In many industries, customers pay in advance for goods and services to be provided at future dates. Education, transportation, magazine publishing, advertising, and construction are all examples of industries where advance customer payments are often required.
Case study 7.1 shows how a major airline reports obligations to provide transportation services to its customers, for which payment has been received in advance.
Case Study 7.1
Delta Air Lines is one of the world’s largest airlines and provides scheduled passenger service, air freight, mail, and other related aviation services. Delta’s current liabilities at the end of fiscal 1997 include over $1.4 billion in obligations for air traffic liabilities and a frequent flyer program. Accompanying footnotes provide the following explanations:
FREQUENT FLYER PROGRAM – The Company accrues the estimated incremental cost of providing free travel awards earned under its SkyMiles(R) frequent flyer program when free travel award levels are achieved.
PASSENGER AND CARGO REVENUES – Passenger ticket sales are recorded as air traffic liability in the company’s consolidated balance sheets. Passenger and cargo revenues are recognized when the transportation is provided, reducing the air traffic liability.
a. Contrast the ways that Delta measures its air traffic and frequent flyer liabilities. Attempt to justify the differences in the two measurements.
b. In what way does Delta’s air traffic liability differ from accounts payable included in current liabilities? In what ways are the two items similar?
a. Delta measures its air traffic liability based on the value of the unused tickets. In contrast, Delta’s frequent flyer liability is measured at the estimated incremental cost of providing travel. As a result, Delta reports revenues, costs, and operating profits when the air traffic liability is satisfied.
It is difficult to justify the different methods used in measuring these two obligations. Both represent liabilities to provide future air travel service. Airline company managements prefer measuring frequent flyer obligations at incremental cost because this results in a lower reported obligation than would measurements based on the value of frequent flyer awards.
b. Delta’s air traffic liability obligates the firm to provide passenger services in the future. Assuming that Delta operates at a profit, the cost of satisfying the liability will be less than the reported amount of the liability. Accounts payable, on the other hand, are recorded at the actual amounts that are expected to be paid to creditors.
The two items are similar in the sense that both items obligate Delta to disburse current assets or to provide services in the near-term future (in other words, within the longer of a year or operating cycle).