Question

The new revenue recognition standard issue by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) will call for major changes in the way companies in the airline industry recognize revenue. Airlines may have to change how they account for loyalty status benefits, mileage credits, change fees, and breakage for tickets that expire unused. The American Institute of Certified Public Accountants (AICPA) has formed an airlines task force to address implementation issues of the new standard for the airline industry. Assume that you have been called upon to present an analysis of the impact of the new standard on Southwest Airlines.

Refer to Southwest’s (ticker symbol: LUV) current/most recent financial statements (10-K) and the accompanying notes to answer the following questions. The current/most recent financial statement can be found on https://www.sec.gov/edgar/searchedgar/companysearch.html. Search for the company in the ‘Fast Search’ box by using the ticker symbol provided above. In the list of results, find the latest filing labeled 10-K and select the ‘Documents’ link. On the next page, select the document of type ’10-K’ to open it.

1. For each of the following revenue categories, describe the current accounting, the likely changes (if any) that the new revenue recognition standard will require, and the potential impact of those changes on patterns of revenue recognition.

a) Flight Transportation (for tickets used and for ticket breakage)

b) Loyalty Program

c) Ancillary Services and Other Revenue

Answer 1

The 2018 effective date1 of the new revenue recognition standard2 issued by the Financial Accounting Standards Board (FASB) is fast approaching. As they work on implementation, airlines need to make sure they consider all developments. For example, the FASB amended its new revenue recognition guidance on accounting for licenses of intellectual property (IP), identifying performance obligations, evaluating whether an entity is a principal or an agent, assessing collectibility and measuring noncash consideration. In addition, the Joint Transition Resource Group for Revenue Recognition (TRG)3 generally agreed on several issues that may affect airlines. This publication highlights key aspects of applying the FASB’s standard to an airline’s contracts with its customers, addresses certain changes to legacy practice and reflects the latest implementation insights. Airlines may want to monitor developments as the airlines task force4 formed by the American Institute of Certified Public Accountants (AICPA) addresses implementation issues

Most airlines offer loyalty programs that allow customers to earn miles or points (referred to as mileage credits) for flying on the airline or using the services of one of its partners such as a financial institution that issues co-branded credit cards, another airline or a car rental or hotel company. Under the standard, issuing mileage credits in loyalty programs generally provides a material right to customers that they would not receive without entering into a contract, and these credits should be identified as performance obligations for purposes of revenue recognition. This is because the customer effectively pays in advance for the right to obtain a future good or service (e.g., travel, upgrades, products) or a discount on that good or service. Airlines are required to allocate a portion of the transaction price to mileage credits and defer revenue recognition until the future good or service is provided or the mileage credits expire unused. Estimating standalone selling price The transaction price generally is allocated to the performance obligations in a contract based on their relative standalone selling prices. Although airlines sell mileage credits, these sales are either not standalone sales (e.g., sales to co-branded credit card partners) or they are sold in limited instances (e.g., sales of “top-off miles” to a customer so they can reach a desired award redemption). Therefore, these sales may not be viewed as a reasonable indicator of the standalone selling price of a mileage credit. Because airlines generally do not have observable standalone selling prices for mileage credits, they have to make an estimate considering all reasonably available information, using a method that maximizes observable inputs. They also have to apply that method consistently. While the standard discusses three estimation approaches, we believe that airlines are likely to conclude that the adjusted market assessment approach maximizes observable inputs. (The other two approaches discussed in the standard are the “expected cost plus a margin” approach and a residual approach.) The adjusted market assessment approach focuses on the amount an entity believes a buyer in the market in which it sells goods or services is willing to pay for a good or service. We expect most airlines to use the redemption value method or the estimated ticket value method to apply this approach. The redemption value method bases the estimate on the price of tickets stated both in mileage credits and in cash. For example, if the airline accepts either dollars or mileage credits as payment for tickets, the implied conversion rate would be the redemption rate. The estimated ticket value method uses the average historical price of tickets, upgrades or other goods or services similar to those redeemed in the airline’s loyalty program, divided by the average mileage credits redeemed to receive the awards. Regardless of which method an airline uses, the airline needs to reduce the estimate to reflect the likelihood that some mileage credits will not be redeemed.

Airlines have to analyze the facts and circumstances of their loyalty status programs to determine whether the benefits they offer program members constitute material rights. Because the analysis has to be done for each status level, an airline could conclude that the benefits offered in the lower-status tiers are marketing incentives but those offered in higher-level status tiers are material rights

Travel to an airline customer’s destination may include multiple flight segments (i.e., connecting flights), including segments provided by other airlines under agreements to provide transportation interchangeably between the carriers. These segments are referred to as interline segments. To apply the standard, airlines must analyze the segments in a ticket to identify the performance obligations. When purchasing an airline ticket, customers have the option to choose, based on their preferences, from multiple itineraries that may include nonstop flights or multiple connecting segments with varying lengths of time between connecting segments. Each segment is capable of being distinct (because segments are frequently sold separately) and is separately identifiable (because the two segments both do not significantly modify each other and are not highly interrelated or interdependent). That is, the airline can fulfill its promise to provide one segment independently of the other segment. Therefore, each segment generally is distinct and is a separate performance obligation.

Under the cost guidance in ASC 340-40, 9 the incremental costs of obtaining a contract (i.e., costs incurred to obtain a contract that would not have been incurred if the contract had not been obtained) are recognized as an asset if the entity expects to recover them (either through direct reimbursement or margin inherent in the contract). As a practical expedient, the standard permits an entity to immediately expense contract acquisition costs when the asset that would have resulted from capitalizing such costs would have been amortized in one year or less. For airlines, costs to obtain a passenger ticket contract typically include credit card fees, global distribution system fees, and travel agency and other commissions. As discussed above, tickets often contain multiple performance obligations. Because the costs to obtain the contract are the same regardless of whether there are other performance obligations (e.g., mileage credits, loyalty status benefits), the costs may be allocated to the travel performance obligations. Costs to obtain the ticket contract (if allocated to the travel performance obligations) generally qualify for the practical expedient because tickets are usually sold less than a year in advance.

Airlines may have to change how they account for loyalty status benefits, mileage credits, change fees and “breakage” for tickets that expire unused. • They also have to make new disclosures. Airlines need to make sure they have the appropriate systems, internal controls, policies and procedures in place to collect and disclose the required information. • We don’t anticipate further significant changes to the recognition and measurement principles in the new standard, so airlines should focus on implementation. Many entities are finding that implementation requires significantly more effort than they expected