In 2018, Accounting Standards Codification (ASC) Topic 606 became effective for all public companies. This major overhaul of revenue recognition has affected almost every industry, and airlines are no exception. The complex arrangements between airlines and their clients pose some interesting difficulties when applying the standard.
The AICPA and the major accounting firms have assembled industry task forces to research the industry-specific accounting issues within ASC 606, and we will draw from the guides they have published as we provide a brief explanation of the key issues the airline industry faces. For more information on any of these issues, see:
- AICPA: Audit & Accounting Guide—Revenue Recognition
- EY: Technical Line: How the new revenue standard affects airlines
- KPMG: Accounting for revenue is changing
The following paragraphs cover key issues that companies in the airline industry commonly face:
1. Passenger Ticket Breakage
Airlines receive payment for tickets before they provide the service of the flight. This performance obligation is normally recorded as a contract liability upon receipt of payment and is not recognized as revenue until the passenger has flown. However, in some instances, a purchased ticket will go unused—often referred to as passenger ticket breakage. Airlines still expect to receive some revenue from the breakage, because many tickets are nonrefundable, such that ticket breakage becomes similar to variable consideration. Consequently, if the airline can reasonably predict the amount of ticket breakage, they may recognize as revenue a certain proportion of ticket breakage on the day of the flight.
Airlines have experienced a record decrease in flight activity as a result of the COVID-19 pandemic, which led to temporarily increased ticket flexibility and waived cancellation fees. Airlines rely on historical flight trends and consistent ticket terms to reasonably predict ticket breakage. Due to the rapid changes in these key inputs, airlines have been forced to re-examine their approach to estimating breakage. In its April 2020 publication, KPMG discusses this and other financial reporting implications of COVID-19 for airlines.
In its correspondence with the SEC, Alaska Airlines notes how it accounts for and discloses breakage, as follows:
We estimate ticket breakage in advance at the time of the sale, but we do not record the breakage revenue until the departure date or flight date. We will update the disclosure in our future filings to state “Passenger ticket breakage is recorded at the flight date using estimates made at the time of sale based on the Company’s historical experience of expired tickets, and other facts such as program changes and modifications.” (July 2018 Letter)
Alaska Airlines also included a summary of its ticket expiration policies that inform the breakage estimates, which can be found in the same comment letter.
2. Change Fees and Ancillary Services
Many airlines charge customers to make changes to their tickets. Airlines normally provide a variety of ancillary services for purchase, such as baggage, priority seat assignments, priority boarding, food, etc. These ancillary services cannot be distinct from the performance obligation of the flight itself, because they cannot be provided for the customer except in conjunction with the flight.
Since ticket change fees and ancillary services are not distinct performance obligations, they must be recognized as “passenger revenue” along with the revenue from airline tickets. In substance, they are contract modifications to the ticket purchase contract, rather than new contracts altogether. Therefore, revenue for these services should be recognized when the travel occurs.
Spirit Airlines (2019 10-K SEC Filing): Disclosure of Revenue Recognition for Change Fees and Other Services
In the Notes to Financial Statements—Passenger Revenues section of its 2019 10-K SEC Filing, Spirit Airlines discloses its revenue recognition policy for travel-related services. These services include ticket change fees, baggage fees, and in-flight sales and are disclosed as follows:
Non-fare revenues: The adoption of ASU 2014-09 impacted the classification of certain ancillary items such as bags, seats and other travel-related fees, since they are deemed part of the single performance obligation of providing passenger transportation. These ancillary items are now recognized in non-fare revenues within passenger revenues, at the time of departure.
Changes and cancellations: Customers may elect to change or cancel their itinerary prior to the date of departure. For changes, a service charge is recognized at time of departure of newly scheduled travel and is deducted from the face value of the original purchase price of the ticket, and the original ticket becomes invalid.
For cancellations, a service charge is assessed and the amount remaining after deducting the service charge is called a credit shell which generally expires 60 days from the date the credit shell is created and which can be used towards the purchase of a new ticket and the Company’s other service offerings.
Both the service charge and credit shell amounts are recorded as deferred revenue and amounts expected to expire unused are estimated based on historical experience.
3. Mileage Loyalty Programs
Most airlines have loyalty programs whereby members earn points or credits for miles flown on the airline and purchases made from partner companies (using a co-branded credit card, staying at a partner hotel chain, using a rental car from a partner company, etc.). Under ASC 606, these loyalty credits create a performance obligation for the airline entity because they effectively represent a customer’s pre-payment for a future good or service (when the customer redeems the points), so revenue must be deferred until the obligation is satisfied. When the airline allocates the transaction price from ticket sales, it should consider the standalone selling price of the mileage credits. This can be difficult to determine because mileage credit sales are rarely conducted through regular, standalone transactions.
ASC 606-10-32-34 gives three methods by which an entity can estimate a standalone selling price, but according to EY, the best method for airlines out of the three is most likely the adjusted market assessment approach. Under this approach, an airline could value mileage credits based on their redemption value relative to outright cash payments. For example, for tickets that can be purchased with either credits or cash, the airline could calculate the implied conversion rate to get a value for each mileage credit.
With airlines experiencing a record decrease in flight activity as a result of the COVID-19 pandemic, the ability of passengers to redeem mileage credits and other rewards has been affected. Reduced redemption activity will have a material effect on a loyalty program’s fair value, so airlines will need to keep this in mind when estimating the standalone selling price of mileage credits. In its April 2020 publication, KPMG discusses this and other financial reporting implications of COVID-19 for airlines.
United Airlines (2018 SEC Correspondence): Revenue Recognition for Airlines with Mileage Loyalty Programs
In its correspondence with the SEC, United Airlines discussed its disaggregation of revenue segments, or lack thereof, mentioning its revenue recognition policy for its mileage program.
The Company did consider disaggregating revenue based on the timing of services provided. The Company determined that materially all of its passenger ticket revenue is recognized at a point in time. Ticket revenue is recognized when the passenger flies. Miles redeemed are recognized when the frequent flyer loyalty program (“MileagePlus”) member redeems them and completes the flight, consistent with passenger ticket revenue, or takes delivery of non-travel goods or services. Revenue from miles redemption is reported separately in the Company’s financial statement footnotes. (June 2018 Letter)
4. Tier Status Affinity Programs
Many airlines have a tier status affinity rewards program whereby customers can achieve a tier status based on the number of miles flown, purchases made, etc. This designation as a tier-member (e.g., Gold Member) affords a variety of benefits to the consumer, with increased benefits normally provided to those who spend and travel more. These benefits are often in the form of discounts, free baggage, seat upgrades, etc. Some tier programs are similar to normal point loyalty programs where a separate performance obligation is incurred, but others are more appropriately designated as marketing incentives on future revenue transactions—with no separate performance obligation.
ASC 606-10-55-42 through 55-43 instructs that if a contract allows a customer to acquire additional goods or services that he or she would not receive without entering that contract, a performance obligation exists that is effectively paid in advance. However, if the customer receives only the option to acquire an additional good or service at a price that reflects the standalone selling price, no material right is being granted, and that part of the contract is a marketing offer.
Therefore, in evaluating an airline’s tier status program, management must determine if the options being granted to tier status members are exclusive to that tier (earned based on past flights, purchases, etc.). If management determines that the tier status is being used more to attract new customers and incentivize future sales—such as a tier status given to a new customer before she even flies with the airline—then it is similar to other marketing efforts and would not be considered a separate performance obligation.
Delta Air Lines (2018 SEC Correspondence): Revenue Recognition for Airline Tier Status Affinity Programs
Delta Air Lines provided an in-depth discussion of its revenue recognition procedure for status programs in its correspondence with the SEC. Its discussion is as follows:
We evaluated our status related benefits and determined that status represents a marketing incentive rather than a material right that is accounted for as separate performance obligation. The accounting for airline status was addressed by the AICPA Airlines Revenue Recognition Task Force [and compiled into an industry position paper].
We carefully evaluated the indicators outlined in the position paper. One of the indicators relevant to making this determination was whether “the entity has a business practice of providing tier status (or similar status benefits) to customers who have not entered into the appropriate level of past qualifying revenue transactions with the entity.” As common in the airline industry, we offer status to attract new high-value customers in anticipation that the customer will enter into future revenue transactions with Delta. For example, as published on our website, we match the status of competitor airlines’ program members for a prescribed period with no minimum amount of prior purchases.
We also considered other indicators such as whether “tier status can be earned or accrued by activity with unrelated companies that have a marketing affiliation agreement with the entity…” Consistent with this indicator, status on Delta can be achieved through activity on partner airlines that retain the bulk of the consideration for the flight. Also consistent with other marketing incentive indicators, we do not separately sell status and status is not transferable to others.
Although status is also achieved by travel with us, the business practices and uses of the program are evidence that we provide status as a marketing incentive to attract customers and incent future travel. Therefore, based on our assessment of the indicators discussed above, we concluded that status should be accounted for as a marketing incentive. (August 2018 Letter)
5. Co-branding Arrangements
Financial institutions and airlines often form co-branded credit card arrangements to attract customers through travel incentives. In these arrangements, the airline typically provides the financial institution with access to its customer lists and permission to use its brand. In return, the financial institution buys mileage credits and other services, which it can subsequently award to its customers. These co-branded arrangements present a number of revenue recognition issues under ASC 606.
The airline must consider principal/agent relationships to determine which parties in the arrangement are its customers and what elements constitute separate performance obligations. The airline may conclude that the credit card holders constitute customers because of the obligations the airline owes the card holders (such as loyalty benefits and other goods/services) and/or that the financial institution is a customer (because of the transfer of access to the customer list and other services). Once the customer(s) is identified, the airline must identify its separate performance obligations.
Some of the obligation owed by the airline to the financial institution may appropriately be bundled together, such as access to the airline’s customer list and use of the airline’s brand. However, the airline must first determine whether these separate obligations significantly affect each other and are thereby not separately identifiable. Complicating the issue is the licensing that normally occurs as part of many agreements. Airlines normally license the use of the brand name, and so must consider the FASB’s guidance on licensing arrangements starting in ASC 606-10-55-54, which requires that an entity assess whether a licensing agreement is distinct from other obligations.
Furthermore, because the purchases by the financial institution from the airline in co-branding arrangements are variable (normally occurring when customers reach mileage credit levels), they would be considered a usage-based royalty. The airline must then assess if the license of IP constitutes the predominant item in the contract, and if it is found to be predominant, recognize revenue from the royalties allocated to the branding agreement at the later of when usage occurs or the obligation is satisfied. If the branding element is not found to be predominant, the airline would estimate the transaction price and then select a measure of progress that accurately depicts the satisfaction of the performance obligation over time.
During a correspondence between United Airlines (United) and the SEC, the SEC requested clarification on several aspects of United Airlines’ revenue recognition regarding its co-branding arrangement with Chase Bank.
The SEC asked United to explain who it “determined the customer to be for each of the performance obligations under the co-brand agreement.” United responded with the following explanation:
Consistent with the AICPA Revenue Recognition Guide, Chapter 10 – Airlines (paragraph 10.6.45 and 10.6.46), customers for the performance obligations under the co-brand agreement include the Company, Chase Bank USA, NA, and the Company’s MileagePlus members. The financial institution is the direct customer of the Company for the sale of marketing-related elements (including marketing and advertising) and the credit card holder (MileagePlus member) is the end customer of the airline for earning the miles awarded under the Company’s MileagePlus program.
The SEC also asked United to explain “whether advertising under the co-brand agreement is performed over the term of the agreement and whether there is an expected pattern of recognition.” United explained with the following:
In accordance with ASC 606-10-55-65 as interpreted by the AICPA Revenue Recognition Guide, Chapter 10 – Airlines (paragraph 10.6.61), the performance obligation(s) related to the brand elements, other marketing services, and ancillary services is (are) satisfied over time. Advertising is provided to the financial institution over the term of the co-brand agreement. As such, the Company utilizes credit card usage, when the MileagePlus members use their co-branded credit cards to make purchases and recognize revenue in accordance with the sales- or usage-based exception in ASC 606-10-55-65.
Additionally, the SEC made the following comment: “You disclose that revenue for the marketing performance obligation under the co-brand agreement is recorded to other operating revenue over the term of the co-brand agreement based on customer’s use of the Mileage-Plus credit card. Please tell us why recognition is based on the customer’s use of the credit card and how this impacts or is expected to impact the pattern of recognition for the marketing performance obligation over the term of the agreement.” United answered:
The Company determined that the predominant element in the co-brand agreement is intellectual property related to the Company’s brand and customer list (collectively referred to as the marketing performance obligation) in accordance with ASC 606-10-55-65A. In accordance with ASC 606-10-55-65, as interpreted by the AICPA Revenue Recognition Guide, Chapter 10 – Airlines (paragraphs 10.6.63 through 10.6.66), the marketing performance obligation is provided to the financial institution continuously over the term of the agreement, and royalties are generated each time the MileagePlus member uses the co-branded credit card and therefore when the Company issues the miles to the customer.
As such, the Company recognizes revenue based on the sales and usage based exception in ASC 606-10-55-65 when the MileagePlus member uses the credit card as it is the time a) the subsequent sale or usage occurs and b) the performance obligation has been partially satisfied as the Company’s obligation is satisfied continuously over the term of the agreement.
The SEC also questioned how United accounts for breakage on miles sold under the agreement. United responded that “for the portion of our outstanding mileage credits that we estimate will not be redeemed, we recognize the associated value proportionally as the remaining mileage credits are redeemed in accordance with ASC 606-10-55-48.”
6. Interline Segments
When an airline sells a ticket with multiple connecting flights, each segment normally represents a separate performance obligation, because the individual flights are not interdependent, and an airline sells tickets for the segments individually—thus making them distinct. Sometimes, one of the segments in a connecting flight is operated by an airline that is not the seller—an interline segment.
The ticket-selling airline must determine if it is a principal or agent in the interline segment arrangement. The selling airline is normally considered an agent because it does not operate the flight or have the right to redirect the flight’s use; consequently, only the revenue from the commission should be recognized (net basis). The flight-operating airline would normally be the principal in the arrangement and would consequently record revenue on a gross basis and recognize the commission paid to the selling airline as an expense.
In its correspondence with the SEC, JetBlue Airways made the case that the revenues generated from interline and code-sharing agreements only represent less than 3% of total revenues and are not material. However, JetBlue Airways also provided its thought process for how it would appropriately account for these transactions if/when they become material, including a discussion on who is considered the principal and agent.
Revenue generated from interline and code-sharing agreements are comprised of tickets sold on behalf of JetBlue by other airlines or by JetBlue on behalf of other airlines. With both of these ticketing arrangements, we believe that each flight segment on the ticket creates a separate performance obligation of the contract.
When applying the guidance in paragraphs 606-10-55-37 and 37A, we have concluded that the operating carrier for each flight segment is the principal as the operating carrier controls the services before being transferred to the customer. Tickets sold by other airlines where JetBlue operates a segment of the ticket are recognized as passenger revenue at the estimated value to be billed to the other airline when travel is provided.
For segments operated by other airline partners on tickets sold by JetBlue, the Company has determined that it is acting as an agent on behalf of the other airlines as they are responsible for their portion of the contract. JetBlue, as the agent, recognizes revenue after the travel has occurred for the net amount, which represents the commission to be retained by JetBlue for any segments flown by other airlines. (April 2019 Letter)
7. Ticket vouchers for flight volunteers
When a scheduled flight is overbooked, many airlines offer flight vouchers to passengers who willingly volunteer to give up their seat on the current flight to go on a later flight instead. Under ASC 606, this voucher performance obligation would generally be accounted for as a contract modification, such that the original contract between the airline and customer is terminated, and a new contract is created. This new contract has at least two performance obligations—the ticket for the new (later) flight and the travel voucher. The airline would allocate the consideration received for the original ticket between the new ticket and the voucher based on relative standalone selling prices. Based on prior experience, the airline could also estimate a percentage of the vouchers that will not be redeemed.
In a comment letter to Delta Air Lines, the SEC questioned whether it complies with ASC 606 in recognizing revenue from travel vouchers. The SEC also asked for an analysis of how Delta allocates the unrecognized consideration between the future flight and the travel voucher. Delta responded with the following analysis and discussion:
We considered ASC 606-10-25-10 and 13(a) and determined that travel vouchers are contract modifications. Upon issuance of a voucher, we defer the face value of the voucher, net of breakage, by reducing passenger revenue during the period the voucher was issued. We recognize revenue for the amount deferred as the customer redeems the voucher for travel or other services. We do not allocate the consideration for the originally scheduled flight between the voucher and alternative flight provided. Allocating revenue between the vouchers and the alternate flights provided would not materially impact the total passenger revenue recognized in any period. (August 2018 Letter)
8. Regional contracts—capacity purchase agreements
Capacity purchase agreements (CPA) are very common in the airline industry. In a CPA, a regional airline operates under the flight codes of a major airline, as the major airline purchases capacity from the regional provider. Additionally, as part of the agreement, regional airlines often provide maintenance, baggage handling, gate personnel, and/or other services. Regional airlines need to analyze their CPAs to see if the usage of the aircraft or terminals under contract with the major airlines constitutes a lease under ASC 840 or ASC 842.
If the regional airline finds that there is a lease, they must distinguish between the leasing and non-leasing goods or services and allocate consideration to either category on the basis of relative standalone selling price. The non-lease services fall within the scope of ASC 606, and must be evaluated by the five-step criteria to determine whether there are separate performance obligations as well as how to allocate and recognize revenue.
Skywest and Alaska Airlines (2019 10-K SEC Filings): Revenue Recognition for Capacity Purchase Agreements
In the Flying Agreements and Airport Customer Service and Other Revenues section of its 2019 10-K SEC Filing, Skywest, Inc. discloses how it accounts for certain elements of capacity purchase agreements under ASC 606. Skywest often uses the term “fixed-fee arrangement” to refer to capacity purchase agreements.
Timing of Recognition
Under the standard, Skywest concluded that “the individual flights are distinct services and the flight services promised in a capacity purchase agreement represent a series of services that should be accounted for as a single performance obligation, recognized over time as the flights are completed.”
Skywest also explained that “compensation associated with the use of the aircraft under the Company’s fixed-fee agreements is considered lease revenue as the agreements identify the “right of use” of a specific type and number of aircraft over the agreement term and was not impacted by the adoption of ASC 606.”
Skywest described other ASC 606 considerations regarding capacity purchase agreements, saying that “under the nonrefundable up-front fees and contract costs considerations of Topic 606, reimbursements from the Company’s major airline partners for up-front contract costs will be deferred and amortized over the contract term. The related up-front costs to obtain the contract will also be capitalized and amortized over the contract term.”
Excerpts from Skywest and Alaska Airlines’ SEC Filings
The following is an excerpt from Skywest’s 10-K, which provides additional detail on how it considers capacity purchase agreements:
The Company recognizes flying agreements and airport customer service and other revenues when the service is provided under its code-share agreements. Under the Company’s fixed-fee arrangements with Delta, United, American and Alaska, the major airline partner generally pays the Company a fixed-fee for each departure, flight hour or block hour incurred, and an amount per aircraft in service each month with additional incentives based on flight completion and on-time performance. The major airline partner also directly reimburses the Company for certain direct expenses incurred under the fixed-fee arrangement, such as airport landing fees and airport rents.
Under the fixed-fee arrangements, revenue is earned when each flight is completed and is reflected in flying agreements revenue. The transaction price for the fixed-fee agreements is determined from the fixed-fee consideration, incentive consideration and directly reimbursed expenses earned as flights are completed over the agreement term.
Skywest also provided more detail on its lease revenue under the agreement.
The amount of compensation deemed to be lease revenue is determined from the agreed upon rates for the use of aircraft included each fixed-fee agreement. The lease revenue associated with the Company’s fixed-fee agreements is accounted for as an operating lease and is reflected as flying agreements revenue on the Company’s consolidated statements of comprehensive income.
One of Skywest’s major capacity purchase agreements is with Alaska Airlines. In its 2019 10-K SEC Filing and in its 10-Q filings, Alaska Airlines breaks out the amounts included in its contractual obligations on its balance sheet. Operating lease commitments make up more than 20% of total contractual obligations, and Alaska Airlines discloses the following about the balance:
At December 31, 2019, Alaska had CPAs with two carriers, including the Company’s wholly owned subsidiary, Horizon. Alaska also has a CPA with SkyWest covering 32 E175 aircraft to fly certain routes in the Lower 48 and Canada. Under these agreements, Alaska pays the carriers an amount which is based on a determination of their cost of operating those flights and other factors intended to approximate market rates for those services.
Financial arrangements of the CPAs include a fixed component, representing the costs to operate each aircraft and is capitalized under the new lease accounting standard. CPAs also include variable rent based on actual levels of flying, which is expensed as incurred.
Capacity purchase agreements require special attention under ASC 606. Timing of recognition, accounting for certain arrangements under the leasing standard, up-front fees, contract costs, and costs to obtain a customer are all considerations a company must properly untangle.
Other issues and questions will continue to arise within the airline industry as entities apply ASC 606. This article serves as a base reference point for your research into some of the primary issues encountered by industry experts. Similar industry-specific discussions and resources are available on the RevenueHub site for major industries. Click on the following link for a list of these articles: Industry-Specific Issues.