Accounting for Airline Frequent Flyer Programs: Management Incentives and Financial Reporting Impacts

ACCOUNTING FOR AIRLINE FREQUENT FLYER PROGRAMS: MANAGEMENT INCENTIVES AND FINANCIAL REPORTING IMPACTS May 2012 Brian J. Franklin, BBA Accounting ‘12, College of Business and Public Policy, University of Alaska Anchorage, 3211 Providence Drive, Anchorage, AK 99508, 907-268-4233 Ext. 401,

ABSTRACT The obligation to provide free or reduced-fare travel to passengers who redeem their accrued frequent flyer program (FFP) benefits represents a significant liability on every major U.S. airline’s balance sheet. Major U.S. airlines employ one of two methods to account for the liabilities they incur when issuing mileage credits to traveling passengers. The Deferred Revenue Method recognizes a liability for the fair value of the outstanding mileage credits (with “fair value” defined under International Financial Reporting Standards (IFRS) as “the amount for which the award credits could be sold separately”). The Incremental Cost Method recognizes a liability for the marginal cost of providing air transportation to eligible award passengers (i.e. the cost of taxes, fuel, food, etc. to fly one additional passenger on a seat that otherwise would have been empty—generally a nominal amount). Incremental cost accounting for FFPs has been subject to increasing scrutiny over time. In the last several years airlines have reduced seating capacity due to high fuel prices and weak demand during the global economic recession, which has caused flights to be fuller and has increased the chance that, for any given seat, a passenger flying on redeemed frequent flyer miles could displace a fare-paying passenger. The Incremental Cost Method does not account for the opportunity cost (i.e. the cash revenue foregone) associated with such a displacement. The U.S. Financial Accounting Standards Board (FASB) considered, but never reached authoritative guidance on, how to account for airline frequent flyer programs. In contrast, airlines reporting under IFRS have been required to use the Deferred Revenue (fair value) Method of accounting since July 2008. Reporting FFP liabilities under fair value, however, has resulted in some airlines’ FFP liabilities increasing dramatically. For example, when Delta Air Lines chose to revalue its FFP under the Deferred Revenue Method following its Chapter 11 reorganization and subsequent fresh start accounting, its FFP liability increased from $412 million to $2.4 billion. Specific management incentives are associated with the adoption and use of each accounting method, and the FFP accounting method chosen by a given airline can potentially drive the way management operates its FFP, including the relative amount of award seats it makes available. Additionally, the Deferred Revenue Method in particular provides opportunities to manage reported earnings through FFP-related accounts. The goal of this thesis project is to examine and answer the following central question: In the context of investors’ informational needs, what are the circumstances under which the Deferred Revenue Method is preferable to the Incremental Cost Method of accounting for FFP liabilities? FACULTY ADVISORS C. Patrick Fort, Professor of Accounting, College of Business and Public Policy, University of Alaska Anchorage, 3211 Providence Drive, Anchorage, AK 99508, 907-786-4138, Kevin E. Dow, Assistant Professor of Accounting, College of Business and Public Policy, University of Alaska Anchorage, 3211 Providence Drive, Anchorage, AK 99508, 907-786-4146,

INTRODUCTION Accounting for airline frequent flyer program (FFP) liabilities has been a controversial topic for decades, beginning in the late 1980s when airlines were first required to display FFP liabilities on their financial statements. At that time, the airline industry protested the requirement to record any liabilities for their FFPs, asserting that they would have to scale down their programs to avoid unattractively large...
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