financial assets. Instead they represent a promise to give a discount on goods/services purchased in the future compared to the normal cash price. Therefore in order to determine whether or not they fall within the scope of HK(IFRIC) 13 it is necessary to consider the circumstances in which the customer acquired them. If such vouchers were received by a customer as a result of a sales transaction (i.e. obtaining the voucher was conditional on buying other goods or services), then they would fall within the scope of HK(IFRIC) 13. The accounting in such cases would follow the principles in the worked examples illustrated below on pages 5, 8 and 9 for a discount voucher which enabled the customer to purchase wine glasses at a reduced price, whether the voucher was for a stated monetary amount or gave "money off" a specified item. If such vouchers are distributed unconnected to a sales transaction (such as money-off vouchers distributed tnípotential customers via advertising leaflets), they would fall outside the scope of HK(IFRIC) 13. In such cases, as and when the customer presented the voucher in order to purchase the eligible items, the vouchers would generally simply result in a lower sale price being recorded for the transaction, than the sales price charged to customers who did not present a voucher. In either case, at all times before redemption or expiry of the vouchers, entities should consider whether the vouchers are potentially onerous, i.e. whether the cost of fulfilling the promise made by the voucher could exceed the revenue, if any, that would be receivable as and when the customer chooses to present the voucher for redemption (which, in the case of vouchers within the scope of 3 FRU issue 38 (December 2007)

4 HK(IFRIC) 13, would include the amount of any deferred income not yet recognised, as discussed below). If so, then the requirements of HKAS 37, Provisions, contingent liabilities and contingent assets, should be considered, with any provisions made generally being regarded as arising from marketing activities to be expensed immediately. HK(IFRIC) 13 requires part of the consideration receivable on the initial sales transaction to be allocated to the award credits In the case of credit card providers, the "consideration receivable on the initial sales transaction" generally refers to the merchant's fees The consideration receivable in the initial sales transaction should be allocated to the award credits "by reference to" their fair value Identifying the amount of consideration to be allocated to award credits As mentioned above, HK(IFRIC) 13 requires entities to apply paragraph 13 of HKAS 18 by accounting for award credits as separately identifiable components of the initial sales transaction in which they are granted (HK(IFRIC) 13.5). Consequently, the fair value of the consideration received or receivable in respect of the initial sale would need to be allocated between the award credits and the other components of the sale. In some initial sales transactions, the entity receives consideration from an intermediate party, rather than directly from the customer to whom it grants the award credits. For example, credit card providers may grant award credits to credit card holders when they make purchases with third party vendors using the credit card. In this case, the fees that the credit card company receives for providing those credit facilities to the customer come indirectly from the customer via the fee that the vendor is required to pay to the credit card company. Nevertheless, this transaction is within the scope of HK(IFRIC) 13, with the vendor's fee being identified as the revenue from the initial sales transaction which needs to be allocated by the credit card provider between credit services provided and the redemption of goods/services under the customer loyalty programme at a later date (HK(IFRIC) 13.BC4). Allocation by reference to fair values HK(IFRIC) 13 requires the consideration allocated to the award credits to be measured "by reference to" their fair value (HK(IFRIC) 13.6). It is clear from the basis for conclusions to HK(IFRIC) 13 that this does not necessarily mean that the award credits must be stated at fair value. Instead, as indicated in HK(IFRIC) 13.BC14, using their judgement management can choose between either of the following allocation methods: (a) (b) the consideration receivable is allocated first to the award credits according to their fair value, with the initial sales transaction being recognised at the residual amount of consideration receivable; or the consideration receivable is allocated on a relative fair value basis, i.e. the amount allocated to the award credits is a proportion of the total consideration, based on the fair value of the award credits relative to the fair values of the other components of the sale. For example, an entity received $100 consideration from an initial sales transaction in which credits were awarded. The entity estimated that the fair value of the items provided in the initial sales transaction was $95 and the fair value of the award credits was $10. In this case, using the above methods would result in the consideration being allocated as follows: Under method (a), the award credits would be allocated $10 of the consideration and the revenue for the initial sales transaction would be recorded at the residual amount of $100-$10 = $90 Under method (b), the award credits would be allocated $100 x 10/105 = $9.5 and the initial sales transaction would be allocated $100 x 95/105 = $90.5 It should be noted that under HK(IFRIC) 13, it would not be acceptable to measure the fair value of the initial sales transaction and to allocate the residual amount of consideration to the award credit, i.e. in the above example, it would not be acceptable to allocate $95 of consideration to the initial sales transaction and only $5 to the award credit as $5 has no reference point to the fair value of the award credits as required by HK(IFRIC) This is irrespective of the fact that it often seems easier to reliably measure the fair value of the initial sales transaction than it is to fair value the award credits. FRU issue 38 (December 2007) 4

5 Measuring the fair value of award credits In order to allocate consideration to the award credits it is necessary to measure their fair value Observable market values should be used if available If observable market values are not available then the fair value should be estimated using a reasonable estimation technique As mentioned above, HK(IFRIC) 13.6 requires that the consideration allocated to the award credits shall be measured by reference to their fair value. If there is an observable market for the award credits (i.e. there are transactions in which accumulated points under award credit programmes are sold between entities), the allocated amount is the amount for which the award credits could be sold separately. If market is not observable, as is often the case, then an entity has to estimate the fair value of award credits, using judgement to select and apply an appropriate estimation technique. HK(IFRIC) 13.AG2 provides guidance on how an entity may estimate the fair value of award credits where fair value information is available for the award items. In accordance with this guidance, the fair value of the award credits could be estimated by reference to the fair value of the awards for which they could be redeemed, reduced to take into account: the fair value of awards that would be offered to customers who have not earned award credits from an initial sale; and the proportion of award credits that are not expected to be redeemed by customers. This approach illustrated in the example below. Example: calculating the fair value of discount vouchers taking into account expected lapse rates In a sales promotion for wine, a store offers to give a discount voucher to customers for each case of wine purchased. Each voucher may be used to purchase a set of wine glasses at a special price of $1,000 and is valid for two years. The retail price of the set of wine glasses is $1,250, but they are currently included in the store's store-wide "10% off" sale. The store sold 100 cases of wine during the promotion period (September 2009) and therefore gave 100 vouchers to the buyers. Based on past experience the store expects that only 80 of the vouchers will be redeemed before they expire. Using the methodology in HK(IFRIC) 13.AG2, the fair value of the vouchers is estimated as follows: Retail price of wine glasses after 10% general price reduction $1,125 Less cash payable by customer on redemption ($1,000) Value of voucher to customer if they want to buy wine glasses $125 Less $125 x 20%, being the proportion of vouchers expected to lapse ($25) Estimated fair value of each voucher at time of initial recognition $100 The reporting entity of which the store is a part adopts the allocation method as set out in HK(IFRIC) 13.BC14(a) i.e. it allocates $10,000 of the consideration received on the sale of the wine to the vouchers, being 100 vouchers at their fair value of $100 each. The $10,000 deferred revenue will be recognised as each of the vouchers is redeemed, as a proportion of the total number of vouchers expected to be redeemed. For example, if 40 vouchers were redeemed during the remainder of the reporting period (i.e. to 31 December 2009), the sales revenue recognised from the wine glasses would be $45,000, comprising $40,000 received in cash and $5,000 release of deferred revenue (being 40/80 x $10,000), assuming that the entity does not revise its estimate of a 20% lapse rate. Thus, if the entity does not revise its estimate of a 20% lapse rate, the revenue recognised on sale of wine glasses to those customers who presented their vouchers would be at a rate of $1,125 per set i.e. equal to the original retail price. In some circumstances, other estimation techniques may be available. For example, if a third party will supply the awards to the customer and the entity pays the third party an amount for each award credit the entity grants to customers, the entity could estimate the fair value of the award credits by reference to the amount it pays the third party plus a reasonable profit margin (HK(IFRIC) 13.AG3). This approach may be underlying Example 2 in the illustrative examples to HK(IFRIC) 13, where an electronic goods retailer pays an airline CU0.009 for each air travel point that the electronic goods retailer grants its customer. In this example, the electronic goods retailer estimated that the fair value of each point was CU0.01 i.e. giving the retailer a profit margin of 10%. 5 FRU issue 38 (December 2007)

6 If customers can choose from a range of different awards, the fair value of the award credits will reflect the fair values of the range of available awards, weighted in proportion to the frequency with which each award is expected to be selected. This is illustrated in the following example. Example: calculating the fair value of award points when customers have a choice of items for which points can be redeemed A credit card company operates a customer loyalty programme, under which it grants the credit card holder loyalty points when they purchase goods or services with use of its credit card. The credit card holders are entitled to obtain one point for each dollar spending and can redeem the points for awards offered by the credit card company in the future. Since the fair value (FV) of the loyalty points is not observable, the credit card company estimates the FV by reference to the FV of the awards offered, reduced by the extent of lapses expected. At present, the credit card holders can use 1,000 points to choose one of the following awards. Based on past experience, the credit card company expects 80% of points granted to be redeemed and the remaining to lapse unused. In addition, the company has made the following estimates regarding the awards to be offered: Computed weighted average Estimated portion estimated FV of Estimated of points being 1,000 award points, FV of the award redeemed for such taking into account items: award: expected lapses: Award items available for 1,000 points: (A) (B) = (A x B) $50 supermarket gift voucher $50 10% $5 20% discount voucher for any purchases in a shoe shop costing over $300 $80 20% $16 Electronic fan $100 25% $25 Computer keyboard $60 15% $ 9 Annual card fee waiver $100 10% $10 80% $65 On the basis of the above, the entity computes an estimated fair value per credit card point of $65/1000 = $0.065 Revenue recognition The amount and timing of revenue recognition for customer loyalty programmes depends on: (a) (b) whether the entity or a third party supplies the award items; and if a third party supplies the award items, whether the entity is acting as a principal or agent. These issues are looked at more closely below. Entity supplies the award items itself When the entity supplies the award items under the programme, revenue is recognised as and when the entity fulfils its obligation in respect of supplying those items If the entity supplies the awards itself in its customer loyalty programme, it recognises the gross consideration allocated to the award credits as revenue as and when award credits are redeemed and the entity fulfils its obligation in respect of supplying the award items. This was illustrated in the simple example on page 5 of discount vouchers, when the deferred revenue was recognised as and when the customer chose to redeem the vouchers by purchasing the wine glasses at a reduced cash price. Such events may happen simultaneously with the initial sales transaction, or may occur sometime later, for example, when the customer needs to accumulate a large number of points before it can claim any awards. FRU issue 38 (December 2007) 6

7 The amount of deferred revenue allocated to the award credits is recognised over the redemption period, in proportion to the total number of credits expected to be redeemed Where the deferred income allocated to the award credits is recognised over a period of time, the amount allocated to each award credit redeemed is calculated as a proportion based on the total number expected to be redeemed. For example, in the example illustrated above, if in the first year 40 vouchers were redeemed, 40/80 x $10,000 = $5,000 of the revenue initially deferred would be released to the income statement, as overall the entity expects that only 80 vouchers will be redeemed. This pattern of proportional allocation continues until the awards expire or all the expected redemptions have been made, whichever is earlier. This is illustrated in Example 1 in the illustrative examples to HK(IFRIC) 13, where the award credits did not have an expiry date. Any adjustments to redemption rates are made on a cumulative basis, as looked at more closely in the discussion below of accounting for changes in estimates (see page 9 of this Financial Reporting Update) where the above example of discount vouchers is continued over its full redemption period. The award items are supplied by a third party When the customer loyalty programmes offer customer awards in the form of goods and services supplied by the third party, the terms of the arrangement with the third party can affect both the timing of recognition of revenue by the entity and also the amount of revenue recognised. In this regard HK(IFRIC) 13 distinguishes between: arrangements where the entity granting the awards is acting as an agent of the third party supplier; and arrangements where the entity granting the awards is the principal i.e. the entity is using the third party to supply awards to the entity's own customers. Arrangements where the entity is acting as an agent Where the entity is acting as agent its only revenue is a service fee, calculated as the net difference between the consideration allocated to the award credits and the amount payable to the third party for supplying the awards HK(IFRIC) 13.8(a) states that if the entity is acting as an agent, i.e. it is collecting the consideration from the customer in respect of the award credits on behalf of the third party, it shall measure its revenue as the net amount retained on its own account i.e. the difference between the consideration allocated to the award credits and the amount payable to the third party for supplying the awards. This net amount is recognised when the third party becomes obliged to supply the awards and entitled to receive consideration for doing so. These events may occur as soon as the award credits are granted, as is illustrated in the simple example below where discount vouchers redeemable with third parties are given to customers at the time of the initial sales transaction. However, if the customer can choose whether to claim awards from the entity or from a third party, these events may occur only when the customer chooses to claim awards from the third party. Arrangements where the entity is acting as principal Where the entity is acting as principal, it reports its income on a gross basis, with any amounts payable to the third party being expenses HK(IFRIC) 13.8(b) states that if the entity is acting as principal when a third party supplies the awards, the entity shall recognise the revenue on a gross basis when it fulfils its obligations in respect of the awards. Recording the income gross means that any amounts payable to the third party for acting as a supplier in the entity's loyalty programme will be reported as a separate expense in the entity's income statement. This is also illustrated in the simple example below. The gross amount is recognised when the entity fulfils its obligations in respect of the awards. As above, this may be at the same time as the initial sale, if the third party assumes the obligations at that time (as is illustrated in example 2 of the illustrative examples to HK(IFRIC) 13), or at a later date, for example, if the customer can choose whether to claim awards from the entity or from a third party. 7 FRU issue 38 (December 2007)

8 Example: recognising revenue when the obligation to honour a discount voucher has been passed to a third party The facts are the same as the example above concerning the discount vouchers for wine glasses, except that in order to redeem the voucher customers need to purchase the wine glasses from a third party glassware retailer and the wine seller has no liability if that third party has no stock available. Scenario A: The joint promotion activity was initially proposed by the third party glassware retailer. The wine seller agreed to distribute the vouchers with its sales of wine for the following month and promised that for every voucher distributed it would pay the glassware retailer $80. Scenario B: Offering the discount vouchers with the wine sales was a promotion idea of the wine seller. The wine seller approached a third party glassware retailer, who agreed to sell the wine seller 100 discount vouchers at a cost of $80 each. Accounting recognition: In both scenarios: $10,000 of the consideration received from customers when they bought the wine is attributable to the discount voucher scheme, on the basis that it is the estimated fair value of the vouchers; and the wine seller is able to complete the recognition of the revenue relating to the discount voucher scheme at the time of making the wine sales as it has no further obligations once it has given the customers the discount vouchers. However, the scenarios differ in that in Scenario A the wine seller considers that it is acting as an agent of the glassware retailer, whereas in Scenario B the wine seller is acting as principal. This impacts on the presentation of the transaction in the income statement as follows: Scenario A: Scenario B: Wine seller's income statement wine seller as agent wine seller as principal Revenue: sales of discount vouchers to customers - $10,000 Revenue: agency services provided to glassware retailer $2,000 - Cost of sales: cost of discount vouchers - ($8,000) Net income from wine glass promotion $2,000 $2,000 NB the above example illustrates the principles of HK(IFRIC) 13. However, as discussed on page 2 of this Financial Reporting Update, HK(IFRIC) 13 only needs to be applied where the effect would be material. In this regard, and with respect to the above example, it is worth noting that: (a) (b) In Scenario A only the deemed profit margin on the vouchers is recognised in the income statement. If this amount was considered to be immaterial, then the agency arrangement could simply be reflected in the financial statements by reporting the revenue from the wine sales net of the amount paid to the third party glassware retailer for the vouchers i.e. in this example by simply deducting $8,000 from the revenue from wine sales, rather than the estimated fair value of $10,000. In Scenario B, as the revenue from the discount vouchers is recognised at the same time as the wine sales, it would only be necessary to compute the fair value of the vouchers and to allocate revenue to them, if the sale of vouchers and the wine sales were classified as different classes of revenue in the income statement. Thus, while in principle customer loyalty programmes are within the scope of HK(IFRIC) 13 whether or not there is a considerable delay before settlement, in practice where the award items are delivered at the same time (or shortly after) the initial sale transaction it may not be necessary to make any changes to the entity's current reporting practices other than to include the costs of loyalty items supplied in cost of sales, rather than, for example, in marketing expenses. Change in estimates The amount of deferred revenue is fixed upon initial recognition regardless of change in estimated lapse rates. However, changes in lapse rates will affect the timing of the recognition of the deferred income After granting award credits, the entity may revise its expectations about the proportion that will be redeemed. The change in expectations does not affect the consideration allocated to the award credits at the time of initial sale, i.e. the amount of deferred revenue is fixed upon initial recognition. Instead, it affects the pattern in which that amount is recognised over the redemption period. The change in expectations is thus accounted for as a change in estimate in the period of change and future periods, as shown in the example below. FRU issue 38 (December 2007) 8

9 Example: recognising revenue when there are changes in the expected lapse rates Background: In the example above concerning a store which includes discount vouchers for wine glasses in a sales promotion for wine, a store distributed 100 vouchers to customers during the promotion period of September 2009 which could be used to buy a set of wine glasses at its store at a reduced price. The vouchers were valid for 2 years and were therefore due to expire in September The store originally estimated that 80% of the customers who had received the vouchers would redeem them before they expired and computed a fair value per voucher of $100, thus deferring 100 x $100 = $10,000 of revenue from the wine sales. By the end of the first reporting period (31 December 2009), 40 vouchers have been redeemed. As management continued to believe that only 80% of the vouchers would be redeemed, this led to sales revenue recognised from the wine glasses of $45,000, comprising $5,000 release of deferred revenue (being 40/80 x $10,000) and $40,000 received in cash. By 31 December 2010, a further 41 vouchers have been redeemed, bringing the total number of redemptions so far to 81 vouchers. As the vouchers were still valid for another 9 months, management revised its overall expectations of the redemption rate to be 90%. The sales revenue from the purchase of 41 sets of wine glasses in 2010 was $45,000 computed as follows: Cumulative recognition of deferred revenue using revised expected lapse rate was 81/90 x $10,000 = $9,000. $5,000 of this was recognised in 2009, resulting in $4,000 of deferred revenue being recognised in 2010, plus $41,000 received in cash on sale of 41 sets of wine glasses By 31 December 2011, a further 7 vouchers have been redeemed, bringing the total number of redemptions to 88 vouchers. The remaining 12 vouchers expired unredeemed. The sales revenue from the purchase of 7 sets of wine glasses in 2011 is $8,000 computed as follows: Cumulative recognition of deferred revenue using revised expected lapse rate is 88/88 x $10,000 = $10,000. $9,000 of this was recognised in 2009 and 2010, resulting in $1,000 of deferred revenue being recognised in 2011, plus $7,000 received in cash on sale of 7 sets of wine glasses Summary: Recognition of revenue from wine glass promotion over redemption period (09/2009 to 09/2011) Total Management's estimate of overall redemption rate 80% 90% 88% 88% Number of vouchers redeemed in current year Cumulative recognition to date of $10,000 deferred revenue $5,000 $9,000 $10,000 Less: deferred revenue recognised in previous years ($0) ($5,000) ($9,000) Deferred revenue to be recognised in current year $5,000 $4,000 $1,000 $10,000 Cash received from sales of sets of wine glasses in current year $40,000 $41,000 $7,000 $88,000 Total revenue recognised in current year from sales of wine glasses $45,000 $45,000 $8,000 $98,000 Average revenue per set recognised in current year $1,125 $1,098 $1,143 $1,114 In summary, this example shows that once the revenue of $10,000 has been allocated to the award credits, changes in the estimates of lapse rates only affect the timing of the recognition of that amount over the redemption period and not the overall amount recognised in respect of the revenue from the award credits. Further, only if the lapse rates are as predicted when the fair value of the award credit was computed will the resulting income recognition amount in any one period reflect the original fair value of the award. Lower than expected lapse rates and/or increases in the costs of the award items may necessitate the recognition of a provision for onerous contracts A change in expectations regarding redemption rates may also affect the costs the entity expects to incur to supply awards. If the estimated redemption rates increase to the extent that the unavoidable costs of supplying awards are expected to exceed the consideration received and receivable for them (which would include any attributable deferred revenue not yet recognised in the income statement), the entity has an onerous contract. This may also be the case where the expected costs of the individual award items increase, if the entity does not hold sufficient stock to meet its obligations. A liability shall be recognised for the excess in accordance with HKAS 37, Provisions, contingent liabilities and contingent assets. (HK(IFRIC) 13.9) 9 FRU issue 38 (December 2007)

10 Effective date and transitional requirements HK(IFRIC) 13 is effective for annual periods beginning on or after 1 July 2008 Changes resulting from this Interpretation should be applied retrospectively, to the extent not impracticable HK(IFRIC) 13 is effective for annual periods beginning on or after 1 July 2008 with early adoption permitted. As the Interpretation does not contain any specific transitional provisions, the general requirements under HKAS 8, Accounting policies, changes in accounting estimates and errors, apply. For example, if an entity has previously applied HKAS and accrued the cost of supplying awards, the adoption of HK(IFRIC) 13 would be treated as a change in accounting policy with retrospective application unless impracticable. In this regard, it should be noted that HKAS 8 does not require retrospective adoption where impracticable provided that the impracticality is determined in accordance with the guidance in that standard (as set out in HKAS 8.50 to 53). In particular, HKAS 8.52 discusses situations where it is regarded as impracticable to determine fair values retrospectively. Where it is considered impracticable to make retrospective adjustments, disclosures should be made in accordance with HKAS 8.28(h). Although HK(IFRIC) 13 is not effective until the first annual accounting period beginning on or after 1 July 2008, entities which operate the customer loyalty programmes within the scope of HK(IFRIC) 13 should take steps in good time to consider whether HK(IFRIC) 13 would have a material impact on their financial statements. In particular, it would be advisable to consider sooner rather than later whether: data is being accumulated in order to apply the Interpretation retrospectively in its first year of adoption; and changes to systems and procedures of recording data in the loyalty programmes would be advisable to facilitate compliance with the Interpretation on an ongoing basis.. If in doubt please talk to your usual KPMG contact. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation KPMG, a Hong Kong partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. All rights reserved. Printed in Hong Kong. FRU issue 38 (December 2007) 10