Blue Sky Airlines Accounting

Accounting Treatment of Reward Flights by Blue Sky Airlines

Regarding the recognition of the flight rewards owed to Hometown Inc. by Blue Sky Airlines, we have developed two potential accounting treatments which satisfy financial reporting principles.

Marginal Cost Method

One potential approach would be to record the reward flight as a liability, the amount of which is based upon the expected additional variable costs which will be incurred by providing the free flight. The nature of these flight rewards satisfies the definition of a liability under the IASB’s Conceptual Framework for Financial Reporting, namely; it is (i) a present obligation of the entity (ii) arising out of past events and (iii) the settlement of which is expected to result

Flights 1-5. Therefore, a company defers the recognition of a particular portion of the revenue from that sale until the reward flight is redeemed by the customer. This method is based upon the principle that future awards are separately identifiable goods for which customers are implicitly paying. In other words, the ‘free flights’ earned by Hometown Inc. are in fact, not free. This involves immediately deferring an appropriate proportion of the revenue received towards the value of the reward flight. Upon the sale transaction of each of the first five flights, 80% of the fare is recognised as revenue when the flights for that ticket are provided. The remaining 20% of each fare is recorded as deferred income, eventually resulting in a total of 100% of the fair value of the reward fight once the five initial flights have been flown (20% x 5 flights). This amount remains a deferred income liability until the airline fulfils its obligation and honours the free flight reward. When the reward flight is redeemed, the amount recorded in deferred income is released from the balance sheet and recorded as income in respect of the sixth flight. Additionally, any marginal costs of the reward flight ($5 per in this case) are matched against this revenue. This method contrasts to the marginal cost method which values the programme liabilities based only upon the variable costs of

Under these alternative accounting treatments, although the total programme costs intrinsically remain unchanged under either method, the timing of revenue and profit recognition vary.

Although different revenue recognition methodologies are employed in these two methods, both approaches establish a liability on the balance sheet. The amount of the liability, and therefore the impact on the company’s net income will be larger under the deferred income approach than under the marginal cost approach. Although the deferred income method results in less income reported the periods in which liabilities are incurred, greater revenue recognition opportunities will be available realise of the deferred income from the balance sheet and into the income statement upon the redemption of the flight