Accounting Presentation Final

8/10/2019 Accounting Presentation Final

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Accounting for

Frequent Fliers

By

Mansoor Iqbal

Muhammad Hissam uddin

Syed Mazhar Ali Kazmi

Ghazanfar Abbas

Hammad Mirza

IBA Karachi

Case Study


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United Airline - Overview

United Airlines, Inc.commonly known as "United" is an AmericanAirline with headquarters in Chicago. It has recently (2010)gone through a merger with Continental Airlines and as aresult has become an airline with more revenue passengermiles compared to any airline in the world. The airline startedits operations on April 5th1926 as an airmail service and overtime it has emerged as a giant in the industry. United in itsinitial days; was once owned by one of the largest aircraftmanufacturer, The Boeing Company.


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Overview

George Bush Intercontinental Airport in Houston isUnited's largest passenger carrying hub where on anaverage over 16 million passengers avail its servicesevery year with a daily average of over 45,000passengers. The company has a workforce of over88,500 employees across the globe. The airline has

a market capitalization of over $10 billion as reportedin October, 2013. Delta and American airlines areconsidered to be the major competitor of thiscommercial airline.


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Overview

The United is customer centered organization and iscontinuously striving to become an airline passengerwant to travel with, the company employees want towork for and an organization where shareholders arewilling to invest. Given below are some highlights of

the airline


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Overview

Biggest globe route network, including world-class international gateAsia and Australia, Europe, Latin America, Africa and the Middle Eas

A Modern and fuel-efficient fleet compared to other U.S. network car

Most rewarding frequent flyer program that enables members to redaround the world.

To facilitate its operations airline has its hub situated in 10 cities whhub in 4 largest cities of US as well.


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Highlights

Worlds Most Comprehensive Route Network Over350Destinations

230 Domestic destinations

Over130International destinations

Serves are available in 59Countries

Average5,279Daily Departures

Served over 138 Million passengers during 2013


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Core Issue of the Case

The case deals with the problem of estimating costand obligations of the United Air Lines frequent flierprogram. The major accounting issue with FFPs ishow an airline accounts for their economic value.Since FFPs represent a present obligation for anairline to provide customers with air travel at a laterdate, they are considered as a liability.


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Incremental Cost Approach

One approach can be to estimate the value of points that are goi

redeemed and the timing of redemption, with the cost being baon the variable costs associated with the redemption of points, idrinks, ticketing. The provision for the variable costs is then recorliability, moving to an expense once the points have been redeeme

A provision can be created for these liabilities based on the preseof the incremental cost estimate, net of any points that are deemto expire. The provision is reduced as members redeem points froit is recorded to expenses.


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This approach can be justified in that customers areredeeming their points for excess capacity on flights, anactivity that is incidental to the process of generating revenuefrom passengers.

The incremental cost approach is designed to maximizeprofitability and minimize provisioning levels, and so an airlineusing the incremental cost approach needs to be able to provethat flights flown by frequent flyers represent excess capacityand are incidental to the normal business of flying passengers.


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Calculations:

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

Liability = (4% of revenue passengers) Extra Capacity Cost peAvailable Seat Mile = 0.04 38,858 0.096 149 ($Millions)

Extra Capacity = Available Seat Miles Revenue Passenger Mile114,995 76,137 = 38,858 (Millions)


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Another approach is to defer a proportion of revenue from the sale oto account for the FFPs. The amount that is deferred is calculated us

assumptions as to what proportion of points are likely to be redeemincludes an amount to cover expected costs as well as an adequateprofit. The deferred revenue amount is recognized as a liability untilare used whereby it is recognized as revenue.

The points that airline does not consider will not be redeemed, so rerecognized directly at the time of sale of points. These provisions arunder liabilities as unearned revenue until the points are redeemedbecomes revenue and is recognized in the Income Statement.

This approach can be justified in that it allows customers to use theaccess any seat at any time.

Deferred Revenue Approach


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Deferred Revenue Approach

Calculations:

We are assuming that free miles constitute 4% of revenuepassenger miles.

Liability = 0.04 Revenue Passenger Miles Average Yield per

Revenue Passenger Mile = 0.04 76,137 0.126 384 ($Milli


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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


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Calculations of Deferred Revenue method:

We are assuming that free miles constitute 4% of revenue passenge

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


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Whether to Continue or not Continue FFP:

As CFO, I would calculate the revenue that United Airlines might loose by abandoninthe 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


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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


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Should United Airlines Account FFP in

Published Financial Statements?

Yes,

we believe that ideally United Airlinesshould account in its published financial

statements for the frequent flier program.


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Reasons

An investor to the airline company must be able to know thecosts that may be incurred in future as a result of frequent fliermembers redeeming their points. These costs are futureliabilities which may affect the revenue of the company infuture years.

By making the provisioning of future liabilities explicit in thefinancial statements, the potential investors will not be trickedinto investing into the airline company if the liabilitiesare potentially huge and the airline is not operating withoperating efficiencies.


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What Should be Accounted for OR

Disclosed?

The Deferred Revenue method should be used and the totof the Frequent Flier Program is mentioned as a deferredliability and once the points are redeemed or expired it isconsidered as revenue.

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


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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


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Possible Ways for United to Account for the

Program in Published Financial Statements

The possible way according to IFRS is the Deferred Revenue Method whichcalculates the costs as a percentage of the revenue and provisions it as adeferred liability.

Also, for customers looking at joining a frequent flyer program it would alsobe useful to consider which accounting procedure is used as an airlineusing the deferred revenue approach would be able to provide frequent

flyer seats on any trip at any time while the airline using the incrementalcost approach can only provide access to seats that represent excesscapacity.


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Accounting Methods Entries

United Airlines should account for the Frequent flier program based on theDeferred Revenue Method because it is recommended by IFRS and IFRIC 13

interpretation on customer loyalty programs has been issued.


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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


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Ledgers to be used

The Ledgers to be used for Frequent Flyerprogram are the Bank, Revenue and the

Deferred Revenue.


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Extract of Balance Sheet

Liabilities $ in Mi

Frequent Flyer Deferred Revenue 38

Note:

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


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What would we do as CFO?

The capacity utilization of United Airlines on anaverage is less or very near to the break even loadfactor. Yet, there may be some routes or flights inwhich the maximum capacity of the aircraft canbe reached.

I would have analyzed various routes where a highutilization factor of the aircraft can be incurred andsubsequently assigned costs on those routes basedon the Deferred Revenue method.


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CONCLUSION

FFP is very valuable for United Airlines as it increasesthe loyalty of customers that ultimately posts increasein future sales.

From accounting perspective, guidelines are availablein International Financial Reporting Standard (IFRS)

to record FFP The most suitable method to record FFP program

according to IFRS is Deferred Revenue Method

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Accounting Presentation Final

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