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Any accounting majors or profs out there up for a theory question on how to calculate an expense?

Suppose an airline wants to report the cost of flights given away as part of a frequent flier program. Figures show an occupied seat brings in 12.6 cents per seat-mile, but that it costs 9.6 cents per seat-mile to transport an empty seat. Let's suppose a frequent flier takes a journey of 1000 miles. Would the airline report:

a) The gross (unit) cost of the trip based on the revenue it would have realized (12.6 * 1000 = $126).

b) The net (marginal) cost of the trip based on how much *extra* the airline would have gotten ((12.6 - 9.6) * 1000 = $30.)

People in my class worked the problem both ways and the instructor seems inclined to accept both, but is there an actual "right" answer as to what FASB accepts?

Corollary (and perhaps related) question:

Suppose Ford supplies a game show with a car in exchange for advertising. When recording the car as an expense, would Ford use the retail price (what it could sell the car for) or the actual cost (what it took to make the car, deliver it to the show, prep it for use,..)?

TDeF
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Sorry, I don't have time to help right now, but you might want to check out the Math Recreations & Puzzles board at: http://boards.fool.com/Messages.asp?mid=24255611&bid=115303

Jennifer
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Thanks, Jennifer, but the problem isn't one of mathematics but rather how (in actual practice) accounts value things for purposes of financial reporting. The instructor, I think, was more interested in each of us having a defendable approach but I'm just curioius as to what truly happens.

TDeF
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I'm in an MBA program, and last semester we did an accounting project that analyzed three annual reports from a specific industry. My team had the airline industry, and this is how I understood that they handle the revenue for frequent flier miles.

At the time the miles are issued, the purchase of the ticket that triggered the awarding of the miles is not recorded at full revenue. What is recorded is the revenue minus the estimated value of the frequent flier miles awarded. That frequent flier amount is recognized as a liability (it is unearned income) until such time as the recipient of the FF reward redeems those miles. At that time, the revenue is recognized and the liability is taken off the books.

For example (and this is simplified - there is an incremental journal entry that I'm leaving out because it is irrelevant to this discussion): I buy a $500 ticket, and that ticket rewards me with 50 FF miles that are worth 12.6 * 50 = $6.30. At that time, the journal entry looks like:

Cash $500
Ticket Revenue $493.70
Unearned Revenue $6.30

Eight months later, I redeem those miles. At the time I take the flight, the journal entry looks like:

Unearned Revenue $6.30
Ticket Revenue $6.30


Expenses are figured however they are figured - and they are figured at actual rates, not "what would have been" rates. So your empty seat is expensed at actual cost when it actually flies empty.

They treat the FF miles as purchases where the delivery of the service purchased is delayed. They don't technically give the miles away - they reduce the price of your original ticket by the price of those miles.

Southwest, Airtran, and JetBlue all account for their FF miles this way.

Hope that helped and answered your question.

Matthew



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And - my indentions didn't work for the journal entries. Sorry - but, if you are doing accounting you'll see what I meant to do.
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Matthew,

Thank you for the analysis. I just got done combing through a couple of annual reports hoping that I'd find information there and, sure enough, found success.

Both UAL and AA appear to use the marginal/incremental cost for valuing the liability associated with frequent flyer miles. Here's what UAL 2005 annual report (http://tinyurl.com/f986b) actually says:

When a travel award level is attained by a Mileage Plus member, we record a liability for the estimated incremental cost to United of providing the related future travel, based on expected redemption. For award redemptions expected to occur on United, United's incremental costs are estimated to include variable items such as fuel, meals, insurance and ticketing costs, for what would otherwise be a vacant seat. The estimate of incremental costs does not include any indirect costs or contribution to overhead or profit. A change to these cost estimates, such as a significant change in jet fuel prices, could have a significant impact on our liability in the year of change as well as in future years, since underlying variable cost factors can differ significantly from period to period. A hypothetical 1% change in the cost of jet fuel has approximately a $783 thousand effect on the liability.

In 1998 I was in a Toronto hotel room and, while getting ready to visit a customer, listened to a high level UAL marketing manager speaking on a TV program. He said that UAL aimed to pretty much break even on their flights and that the real money was in selling mailing lists.

TDeF
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First, thanks again to all who replied and shared their thoughts.

I wrote the OP as neutrally as possible in order not to sway opinions, but the fact is that everyone except me used approach "a". While the instructor said she'd accept both methods, it was my sense that she didn't like mine very much.

Out of curiousity I checked several airlines' annual reports just to see if some hint of the calculations might be there. eureka! Airlines use the marginal/incremental cost approach just as I did and, for the first time ever, I got 100% on an accounting assignment.

TDeF
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One thing to consider is that there is a lot of grey area in interpreting FASB statements, and there is never a true "right answer." If you've ever read a FASB pronouncement you'll see that at many times the language is purposely vague, and includes words like "should" instead of "must," implying that judgment is important.
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A very late follow-up as I once again visited this board....

The instructor send me an "in your face" type email after class which contained the annual report for the airline we studied. In it, she noted that they did indeed deduct the cost of the frequent flyer program.

I read further in the annual report and found that the method they used for actually calculating the deduction was the one I used -- the one she beat me up over and said was totally wrong.

I replied to her email, thanking her for the information but also asking if she'd read the paragraph explaining the method they actually used and that it was the one I did. I got no reply or apology for what she said to me in front of the class, but she silently capitulated and gave me 100% on the assignment.

BG (formerly TourDeFarce)
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