Accounting for

Frequent Fliers
By

Mansoor Iqbal
Muhammad Hissam uddin
Syed Mazhar Ali Kazmi
Ghazanfar Abbas
Hammad Mirza

IBA Karachi
Case Study
United Airline - Overview
United Airlines, Inc. commonly known as "United" is an American
Airline with headquarters in Chicago. It has recently (2010)
gone through a merger with Continental Airlines and as a
result has become an airline with more revenue passenger
miles compared to any airline in the world. The airline started
its operations on April 5
th
1926 as an airmail service and over
time it has emerged as a giant in the industry. United in its
initial days; was once owned by one of the largest aircraft
manufacturer, The Boeing Company.

Overview
George Bush Intercontinental Airport in Houston is
United's largest passenger carrying hub where on an
average over 16 million passengers avail its services
every year with a daily average of over 45,000
passengers. The company has a workforce of over
88,500 employees across the globe. The airline has
a market capitalization of over $10 billion as reported
in October, 2013. Delta and American airlines are
considered to be the major competitor of this
commercial airline.
Overview
The United is customer centered organization and is
continuously striving to become an airline passenger
want to travel with, the company employees want to
work for and an organization where shareholders are
willing to invest. Given below are some highlights of
the airline
Overview
Biggest globe route network, including world-class international gateways to
Asia and Australia, Europe, Latin America, Africa and the Middle East
A Modern and fuel-efficient fleet compared to other U.S. network carriers
Most rewarding frequent flyer program that enables members to redeem miles
around the world.
To facilitate its operations airline has its hub situated in 10 cities which includes
hub in 4 largest cities of US as well.
Highlights
Worlds Most Comprehensive Route Network
Over 350 Destinations
230 Domestic destinations
Over 130 International destinations
Serves are available in 59 Countries
Average 5,279 Daily Departures
Served over 138 Million passengers during 2013

Core Issue of the Case

The case deals with the problem of estimating cost
and obligations of the United Air Lines frequent flier
program. The major accounting issue with FFPs is
how an airline accounts for their economic value.
Since FFPs represent a present obligation for an
airline to provide customers with air travel at a later
date, they are considered as a liability.

Incremental Cost Approach
One approach can be to estimate the value of points that are going to be
redeemed and the timing of redemption, with the cost being based only
on the variable costs associated with the redemption of points, i.e. meal,
drinks, ticketing. The provision for the variable costs is then recorded as a
liability, moving to an expense once the points have been redeemed.

A provision can be created for these liabilities based on the present value
of the incremental cost estimate, net of any points that are deemed likely
to expire. The provision is reduced as members redeem points from which
it is recorded to expenses.



Incremental Cost Approach
This approach can be justified in that customers are
redeeming their points for excess capacity on flights, an
activity that is incidental to the process of generating revenue
from passengers.

The incremental cost approach is designed to maximize
profitability and minimize provisioning levels, and so an airline
using the incremental cost approach needs to be able to prove
that flights flown by frequent flyers represent excess capacity
and are incidental to the normal business of flying passengers.
Incremental Cost Approach
Calculations:

We are assuming that free miles constitute 4% of revenue passenger
miles.
Liability = (4% of revenue passengers) Extra Capacity Cost per
Available Seat Mile = 0.04 38,858 0.096 149 ($Millions)
Extra Capacity = Available Seat Miles Revenue Passenger Miles =
114,995 76,137 = 38,858 (Millions)

Another approach is to defer a proportion of revenue from the sale of each ticket
to account for the FFPs. The amount that is deferred is calculated using
assumptions as to what proportion of points are likely to be redeemed and
includes an amount to cover expected costs as well as an adequate amount of
profit. The deferred revenue amount is recognized as a liability until the points
are used whereby it is recognized as revenue.
The points that airline does not consider will not be redeemed, so revenue is
recognized directly at the time of sale of points. These provisions are identified
under liabilities as unearned revenue until the points are redeemed where it
becomes revenue and is recognized in the Income Statement.
This approach can be justified in that it allows customers to use their points to
access any seat at any time.
Deferred Revenue Approach
Deferred Revenue Approach
Calculations:

We are assuming that free miles constitute 4% of revenue
passenger miles.
Liability = 0.04 Revenue Passenger Miles Average Yield per
Revenue Passenger Mile = 0.04 76,137 0.126 384 ($Millions)

Difference of Cost Under Incremental Cost and
Deferred Revenue Method


Cost Under Incremental Method $ 149 million

Cost Under Deferred Revenue Method 384 million

Difference $ 235 million
Deferred Revenue Method to be Used
Under IFRS, revenues from original sales that give rise to loyalty points (or
other award credits) should be allocated.
Fair value of award credits should be deferred as unearned revenue and
recognized when exchanged for promised rewards
The recommendation to use the deferred revenue method is given by
International Financial Reporting Interpretations Committee 13(IFRIC 13).
Deferred Revenue Approach is based on deferring a portion of the revenue of
sale of a ticket as deferred revenue on the liability side of the balance sheet.
Once the points are redeemed or expired they are considered as revenue.
So we use Deferred Revenue Method Approach.

Calculations of Deferred Revenue method:


We are assuming that free miles constitute 4% of revenue passenger miles.

Liability = 0.04 Revenue Passenger Miles Average Yield per Revenue
Passenger Mile = 0.04 76,137 0.126 384 ($Millions)

Whether to Continue or not Continue FFP:
As CFO, I would calculate the revenue that United Airlines might loose by abandoning
the program

Revenue Gained = 130,000 new members x 12months

= 1,560,000 PAX x $0.126 x 1322mi RPM

= 196,560 x 1322mi RPM

= $ 259,852,320


Whether to Continue or not Continue FFP:
Assuming that no Revenue PAX is displaced by FF PAX and that 4% of all RPM
generated through the program is redeemed
=1,560,000 PAX x 4%
= 62,400 x $167.26

Lost Revenue = $10,437,024

NET Revenue = 259,852,320 10,437,024 = $249,415,296

Its highly beneficial to continue the FFP


Should United Airlines Account FFP in
Published Financial Statements?

Yes, we believe that ideally United Airlines
should account in its published financial
statements for the frequent flier program.
Reasons
An investor to the airline company must be able to know the
costs that may be incurred in future as a result of frequent flier
members redeeming their points. These costs are future
liabilities which may affect the revenue of the company in
future years.

By making the provisioning of future liabilities explicit in the
financial statements, the potential investors will not be tricked
into investing into the airline company if the liabilities
are potentially huge and the airline is not operating with
operating efficiencies.
What Should be Accounted for OR
Disclosed?
The Deferred Revenue method should be used and the total cost
of the Frequent Flier Program is mentioned as a deferred
liability and once the points are redeemed or expired it is
considered as revenue.

The load factor should also be disclosed along with the financial
statements. This will be essential to gain an insight into the
operating efficiencies of the airline company.

What Should be Accounted for OR
Disclosed?
The Other Things to be disclosed are:
Gallons Consumed FFP
Fuel Expense for FFP
Average Price per Gallon
Percentage of Total Operating Expense
Frequent flyer deferred revenue opening balance
% of miles earned expected to expire
Impact of change in outstanding miles
or weighted average ticket value on deferred revenue


Possible Ways for United to Account for the
Program in Published Financial Statements
The possible way according to IFRS is the Deferred Revenue Method which
calculates the costs as a percentage of the revenue and provisions it as a
deferred liability.

Also, for customers looking at joining a frequent flyer program it would also
be useful to consider which accounting procedure is used as an airline
using the deferred revenue approach would be able to provide frequent
flyer seats on any trip at any time while the airline using the incremental
cost approach can only provide access to seats that represent excess
capacity.
Accounting Methods & Entries

United Airlines should account for the Frequent flier program based on the
Deferred Revenue Method because it is recommended by IFRS and IFRIC 13
interpretation on customer loyalty programs has been issued.
Journal Entry To record Revenue and
Deferred Liability
Dr. Cr.
($ in Millions) ($ in Millions)
Bank 9,593
Revenue 9,209
Deferred Revenue 384

Total Revenue = 76,137 Millions x $0.126=$9,593 Millions
Revenue Earned = $9,593 x 96% =$9,209 Millions
Deferred Revenue = $9,593 x 4% =$384 Millions






Ledgers to be used
The Ledgers to be used for Frequent Flyer
program are the Bank, Revenue and the
Deferred Revenue.
Extract of Balance Sheet
Liabilities $ in Millions
Frequent Flyer Deferred Revenue 384



Note:
The Frequent Flyer Deferred Revenue can be classified in the balance sheet in the liabilities side under two heads.
One Current Liabilities the FFP will be redeemed or expired within one year. The Second under Long term
Liabilities where FFP will be redeemed or expired more than a year.


What would we do as CFO?
The capacity utilization of United Airlines on an
average is less or very near to the break even load
factor. Yet, there may be some routes or flights in
which the maximum capacity of the aircraft can
be reached.
I would have analyzed various routes where a high
utilization factor of the aircraft can be incurred and
subsequently assigned costs on those routes based
on the Deferred Revenue method.
CONCLUSION
FFP is very valuable for United Airlines as it increases
the loyalty of customers that ultimately posts increase
in future sales.
From accounting perspective, guidelines are available
in International Financial Reporting Standard (IFRS)
to record FFP
The most suitable method to record FFP program
according to IFRS is Deferred Revenue Method