ACCOUNTING FOR FREQUENT FLIERS

FSA

Part 1
a) What are the various methods United might use to measure the costs of its frequent flier program? What are the potential differences in dollars of the cost measured by each method? Method 1. Incremental Cost Approach Details Incremental Cost Approach results in the provision being set based on the estimated value of points that are going to be redeemed and the timing of the redemption. It considers the incremental cost that are associated with expenses like ticketing (through agencies etc), meals and drinks. 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 it is considered as revenue Calculations According to Exhibit 2, it is seen that the Cost per available seat mile is 9.60 cents. Total travel awards redeemed by members is 1.2 million free trips Therefore the total cost = (Total travel awards redeemed) * (Cost per available seat mile)*(Average Flight Length) = 1.2 million * 9.60 cents*912 = $ 105062400 = $ 105.06million

2. Deferred Revenue Approach

Consider 6% as the percentage of total revenue passenger From Exhibit 2, Average Yield per Revenue passenger mile = 12.60 cents Total Revenue passenger mile = 76137 millions Deferred revenue as a result of Frequent fliers = (Total Revenue passenger miles)*(Average Yield per Revenue Passenger mile)*(0.06) Deferred revenue as a result of Frequent fliers = 76137*0.1260*0.06*1000000 = $ 575,595,720 = $ 575.6 million

b) What method should United Airlines use to measure the cost of its frequent flier program? Estimate the cost of the program using this method. Show all calculations and indicate the assumptions you make. The incremental cost approach treats the passengers who redeem points based on Frequent Flier programs as separate from the normal revenue passengers. As a result only increment costs are considered. Whereas, the deferred revenue approach, costs are considered by

ACCOUNTING FOR FREQUENT FLIERS

FSA

taking into account that there is no distinction and the full value of the cost associated with the trip is accounted for. Case fact The Passenger Load factor in United Airlines is 66.20% (year 1990) which means that the load factor is lower than the breakeven load factor of 66.50%. This means that the airline is operating with additional capacity. As a result the Incremental cost method approach is more suitable as this approach considers the incremental cost involved in providing service to a passenger who uses the frequent flier program points (redeems the points and uses the service free) in an airline which is not operating at capacity. However the deferred revenue method results in higher provisioning and since it considers the entire costs associated with providing service rather than the incremental cost, the provisioning of liability is very large compared to incremental approach. These results in lower reporting profitability of the business compared to the incremental cost approach.

c) If you were the chief financial officer (CFO) of United Airlines, how would you determine if continuing the frequent flier program would be beneficial to United Airlines? Analysis By considering the total cost provisioned as per the Incremental cost method we can see that for the year 1990 the cost is $105.06 million. If the frequent flier program was halted the additional cost that should be provisioned can be phased out. However we can assume that there will be a drop in the number of passengers who opt for flying by United Airlines. As per the data in 1990 we can see that there were a total of 1.2 million free trips (as a result of redeeming the points). Assuming that we lose the customers accounting to 1.2 million trips we can see a drop in revenue as follows =(1.2 million trips)*(Average Yield per Revenue)*(Average Flight Length) = 1.2 million * 12.60 cents*912 = $ 137894400 = $ 137.9 million Therefore considering that 1.2 million trips are reduced we see that the total revenue reduced is more than the total costs (105.06 million) that we have saved. The 1.2 million trips is a conservative estimate. There is a greater likelihood of the number increasing as the frequent flier program is scrapped. Snapshot Revenue drop: $137.9 millions Cost Saved: $105.06 millions

Profit/Loss: ($32.84 millions)

ACCOUNTING FOR FREQUENT FLIERS

FSA

Action CFO should discontinue the frequent flier program.

Part 2
a) Do you believe that United should account in its published financial statements for the frequent flier program or is disclosure in public filings with the SEC sufficient? Why? Yes, I believe that ideally that United should account in its published financial statements for the frequent flier program. Reason 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. b) In either case, what is it that should be accounted for or disclosed? Why? 1. If the airlines operate with a lower load factor, the total cost that could be incurred due to Frequent Flier Program is calculated using the incremental cost method should be mentioned on the liability side of the financial statement. 2. If the Deferred Revenue method is used the total cost of the Frequent Flier Program is mentioned as a deferred liability and once the points are redeemed it is considered as revenue. 3. 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. c) What possible ways might United choose to account for the program in its published financial statements if it chooses to do so? 1. The possible ways that United Airlines might choose to account for the program are the Incremental Cost Method where provisions are set aside considering only the incremental costs that will be incurred in providing the service. This is mentioned on the liabilities side of the financial statement. 2. The other possible way is the Deferred Revenue Method which calculates the costs as a percentage of the revenue and provisioning it as a deferred liability.

ACCOUNTING FOR FREQUENT FLIERS

FSA

d) How do you believe United Airlines should account for the program in its published financial statements? Explain and support your chosen method and why you rejected other approaches? Action United Airlines should account for the Frequent flier program based on the Incremental Cost Method in its financial statements. Reason The airlines operate with additional/excess capacity of around 64-67% throughout the years 1986-1990. The load factors are almost just equal to the breakeven load factor. As a result it is safe to assume that the frequent fliers who redeem the points and travel free on certain flights can be assigned the additional seats on most routes or trips. This results in only an incremental cost incurred of serving a passenger and not the loss of revenue on assigning a seat to a free flier when that seat can be filled by a passenger who travels without redeeming any points. e) If you were the CFO of United Airlines, what would you do? The capacity utilization of United Airlines on an average is less or very near to the breakeven load factor. Yet, there may be some routes or flights in which the maximum capacity of the aircraft can be reached. In such routes or flights, the Incremental approach may not be efficient in determining the costs associated with the Frequent Flier Program. I would have analyzed the 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 and on the less occupied routes with the Incremental Cost Method.