IFRIC 13 Fasten your seatbelts

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Fasten Your Seatbelts IFRIC 13 could lead to turbulent times Spring 2008

Contents Introduction

1

What is IFRIC 13?

2

What is fair value and

what impact will it have?

3

Practical steps in applying IFRIC 13 What are the possible outcomes? How can KPMG help you?

We should all be familiar with the customer loyalty programs that airlines use to build brand loyalty, retain their valuable customers and increase sales volumes.

The potential benefits and strategic importance of having a successful Frequent Flyer Program (FFP) are well 5 documented. Some commentators would even argue that the FFP is one of the primary value drivers for many 6 airlines given the vast sums of money third parties (e.g. financial institutions) are willing to pay airlines to allow them 7 to offer redemption opportunities through their own sales channels and clients. The benefit of having a successful FFP has always come at a price to airlines – the on-balance sheet liability to recognize the cost of future redemptions. However, in the past many airlines would contend that such a cost was not significant given that the estimate of the liability was based

on the marginal cost of carriage. The airlines’ sophisticated yield and revenue management systems ensured that frequent flyer redemptions rarely, if ever, displaced a fee paying passenger and in the case where a redemption occurred, the cost to the airline was considered to be marginal e.g. the cost of an extra meal or wash pack. IFRIC 13 will change all of this as it requires airlines to measure the FFP award with reference to fair value being the amount that it could be sold separately, for example the fair value to the holder of the award. The impact on the quantum of the liabilities could be massive which in turn could lead to an adverse impact on book equity values and accounting profit. Are you sufficiently prepared or can you expect turbulent times ahead?


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What is IFRIC 13?

Currently, a number of airlines preparing their financial statements in accordance with IFRS, account for the FFP liability from passengers flying using the incremental cost method or marginal cost to carry. The IFRIC considered the issue of accounting for loyalty points issued with an airline ticket and, in June 2007, the IASB issued Interpretation 13 Customer Loyalty Programs.This is applicable to annual periods beginning on or after July 1 2008, although it may be applied earlier. The Interpretation reflects the conclusion of the IFRIC that granting award credits to customers is a separate component of the initial sales transaction with the customer and therefore consideration should be allocated between the award credits and the other components of the sale.

For entities that have previously applied a cost approach and, in particular, an incremental cost, the interpretation may result in a significant change in the amount of the loyalty program liability. Although IFRIC 13 is applicable to financial periods starting on or after July 1 2008, airlines will also be required to disclose the potential impact on the FFP liability for financial periods ending before the date from which IFRIC 13 is adopted. For large and complex programs, initial application can be a very timeconsuming exercise. Management should begin to determine the impact as soon as possible.


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What is fair value and what impact will it have? IFRIC 13 requires the consideration allocated to award credits to be measured by reference to their fair value and it defines fair value as ‘the amount for which the award credits could be sold separately’. A key challenge is to determine the amount for which the award credits could be sold. Often, this is not directly observable and hence it is expected that, in many cases, fair value will need to be estimated using valuation methodologies. The biggest impact will therefore arise from a shift away from the incremental cost method to a fair value measurement. Airlines might estimate the fair value of the rewards issued based on the fair value of the goods and services for which the rewards may be redeemed e.g. flights. In such cases, the cost of air travel can vary from day to day, depending on the airline’s desire to fill capacity. If the airline can demonstrate that the opportunities for customers to redeem rewards is limited to situations where the service would otherwise be sold at relatively low prices, they may be able to argue that the liability should be priced at these low prices. It is worth noting however, if airlines have significant sales of points to third parties, and these points have the same characteristics as those awarded to customers flying, this sales value provides compelling evidence of fair value and should be considered prior to any fair value calculation based on award redemption.

In addition to this, an airline would need to estimate the likely redemption rate and this remains a challenging aspect of the fair value measurement. For example, companies may need to consider the following: • Has the program become more or less popular such that historical behavior is no longer a valid proxy for the future? • What percentage of customers accumulate rewards to enable one-off, high value redemptions? • How will redemption rates be affected by changes in the demographic of the customer base? • How is the redemption rate applied to the fair value calculation? • How should points that will never be redeemed be treated?


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In the case of complex reward programs which offer a wide range of redemption opportunities, the estimation process will be complex and will require comprehensive data to be collected. Other key considerations will therefore include: • Is there sufficient information already available on which to base these assumptions? • Will a comparison of actual redemptions to the estimates made in previous periods alter views on the reliability and accuracy of the models applied? The time and effort required to develop models that provide a reliable estimate of the value of the FFP liability may also require valuation specialists. The fair valuation of the FFP liability might significantly affect the financial position of airlines. An increase in FFP liabilities could potentially decrease net shareholders’ equity considerably and lead to debt covenant breaches as a result. Similarly, an increasing level of liabilities may lead to an adverse impact on accounting profits.

Company United Airlines

Below is a summary of some of the FFP liabilities disclosed by a number of leading airlines. This demonstrates the potential quantum of the FFP liability. Whilst those airlines that report under US GAAP will not need to adopt IFRIC 13, it is interesting to note that when certain U.S. carriers emerged from Chapter 11 and similar bankruptcy proceedings, they were required to mark to market their FFP liability (see table below). In some cases, this market value measurement resulted in the FFP liability increasing by over 400 percent - food for thought for those airlines that will be affected by IFRIC 13. Qantas announced in August 2007 that it was early adopting IFRIC 13. In a press release on 21 February 2008, Qantas announced that the implementation of this change, which is detailed in Qantas’ Half-Year Report, had the effect of reducing the opening retained earnings at 1 July 2006 by AUD 508.4 million.

Revaluation impact at fresh-start reporting date

Accounting policy adopted post fresh-start reporting date

- Mileage Plus Frequent Flyer Program obligations revalued at fair value

- Obligation based on the equivalent ticket value of similar fares on United or amounts paid to other Star Alliance partner, as applicable

- US$2.4 billion non-cash reorganization charge recognized - Before fresh-start reporting date, frequent flyer liability was US$923 million Northwest Airlines

- US$1.5 billion charge recorded to recognize additional fair value of the frequent flyer liability - Frequent flyer liability was US$412 million before fresh-start accounting

Delta Airlines

- US$2.6 billion reorganization charge for revaluing its SkyMiles flyer obligation at fair value - Frequent flyer liability was US$896 million before fresh-start accounting

Source: Delta Airlines 10-Q filing, April 2007 Northwest Airlines 10-Q filing, September 2007 United Air Lines 10-K filing, December 2006

- Mileage credits earned are deferred based on price for which mileage credits are sold to other airlines

- Fair value component of mileage credit based on the selling price rate per mile to other SkyTeam alliance members


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Practical steps in

applying IFRIC 13

The impact of IFRIC 13 will need to be strictly monitored from a financial communication stand point: • IFRIC 13 is effective for annual periods beginning on or after July 1 2008 with earlier application permitted. For the first year of adoption, the airline will have to apply IFRIC 13 retrospectively. It is therefore imperative to start the process early enough to have all the information ready to be in a position to comply with the requirements of IFRIC 13 • An analysis of the fair valuation model/techniques most relevant to the FFP of the airline will have to be carried out. Such an analysis will likely comprise the following steps:

• To calculate reliably the fair value of the miles at a given period • To allow the airline to properly track the miles after the implementation of the new method of accounting (when such miles are earned and redeemed) • To determine the adjustments necessary to the airline’s information systems in light of the results of the above analysis • To determine the impact on internal and external reporting on yields and passenger revenues

i. Gain a full understanding of the program, the existing information systems and the available information

In addition, investor briefings using the new revenue metrics and no doubt reconcilitaries to prior periods requires consideration.

ii. Carry out a benchmark with other airlines

Finally, proper disclosure to present the accounting method followed by the airline to account for its loyalty programs will have to be prepared.

Once the fair valuation method is selected, an analysis of the information systems will have to be undertaken to determine whether such systems are sufficient:


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What are the possible outcomes? The general consensus is that the move to a fair value measurement of the FFP liability will likely lead to a significant increase in the FFP liability with the resultant impact on book equity values. This could have an adverse impact on airlines.

Faced with such an issue, possible options open to airlines are: • Determine if current sales of frequent flyer points provide evidence of fair value • Commence a process to determine the fair value of flying redemptions

• Increase the amount of FFPs which are hived off into separate entities not under direct ownership of the airlines? (Such a move may remove the problem from the airline’s balance sheet, but also raises other issues such as how the airline could continue to control the FFP to ensure it met its strategic objectives and the complex accounting for demergers and internal reconstructions)


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How can KPMG help you? We are currently working with a number of airlines in relation to the possible impact of IFRIC 13 on FFP liabilities and possible alternative approaches to quantification and measurement.

Whilst the first point of call for determining fair value should be the external sale of frequent flyer points, the standard is not specific on other methodologies to apply. There is as yet no standard agreed approach amongst airlines, regulators or auditors.

Our global client base means that we are aware of the approaches being considered by many global airlines and can assist clients in building their support for the position adopted. This is typically done in conjunction with our wider accounting and modeling team who can work with airlines on the implementation of going forward systems to quantify the liabilities post application.


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kpmg.com

For further information please contact:

Doug McPhee Deputy Chair Global Valuation Services KPMG in the U.K 8 Salisbury Square London EC4Y 8BB U.K.

Tel: +44 20 7311 8524

Email: doug.mcphee@kpmg.co.uk

Viral Desai Director - Valuation Services KPMG in the U.K. 8 Salisbury Square London EC4Y 8BB U.K.

Tel: +44 20 7311 8394

Email: viral.desai@kpmg.co.uk

Dr. Ashley Steel Global Chair - Transport KPMG in the U.K One Canada Square London E14 5AG U.K.

Tel: +44 20 7311 6633

Email: ashley.steel@kpmg.co.uk

Martin Sheppard Global Head of Aviation KPMG in Australia 10 Shelley Street Sydney 2000 NSW Australia Tel: +61 2 9335 8221 Email: msheppard@kpmg.com.au

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

© 2008 KPMG International. KPMG International is a Swiss cooperative. Member firms of the KPMG network of independent firms are affiliated with KPMG International. KPMG International provides no client services. No member firm has any authority to obligate or bind KPMG International or any other member firm vis-à-vis third parties, nor does KPMG International have any such authority to obligate or bind any member firm. All rights reserved. Printed in United Kingdom KPMG and the KPMG logo are registered trademarks of KPMG International, a Swiss cooperative. Designed and produced by KPMG LLP (UK)’s Design Services Publication name: Fasten Your Seatbelts Publication number: 311474 Publication date: March 2008 Printed on recycled material.


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