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Query No. 28
Subject:
Accounting
treatment of reward points given to credit
card holders under credit card
reward point schemes.1
A. Facts of the
Case
1. A bank is
engaged in providing credit card services to its customers
in India.
The customers, who are members of the credit card schemes of the bank, can
acquire products/avail of services on credit using the credit cards issued to
them.
2. In order to
promote credit cards and their usage and loyalty amongst its customers, the
bank has introduced a reward point scheme, whereby customers earn points as a
percentage of the amounts spent by them by using the credit cards. These reward
points can be subsequently exchanged by the customers for acquiring various
items, which the bank has put up in rewards catalogue. The reward points earned by the
cardholder, thus represent the value of products/items which the bank is
expected to provide to the cardholder against the points outstanding to his
credit. The querist has mentioned that no consideration is paid by the customer
for acquiring such reward points.
According to the
querist, such a
practice is also widespread in hotels and airlines
industry where bonus points are given based on room usage and traveller miles.
Cellphone companies are also selectively taking recourse to such a measure to
build customer loyalty.
3. The querist
has stated that these reward points are ‘evergreen’ in the sense that
once earned, they
can be redeemed
at any point
of time in future as long as the customer does not
lose his eligibility by virtue of defaulting
on payment or by virtue
of closure of
his card. The
bank, however, reserves the right to decide the items which the card
holder will be entitled to receive in exchange of a specified number of reward
points. The bank also reserves the right to vary the terms and conditions of
the scheme as well as to withdraw the scheme at any point of time.
4. While the
customers spend using their credit cards on an ongoing basis, they
earn reward points,
which they may choose
to redeem at a later date. In the event a customer chooses to redeem his
reward points against the items listed in a reward catalogue, the bank obtains
the item from the market
and provides the
same to the
customer. The reward points, in
cases of co-brand credit
cards with airlines,
may also be transferred as mileage points.
5. When the
reward points are
redeemed by the
customers against items listed in
the reward catalogue, the bank acquires such items at a discount from the
dealers. In cases where the reward points are converted into mileage points, the
bank may share the cost of the miles
with the airlines.
6. To cover the
cost of redemption, the bank makes a provision in its books, which is
calculated based on the reward points outstanding as at the year-end. The
amount provided for is affected by the following factors:
(a) As the cost
of the items purchased by the bank for the customer redeeming his reward points
is lower than the reward points being redeemed (due to the discount available),
the provision is made only to the extent of such a discounted amount.
(b) The provision for the cost to be incurred in respect of the
outstanding reward points is made on the basis of the expected redemption rate. The redemption rate is affected by the
following factors:
The redemption rate
calculated by the
bank, which takes
into consideration the above points, is determined on the basis of an
actuarial analysis covering behavioural data of customers across several
countries, the specific nature of scheme, vintage and past redemption trends.
The bank’s portfolio of
credit card customers
is stable and
mature having been in existence
for about 10 years. While it has been observed that the current redemption rate
for the bank has been in the region of 10% of the reward points
outstanding and has
been holding at
approximately this level for the
last 18-24 months, the bank, on a conservative basis, makes a provision in its books significantly higher than the
observed redemption rate of such points outstanding, so as to fully cover the
cost of redemption.
7. A view
has been expressed
in the course
of audit of
the bank’s books that the bank
should make a provision in respect of all the reward points outstanding at the
year-end, irrespective of the behavioural pattern
of usage of such reward points. The bank is, however, of the
opinion that the provision is required to the extent of the cost that will be
incurred by the bank in respect of the reward points expected to be redeemed
based on the aforementioned redemption
rate as revealed
by actuarial trend analysis, e.g., if the total reward points
outstanding is 100 and the cost at which the bank can procure reward items is
Rs. 70, then using a redemption rate of say 40%, the bank currently makes a
provision for Rs. 28 (70 x 40%) in its books. The bank’s view is based on the following
premises:
(a) Accounting Standard
(AS) 1, ‘Disclosure
of Accounting Policies’, issued
by the Institute of Chartered Accountants of India, in its definition of
accrual, states that costs are recognised as
they are incurred
and recorded in
financial statements of the periods to which they relate.
(b) The
‘Guidance Note on Accrual Basis of Accounting’, issued by the Institute of
Chartered Accountants of India, has defined the accrual basis of accounting as “the method of recording transactions by which revenues,
costs, assets and liabilities are reflected in the accounts in the period in
which they accrue”.
(c) The cost of
redemption of the reward points is an obligation for the bank. The bank has to
evaluate the possibilities of the customers redeeming these reward points in
future on the basis of available information, and should calculate the amount
to be provided for in the books on an actuarial basis, based on the estimated redemption rate or past utilisation of reward points accrued.
(d) Accounting Standard (AS) 4, ‘Contingencies and Events Occurring after the Balance Sheet Date’, issued by the Institute
of Chartered Accountants of India, states that where a reasonable estimate of the amount of a
contingent loss cannot be made, a disclosure in respect of the same should be
made in the financial statements. It also states that the estimates of the
outcome and the financial effect of contingencies are determined by the judgement of the management of the
enterprise and this is based on the information available as well as supplemented by experience of similar transactions and, in some
cases, reports from independent experts. As there
is uncertainty in determining the total reward points
expected to be redeemed in any financial year, the bank is of the opinion
that based on AS 4, it would be required to provide in its books, the total cost of
reward points which are expected to be redeemed during the year, based on an
estimation given as per an actuarial trend analysis which takes into
consideration the past redemption experience of the bank. The methodology and
the basis on which the amounts provided for are determined, would be disclosed by
way of a note in the financial statements.
(e) The
‘Guidance Note on Terms Used in Financial Statements’, issued by the Institute of Chartered Accountants of India, defines the term ‘Reserve’ as “the portion of earnings, receipts or
other surplus of an enterprise (whether capital or revenue) appropriated by the management for a general or a specific purpose other than a
provision for depreciation or diminution in the value of the assets or for a
known liability”. Based on this definition, the bank is of the view that the
amount expected to be incurred for the purpose of redemption of reward points
can be considered as a provision and any amount provided in the books over and
above this provision should be considered
as a reserve at the year-end.
B. Queries
8. The querist
has sought the opinion of the Expert Advisory Committee on the following
issues:
(a) Whether the
bank is justified
in providing for
an amount equivalent to
the cost of
the reward points expected to be redeemed at any given point in time which
is calculated on an actuarial basis based
on its own
experience and that
of the industry.
(b) If the bank
provides for the entire reward points in its books, whether the amounts provided for in excess of the amounts expected to be
redeemed by the bank should be considered as reserves in the books at the
year-end.
(c) In the event
the bank provides only to the extent of the amounts expected to be redeemed,
whether it would suffice if the bank gives a suitable note to this effect in
its financial statements so as to make the financial statements more
meaningful.
(d) In view of
AS 4 and the fact that the bank is disclosing in its financial statements, by
way of a note, the methodology and the basis of provisioning, whether the bank
would be required to disclose the balance reward points outstanding as at the
year-end as a contingent liability in its financial statements.
(e) If the bank
reports the reward points mentioned in (d) above as a contingent liability,
whether any provision is required to be made by the bank in respect of the same in its books of account.
C. Points
considered by the Committee
9. The
Committee notes that paragraph 49(b) of ‘Framework for the Preparation and
Presentation of Financial
Statements’, issued by the
Institute of Chartered Accountants of India, defines the term ‘liability’ as
below:
“A liability is
a present obligation
of the enterprise
arising from past events,
the settlement of
which is expected
to result in an
outflow from the
enterprise of resources
embodying economic benefits.”
10. From the above,
the Committee notes that a ‘liability’ is a present obligation relating
to the events
or transactions which
have already occurred in past.
The Committee is of the view that the bank’s obligation towards reward points
arises as soon as a customer becomes entitled to the reward points although
payment in this regard is made whenever the customer chooses to redeem the
reward points any time in future.
11. The Committee is
of the view that the bank should create a provision for the liability at an
amount equivalent to the cost expected to be incurred on redemption
of outstanding reward
points any time
in future. The liability for reward points outstanding
expected to be redeemed in future may
be estimated, at
the year-end, by
applying actuarial method.
In applying the actuarial method, the bank should take into account
factors such as discount
available to the
bank on purchase
of related items, customers leaving the credit card
scheme without redeeming the points,and customers losing
eligibility to redeem
points provided they
are permanently deprived off for redeeming these points. The Committee
is
of the view that the liability should not be limited to the
points expected to be redeemed in a particular time period such as next year.
12. The Committee
is of the
view that the
factors required to be
considered for estimating the liability may be determined on the basis of past experience
of the bank and other relevant factors. The trends prevalent
in the industry would be relevant only where the major
features of the scheme such as
rewards offered, method
of redemption, and
nature of customers’ profile are
similar. The Committee is also of the view that use of behavioural data of customers across several countries
might not be appropriate keeping in view different economic, social and other
factors.
13. The Committee
notes that paragraph
37 of ‘Framework
for the Preparation and
Presentation of Financial
Statements’, issued by the
Institute of Chartered Accountants of India, inter-alia, states the following
with regard to the consideration of prudence:
“The preparers of
financial statements have
to contend with
the uncertainties that inevitably surround many events and
circumstances, such as the collectability of receivables, the probable useful
life of plant and machinery, and the warranty claims that may occur. Such
uncertainties are recognised
by the disclosure
of their nature
and extent and by
the exercise of
prudence in the
preparation of the financial statements. Prudence is the
inclusion of a degree of caution in the exercise
of the judgements needed
in making the estimates required under conditions of
uncertainty, such that assets or income are
not overstated and
liabilities or expenses
are not understated. However, the exercise of
prudence does not allow, for example, the creation of hidden reserves or
excessive provisions, the deliberate understatement of assets or income, or the
deliberate overstatement of
liabilities or expenses,
because the financial
statements would then not be
neutral and, therefore, not have the quality of reliability.”
14. In this context,
the Committee also refers to the clause 7(2) of Part III of
Schedule VI to
the Companies Act,
1956, which provides
the following:
“(2) Where—
(a) any amount
written off or retained by way of providing for depreciation, renewals or
diminution in value of assets, not being an amount written off in relation to fixed assets
before the commencement of this Act; or
(b) any amount
retained by way of providing for any known liability;is in excess of the amount which in the opinion of the
directors is reasonably necessary for the purpose, the excess shall be treated
for the purposes of this Schedule as a reserve and not as a provision.”
15. On the
basis of the
above, the Committee
is of the
view that the provision for liability for reward points
should be at the amount estimated
as per paragraphs 11 and 12 above and provision in excess
thereof should not be made. If excess provision is made for liability
outstanding at the year-end, the excess
should be considered
as a reserve
and not as a
provision.
16. The Committee
notes that AS 4 has defined the term ‘contingency’
as below:
“A contingency is a condition or situation, the ultimate
outcome of which, gain or
loss, will be
known or determined
only on the occurrence, or
non-occurrence, of one
or more uncertain
future events.”
17. The Committee
notes that paragraph
4.2 of AS
4 provides the following:
“Estimates are required for determining the amounts to be
stated in the financial statements for many on-going and recurring activities
of an enterprise. One must, however, distinguish between an event which is
certain and one which is uncertain. The fact that an estimate is involved does not, of itself, create the type of
uncertainty which characterises a contingency. For example, the fact that
estimates of useful life are
used to determine
depreciation, does not
make depreciation a contingency; the eventual expiry of the useful life
of the asset is not uncertain. Also, amounts owed for services received are not
contingencies as defined in paragraph 3.1, even though the amounts may
have been estimated,
as there is
nothing uncertain about the fact
that these obligations have been incurred.”
18. The Committee
notes that the liability for reward points outstanding
at the year-end is certain; uncertainty exists, if any, only
in relation to the amount which should be estimated as per paragraphs 11 and 12
above. The Committee is, therefore, of the view that liability for reward
points scheme is not a contingent liability.
D. Opinion
19. On the basis of
the above, the Committee is of the following opinion on the issues raised in
paragraph 8:
(a) The bank is
justified in providing for an amount equivalent to the cost of the reward
points expected to be redeemed in future provided the amount of provision is
estimated as per paragraphs 11 and 12 above.
(b) The amount, in excess of the estimated liability as per paragraphs 11 and 12 above, should not be provided in the books. If the amount provided in the
books is in excess of the amount required to be provided, the excess would be
considered as a reserve.
(c) If the amount provided for reward points expected to be redeemed has been estimated as per paragraphs 11 and 12 above, any additional disclosure by way of a note is not necessary. However, additional disclosures,
e.g., regarding the bases for arriving at the amount of the estimate may be
made
if it is considered that it would result in presentation of
more meaningful financial information. In case the amount provided is less than that required as per paragraphs 11 and 12
above, any disclosure to this effect in the financial statements would not
rectify the short provision made by the company.
(d) No, the bank is not required to disclose the balance reward points outstanding as at the year-end
as a contingent liability.
(e) The question
does not arise in view of (d) above.
1Opinion finalised
by the Committee on 5.7.2001.
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