Case Analysis: Accounting for Frequent Fliers Essay

747 Words Aug 16th, 2011 3 Pages
(FFP: Frequent Flier Program)

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 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 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 recognised as a liability until the points are used whereby it is recognised as revenue. For those points that the airline considers will not be redeemed, revenue is recognised 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 recognised 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.

The main issue associated with the deferred revenue approach is that it results in higher provisioning levels, as the full value of providing air travel to a customer has to be accounted for not just the variable cost. Higher provisioning levels in turn would result in higher liabilities having the effect of reducing profitability through a reduction in revenue as it becomes diverted to revenue provisions.

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)

Questions:
1.a. Various methods as illustrated above

1.b. United should use the Incremental Cost