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Dec 1991

Airline accounting: AICPA versus FASB. (American Institute of Certified Public Accountants; Financial Accounting Standards Board )

by Taylor, Charles W.

    Abstract- Many airlines are using frequent-flyer travel awards as a marketing tool to boost passenger rate and develop passenger loyalty. The American Institute of Certified Public Accountants (AICPA) and the Financial Accounting Standards Board (FASB) have been in disagreement over the method to be used in accounting for free travel awards. The AICPA was proposing the use of the increment cost method for promotional or premium travel programs, and the deferred revenue method for discount travel programs. The FASB, on the other hand, was insisting on the deferred method for all free travel programs. Due to the disagreement between the two bodies, the AICPA's proposed guidelines for free travel accounting have been abandoned. This means that airlines may continue their practice of using the incremental cost method.

Use of these free travel awards has the potential of causing revenue displacement for the participating airlines. Revenue displacement occurs when a passenger using a free travel award occupies a seat on a flight which would otherwise have been occupied by a paying passenger. This results in lost revenue for the airlines. Thus, the AICPA Task Force on Airlines studied this free travel award issue.

The task force developed a Statement of Position to provide guidance on accounting for frequent traveler programs, but a disagreement between the AICPA and the FASB has resulted in abandonment of the proposal. This article reviews the accounting issues, the disagreement, and the outcome.

Accounting for Free Travel Awards

Since the advent of free travel awards in 1981, airlines have been accounting for them in their financial statements. Moreover, the airline industry has weathered most of the 1980s without any specific accounting guidelines addressing free travel awards.

Most airlines use the incremental cost method to account for their free travel awards. Once a program member accumulates the required number of miles or flights to qualify for free travel awards, then the incremental cost of providing these passengers free air transportation is recorded. A charge is made to the current passenger revenue account and a credit is made to the air traffic liability account in the amount of the incremental cost. When the airline provides the free transportation, the previously deferred amount is recognized as revenue.

United Airlines utilizes a slightly different version of the incremental cost method to account for its free travel awards. United's variation involves an expense accrual and an accrued liability. Similar to the first method, when its program members achieve the necessary level to request free travel awards, the airline records the incremental cost expected to be incurred when the awards are used. However, the charge is made to the promotion expense account. Therefore, United views the transaction as an expense accrual as opposed to a revenue reduction.

Many factors are involved in calculating the estimated incremental cost of transporting a free travel award passenger. The costs of food and beverage sipplies, additional fuel, making the reservation, issuing the ticket, passenger liability insurance, and handling of baggage are elements of the incremental cost.

Several major variables are considered when determining the amount of the incremental cost to be allocated to the free travel awards. These include estimates of the number of unused awards, the route segments on which the award earners will fly, and the number of miles that will be redeemed for awards offered by participating partners. One recent survey of the airline industry indicated that the average incremental cost of providing air transportation to a free travel award passenger was $8.

Proposed Accounting Guidance

Frequent travel award programs have developed rapidly in the airline industry. A tremendous growth in memberships and the importance of these marketing programs to the carriers has occurred. The airlines have realized a great deal of success from the programs manifested by increased passenger loyalty, traffic, and revenue. This success coupled with greater competition have fostered the sponsoring airlines to expand their marketing emphasis on these programs.

Accounting for these powerful frequent travel award programs since their beginnings has been a perplexing problem. The Task Force on Airlines tackled this confusing accounting matter in response to the previously mentioned developments. Ultimately, a proposed Statement of Position, Accounting for Frequent Travel Award Programs, was prepared. It contained five major recommendations concerning the proper accounting for free travel award programs. AcSEC accepted this proposed SOP in late 1989.

The incremental cost method of accounting for free travel awards is appropriate when the program is a promotional or premium program. The free travel awards in this case must be merely incidental to the earnings process.

The deferred revenue method of accounting for free travel awards is proper when the program is a discount program. The free travel awards earned by the program members in this case are essentially discounted tickets. This deferred revenue method requires the air carrier to defer a portion of the sales price of a ticket purchased by a program member in the air traffic liability account until the free travel award is used. The amount of revenue to be deferred is based on the allocated revenue value of a free travel award to the carrier. The deferred, allocated amount, representing the discounted fare, is recognized as earned revenue when the program member uses the free travel award. The computation of the deferred, allocated amounts can be extremely complicated and involve many estimates, such as the yield rate assigned to the mileage associated with the free travel awards. The yield rate represents the average amount paid by a passenger flying one mile.

Attributes of Premium Programs

The incremental cost method of accounting for free travel awards is acceptable when the free travel awards earned are incidental to, or a by-product of, the original sales and utilization of tickets by program members. These tickets produce the mileage leading to free travel awards. The proposed SOP provided key characteristics of a frequent travel award program that must be present for the airline to demonstrate the incidental nature of its free travel awards to the earnings process. Objective measurements are used to determine whether the key attributes are present. These objective tests should be based on system-wide data for an airline since a free travel award may be used throughout the carrier's route system. Whenever a frequent travel award program is modified, these tests should be applied to determine whether the incremental cost or the deferred revenue method is appropriate.

There are two key attributes of programs which reflect their incidental nature. First, free travel award passengers do not displace revenue-paying passengers. Second, the earnings process has been substantially completed. Both of these characteristics must be present; therefore, objective measurements will be used to demonstrate their presence.

An airline's program must satisfy three objective tests to demonstrate that there is no revenue displacement. First, the air carrier must have effective black-out periods, restrictions, and capacity controls in operation regarding the use of free travel awards. Second, the airline must fly with significant excess capacity (empty seats). Third, passengers using free travel awards utilize less than 25% of this otherwise unused, excess capacity. When an airline satisfies these three tests, the possibility of displacing revenue-paying passengers is considered remote.

An airline's program is required to meet one of two objective measurements to provide evidence that the earnings process has been substantially completed. The first test requires that the yielded value of the average miles actually flown on free travel awards must not exceed 10% of the yielded value of the average miles actually flown by program members to qualify for the average free ticket. An alternative test is available. The ratio of twice the number of miles earned for the average flight to the number of miles necessary to redeem the average free round trip ticket cannot exceed 10%. This applies to mileage-based frequent travel award programs. For flight-based programs, a program member must fly at least 10 round trips to earn a free round trip ticket.

Disagreement Between the AICPA and the FASB

A conflict has developed between the AICPA and the FASB regarding the proper accounting treatment of free travel awards. The FASB adamantly believes that all free travel award programs should be accounted for using the deferred revenue method. Under this view, there are no exceptions to the deferred revenue method; therefore, the incremental cost method is unacceptable. The AICPA, as stated in the proposed SOP, believes that the incremental cost method should be used to account for free travel award programs which are incidental in nature. If a program fails the incidental-in-nature test, then the AICPA recommends use of the deferred revenue method.

AcSEC decided to abandon the frequent travel award program project at its September 1990 meeting. Thus, the AICPA has not issued the SOP regarding accounting for frequent travel award programs, which was to be effective as of January 1, 1991. Upon learning of the AICPA's decision, the FASB and the SEC sent letters to the AICPA that encouraged the AICPA to do something with the frequent travel award program project, other than abandoning it. The AICPA however, declined to pursue the matter and expressed hope that the FASB or the SEC would pursue the project. Since the project only affects a small number of companies (airlines), the FASB probably will not add the project to its agenda in the near future.

A Sigh of Relief

Based on recent developments, airlines sponsoring free travel award programs should be relieved. Airlines may continue using the incremental cost method to account for free travel awards. Thus, airlines will not have to defer a portion of the price of each ticket purchased by a program member until a free flight is taken.

Many of the complexities and costs of the deferred revenue method have been avoided as a result of these recent developments. To estimate the dollar amount of revenue to be deferred, airlines would have to make numerous, complex assumptions which would add a material degree of uncertainty to their financial statements. These estimates and supporting assumptions would reduce the level of comparability of financial results among the airlines. Airline computer systems would have to be greatly modified to accommodate the deferred revenue method. The costs of implementing and using the deferred revenue method could conceivably exceed the benefits to be derived.

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