3.100 FFPs were introduced by many airlines in the early 1980s, prin-cipally to induce higher levels of repeat business from their customers. The basic concept of an FFP is to encourage passenger loyalty by providing awards geared to the frequency of travel on the sponsoring airline, typically in the form of frequent flyer miles, points, or segments (collectively referred to as mileage credits) that can be accumulated and converted into free or discounted travel.
3.101 Some airlines also enter into code-sharing or other arrangements whereby they cooperate with other airlines in providing travel-related benefits to passengers. Typically, such arrangements involve an ability to access one another's FFP so that members of one airline's FFP can use their mileage cred-its to obtain awards on another participating airline, earn mileage credcred-its for flights taken on another participating airline, or both.
3.102 Some FFPs also involve participants other than airlines, for exam-ple, credit card issuers, hotels, car rental companies, and restaurants. The most prevalent nonairline participants in FFPs have historically been credit card is-suers. Nonairline participants grant mileage credits as an inducement for the purchase of products or services. These nonairline participants pay the airline based upon the level of purchases for the ability to utilize the marketing ben-efits of the FFP. These programs can account for a significant portion of the mileage credits issued in an FFP.
3.103 In addition to free travel awards, various other types of awards may be offered by an FFP in exchange for mileage credits accumulated under the program, including the following:
r
The ability to buy a ticket at a discountr
Upgradesr
Free companion ticketsr
Free travel on a participating airliner
Other nontravel awards3.104 The extent of the marketing benefits to be obtained from an FFP by the sponsoring airline depends partly on the airline's ability to handle the extra traffic generated by the FFP while not displacing fare-paying passengers. As a result, as FFPs have developed, it has become more commonplace for airlines to impose restrictions involving, for example, the limitation of capacity that is available for frequent flyer passengers on some or all flights, including, in particular, those during peak travel periods on high density routes.
3.105 There are two methods of accounting for free or discounted travel arising under FFPs: the incremental cost method and the deferred revenue method. There is no specific authoritative accounting guidance on the account-ing for FFPs. FASB previously considered but reached no consensus on the ac-counting for FFPs. Although certain aspects of frequent flyer acac-counting have been governed by the principles set forth in SAB No. 104 (primarily related to the sale of FFP credits, as discussed later in this chapter), other aspects have simply evolved as a matter of industry practice. Over the years, airlines have used both methods and provided certain disclosures concerning FFPs. In the absence of any specific authoritative guidance, many airlines have analogized to the guidance in either FASB ASC 605-50 to support use of the incremen-tal cost method, or FASB ASC 605-25, to support use of the deferred revenue method.
3.106 Under the deferred revenue method, an airline recognizes a lia-bility for the issuance date fair value (in accordance with guidance FASB ASC 605-25-25)*of all outstanding mileage credits, regardless of how they orig-inated. In contrast, under the incremental cost method, an airline recognizes a liability under a mixed model comprised of an incremental cost accrual for mileage credits not sold to third parties and expected to be redeemed for travel on the airline, the fair value of mileage credits sold to third parties (that is, deferred revenue), and the cost of settlement for mileage credits not sold to third parties and expected to be redeemed for travel on a partner airline or a nontravel award.
3.107 The deferred revenue method is acceptable in all circumstances, whereas the incremental cost method is acceptable in only certain stances. For example, the incremental cost method is inappropriate in circum-stances in which (a) a significant number of paying passengers are displaced by passengers redeeming awards2 or (b) the value of an individual award is significant compared with the value of the purchase(s) earning the award.
Incremental Cost Method
3.108 Historically, there has been substantial industry practice to use the incremental cost method rather than the deferred revenue method. The incremental cost method is based on the concept that FFP awards are tightly controlled so that passengers redeeming the awards are simply filling excess capacity and, as a result, the carrier is incurring only the incremental cost of providing what would have otherwise been an empty seat. However, AcSEC believes if FFP awards are without limitations (such as capacity restrictions or
*See footnote* in paragraph 3.49.
2For purposes of applying the guidance discussed in this guide, the fact that a passenger re-deeming an award might otherwise have been a paying passenger had they not redeemed the award should not lead to the conclusion that a paying passenger has been displaced by a passenger redeem-ing an award. In other words, passengers redeemredeem-ing an award do not displace themselves as payredeem-ing passengers for purposes of applying the guidance discussed in this guide.
blackout dates) or if special promotional programs are used that could cause the value of an individual award to be significant compared to the value of the purchase(s) earning the award, use of the incremental cost method may be inappropriate.
3.109 Under the incremental cost method, a liability is recorded for the incremental cost associated with rewarding those FFP members expected to redeem mileage credits. For awards expected to be redeemed for free travel on the sponsoring airline, incremental cost typically includes the cost of fuel, food and drinks, ticketing, and certain types of insurance because these are the typ-ical incremental costs an airline will incur to provide travel to one additional passenger. For awards expected to be redeemed for free travel on other airlines or for nontravel awards, the incremental cost is the amount the sponsoring airline will be obligated to pay the other airline (see the "Accounting for Inter-line Mileage Credits" section of this chapter for additional guidance) or other third-party providing the award.
3.110 A key factor in estimating an FFP obligation under the incremental cost method is the estimate of mileage credits that are expected to be redeemed.
In practice, that estimate is influenced by a number of factors, including the following:
r
The threshold of mileage credits required before an FFP member can secure an award and the mix of award redemptions under the FFP. The rate of redemption will be affected by the ease with which members can accumulate sufficient mileage credits to make a redemption and the attraction of the awards offered by the FFP.r
The expiration/purge period, if any, established for the program.Some FFPs provide that mileage credits must be used within a specified period or they are lost. The rate of redemption of mileage credits will be affected by the airline's policy for credits lost through expiration or nonuse.
r
The airline's redemption experience. Airlines develop statistics in-cluding— overall number of mileage credits redeemed.
— proportion taken in air (including air travel provided by airline partners) and nonair travel awards.
— flight segments against which awards are taken.
— nature of other awards taken.
— frequency of redemptions.
— utilization of mileage credits among particular member categories.
3.111 Some airlines with well established programs and comprehensive redemption data have been able to build up experience-based statistical models for estimating the likelihood and type of redemptions.
3.112 The cost of offering nonair travel awards is the cost charged to the airline for the product. Airlines need to accumulate sufficient data regarding the level of mileage credits redeemed for nonair travel awards to be able to properly estimate their obligation for nonair travel awards.
Deferred Revenue Method
3.113 Under the deferred revenue method, the fair value of all mileage credits, including those granted for travel on the issuing airline, is deferred until such time as the mileage credits are used for an award. Historically, there has been limited use of the deferred revenue method, although some airlines have adopted it in connection with business combinations or upon application of fresh start accounting when exiting bankruptcy. However, the deferred rev-enue method is required under International Financial Reporting Standards.
Accordingly, in addition to guidance provided in this chapter, an airline may also give consideration to International Financial Reporting Interpretations Com-mittee Interpretation No. 13, Customer Loyalty Programmes, when applying the deferred revenue method.
3.114 FASB ASC 605-25-30-9* provides that the use of vendor-specific objective evidence (VSOE) of fair value is preferable in all circumstances in which it is available.
3.115 Therefore, in determining the fair value of mileage credits, airlines first need to determine if measurement representative of VSOE of fair value as discussed in FASB ASC 605-25-30-9∗is available.
3.116 The industry generally has looked to transactions involving the transportation element of sales of mileage credits to third parties (such as other airlines) to derive VSOE of fair value. If such transactions are not representa-tive of VSOE of fair value, airlines may look to purchased tickets with the same or similar restrictions as frequent flyer awards.
3.117 The fair value of mileage credits is determined at issuance of the credits and the resulting liability is not adjusted, or marked-to-market, for fu-ture changes in fair value. However, as the fair value of mileage credits issued changes over time it is necessary to change the initial deferral rate, which results in a pool of mileage credits valued at different rates. Because mileage credits are frequently fungible and therefore airlines have difficulty in tracking individual mileage credits from issuance to usage for a flight or other award, airlines generally adopt a methodology to determine the value of mileage cred-its used for awards. A common approach is to use a weighted average or first-in, first-out method, much like an inventory valuation, to determine which miles are used for redemptions and which remain in the pool of outstanding miles.
3.118 Mileage credits that expire under the terms of the airline's policy or not likely to be redeemed are collectively referred to as breakage. The estima-tion and accounting for the breakage of mileage credits is a critical accounting consideration. AcSEC believes that breakage should be recognized using one of the following methods:
r
Expiration recognition method. Breakage is recognized at expira-tion of the mileage credits, or, if mileage credits do not expire, when the likelihood that the mileage credits will ever be redeemed for future services becomes remote.r
Redemption recognition method. Breakage is estimated and rec-ognized in proportion to actual mileage redemptions.*See footnote* in paragraph 3.49.
3.119 Immediate recognition of breakage is not appropriate. AcSEC be-lieves that an airline's breakage methodology should be based on company-specific historical evidence of customers' redemption rates and should be ap-plied consistently.
3.120 The estimation of the breakage rate will frequently require the use of sophisticated statistical modeling techniques to analyze historical information.
Typically, the models will take into account historical behavior such as the num-ber of mileage credits accumulated and the frequency and size of redemptions.
Also, customer characteristics, such as geographic location and length of time in the program, would need to be considered. It is necessary to consider care-fully whether historical redemption behavior is indicative of expected future behavior by reference to such factors as changes in the terms of the program or the customer population or goods or services offered. In particular, the following factors may affect the estimated rate:
r
Changes in the popularity of the program over the years, with many new members joining, such that the redemption history re-lating to the older years is no longer representative.r
Customers who have rarely or never redeemed mileage credits, building up their balance for redemption for a highly valuable award or future travel, thus making their historical redemption activity not representative of their future activity.r
Differing patterns in the redemption rates relating to such factors as the age of customers, their geographical locations, their past buying pattern, the length of time as a customer, or other factors that may indicate that population may need to be segmented into different groups for the purpose of estimating future redemptions.r
Requirements for customers to build up to a minimum level of mileage credits before they can reach an award level, which may mean a number of customers will not be able to redeem their mileage credits.r
The expiration/purge period, if any, established for the program.Some FFPs provide that mileage credits must be used within a specified period or they are lost. The redemption rate will be af-fected by any systematic elimination of unused mileage credits.
3.121 The assumptions and models used to estimate the breakage rates need to be reasonable, reliable, and objectively determined.
Accounting for Mileage Credits Sold to Third Parties
3.122 FASB ASC 605-25-25* provides the most appropriate guidance for accounting for the sale of mileage credits to nonairline participants. Paragraphs 1–2 of FASB ASC 605-25-25 explain the criteria for determining whether ar-rangements with multiple deliverables should be divided, how to measure and allocate the arrangement among the separate units of accounting based on spe-cific criteria as described in 605-25-25-5, that the allocation should be based on their relative fair values, and that the applicable revenue recognition criteria should be considered separately for separate units of accounting.
*See footnote* in paragraph 3.49.
3.123 Under FASB ASC 605-25-25,*the airline would, if possible, separate the component of the sale representing the value of the future travel awards (the travel component) from the component that represents the value associated with other goods or services acquired by the nonairline participant, such as the right to use the airline's database or customer mailing list (the marketing component). If objective and reliable evidence of fair value of the delivered element (the marketing component) is not available, the residual method is used in accordance with FASB ASC 605-25-30-2.∗
3.124 The marketing component may be recognized as revenue at the point of sale of the mileage credits to the affinity partner, whereas the travel component is recognized as travel occurs.
3.125 For airlines accounting for their FFPs under the deferred revenue method, the fair value of the travel component is determined based on the same rate used for mileage credits granted for travel on the issuing airline, as discussed in paragraph 3.117 of this chapter, and recognized as revenue using the same methodology selected by the airline pursuant to paragraph 3.118.
3.126 For airlines accounting for their FFPs under the incremental cost method, the fair value of the travel component is typically derived in the same manner as the fair value of mileage credits under the deferred revenue method.
Also, because airlines generally do not track miles on a specific identification basis (that is, miles awarded for flying are not distinguished from those sold to nonairline participants), airlines accounting for their FFPs under the incre-mental cost method have developed conventions for allocating mileage credits used between those granted for travel on the issuing airline (an incremen-tal cost model) and those sold to nonairline participants (a deferred revenue model). This convention assumes that the mileage credits sold to nonairline participants are used for travel awards, and thus recognized as revenue, on a straight-line basis over the historical usage period of the mileage credits. In applying this concept, an airline needs to eliminate from its incremental cost liability the mileage credits sold to nonairline participants for which revenue is deferred.
3.127 AcSEC recommends that revenue attributed to the marketing com-ponent be classified as other operating revenue and that revenue attributed to the travel component be classified as passenger revenue.
Accounting for Interline Mileage Credits
3.128 Airlines frequently include other airline partners in their FFPs to extend their programs in order to attract and retain certain premium passen-gers as well as to offer their FFP members extended options for the potential use of their accumulated mileage credits. In most of these cases, the airline also participates in the other airline's FFP on a reciprocal basis. Such cross-participation by airline partners in each other's FFP creates a number of ac-counting issues for airlines acac-counting for their FFPs under the incremental cost method that stem primarily from the settlement of usage under the con-tracts between the carriers. The majority of concon-tracts call for settlement of the net activity between the 2 carriers' FFPs—generally, at least annually—at a stated rate per mileage credit that is frequently higher than the carriers' own
*See footnote* in paragraph 3.49.
incremental cost to provide an FFP seat. In fact, these rates are frequently up to 10 times higher than the incremental cost rate because they tend to repre-sent the mileage credit equivalent of the fair value of a restricted ticket. For airlines accounting for their FFPs under the deferred revenue method, these issues are generally not present because deferral rates approximate or exceed the settlement rates.
3.129 In the early stages of these partner relationships, many airlines accounted for interline FFP activity on a net basis. Individual activities were not recorded; rather, the net result of the settlement was recorded as income or expense in the period of settlement. AcSEC believes that gross-basis accounting is the appropriate practice.
3.130 Following is an illustration of the accounting for interline FFP ac-tivity for an airline using the incremental cost method. In this illustration, four activities affect the settlement between Home Airline (HA), the reporting entity, and Partner Airline (PA).
a. Home Airline FFP members earn mileage credits in the Home Air-line FFP for travel that occurred on Partner AirAir-line. Partner AirAir-line is obligated to pay Home Airline for the mileage credits earned.
b. Home Airline FFP members use mileage credits to fly on Partner Airline. Home Airline is obligated to pay Partner Airline for the seats provided to Home Airline FFP members by Partner Airline, generally at a converted award level.
c. Partner Airline members earn mileage credits in the Partner Air-line FFP for flights on Home AirAir-line. Home AirAir-line is obligated to pay Partner Airline for the mileage credits earned.
d. Partner Airline FFP members use their mileage credits to fly on Home Airline. Partner Airline is obligated to pay Home Airline for the seats provided to the Partner Airline FFP members by Home Airline. The seat cost from Home Airline is generally at a converted award level.
3.131 The following table summarizes the accumulation of the net
3.131 The following table summarizes the accumulation of the net