Question

What are the two basic methods used by airlines to calculate earned revenue? Briefly describe each. Cite a section of the FASB ASC to support your answer.

Answer 1

The two methods used by airlines to calculate earned revenue are

1. Incremental cost method

2. Deferred revenue method

Incremental Cost Method: The Incremental Cost Method’s conceptual soundness relies on an environment in which FFP awards are carefully controlled by the issuing airline such that passengers redeeming awards are filling seats that otherwise would have been empty (thus justifying an accrual of only the incremental cost of transporting one additional passenger). Airlines using the Incremental Cost Method estimate and record a liability for the incremental cost of issuing awards to their FFP members. For awards expected to be redeemed in the form of free travel on the issuing airline, the incremental costs include fuel, food and beverage, insurance, and other handling costs. For awards expected to be redeemed for free travel on other partner airlines, the incremental cost is represented by the amount the issuing airline must pay the other airline pursuant to the terms of its agreement with the other airline. A number of factors influence an airline’s estimate of the amount of mileage credits it expects to be redeemed. Among those factors are the threshold of mileage credits the airline requires for an award to be issued (the higher the threshold, the lower the rate of the redemption), the expiration period (if any) for mileage credits earned, and the airline’s historical redemption rates. Major airlines accumulate significant amounts of data on mileage credit redemption patterns and have developed statistical models to estimate future redemptions (AICPA, 2011).

Deferred Revenue Method: The Deferred Revenue Method, while acceptable as one of two options under U.S. generally accepted accounting principles (GAAP), is required under International Financial Reporting Standards and is specifically addressed in International Financial Reporting Interpretations Committee (IFRIC) Interpretation No. 13, Customer Loyalty Programmes. The Deferred Revenue Method’s conceptual soundness, according to IFRIC, relies on the principle that future awards are separately identifiable goods for which customers are implicitly paying (IASB, 2007). Airlines using the Deferred Revenue Method divide the proceeds of a sale in which mileage credits are awarded into two components: an amount reflecting the value of the air transportation specifically purchased by the customer in the first sale and an amount reflecting the fair value of the mileage credits awarded to the customer. The amount assigned to the first component is recognized as revenue once the first sale is complete (i.e. once air transportation for the ticket purchased is provided). The amount assigned to the second component (the fair value of mileage credits awarded) is deferred as a liability until the airline fulfills its obligations with respect to the mileage credits (i.e. honors the redemption of those mileage credits by providing free travel or some other award). To determine the value to assign to the deferred revenue component, under both U.S. GAAP and IFRS, airlines look to transactions in which mileage credits are sold by airlines to third parties (such as banks that issue FFP miles to credit card customers), or to sales of tickets with similar restrictions as those associated with frequent flyer award redemptions. 4 The fair value of mileage credits awarded is determined at the time of issuance, and the liability balance resulting from individual deferrals is not adjusted for future changes in fair values. However, as the fair value of mileage credits changes over time, airlines change the amount of revenue they defer as part of any given ticket sale (known as the “deferral rate”). The change in deferral rates results in a pool of mileage credits valued at a variety of different rates; airlines employ a methodology such as weighted average or first-in, first-out to determine the amount of revenue to recognize from customer redemption of an award. Thus, for a given level of mileage credits awarded and redeemed, the amount of revenue deferred and recognized varies from period to period (AICPA, 2011).