FINANCIAL INFORMATION ANALYSIS
Accounting Analysis
Application Exercises
Question 2
Most airlines have frequent flyer programs that promise customers free flights once
they have accumulated 25,000 miles of travel with the same airline. Using the simple
definition of assets, liabilities, revenues, and expenses presented in the lecture, how
should these programs be reflected in the airlines’ financial statements?
Promises that require future expenditures are liabilities even if they cannot be measured
precisely. According to the definition, liabilities are economic obligations of a firm arising
from benefits received in the past that are:
(a)
required to be met with a reasonable degree of certainty;
(b)
at a reasonably well-defined time in the future;
Airline companies have economic obligations to serve frequent flyer program passengers due
to ticket sales (benefits) in the past to the frequent flyer program passengers. These
obligations are:
(a)
likely to be met1;
(b)
fulfilled within a well-defined time in the future2;
A frequent flyer program has an impact not only on the balance sheet but also on the income
statement. In principle, the costs associated with benefits that are consumed in this time
period are estimated and recognized as expenses (matching concept)3;
However, it is not easy to measure the costs associated with frequent flyer program
accurately. At least the following three cost categories should be considered in the
estimation:
1.
The administrative costs, such as maintaining the accounting system for the program,
mailings to program members, and providing service to those who request free flights;
2.
The costs related to the flight itself, including meal expenses, luggage handling costs,
and additional fuel expenditure;
1
For example, United Airline frequent flyer program totaled 1.2 million free trips in
1990;
2
3
Typically within 3 to 5 years after the revenue ticket sales are made;
Note that airline companies increased revenue ticket sales (benefits) in this period by
promising free-trip tickets (costs) in the future;
3.
The opportunity costs that airline companies may incur because the seats used by
flight award passengers could have been sold to revenue paying passengers.
Question 3
If there are no accounting standards on reporting for frequent flyer programs, what
incentives are likely to drive management’s choices of accounting for these
transactions?
Managers have potential incentives not to accrue liability and to recognize expenses related to
frequent flyer programs - and hence increase net income - for the following reasons:
1.
Managers do not want competitors to know how much or how successfully the
frequent flyer program is used. The disclosure of liability may help competitors in
their business decisions;
2.
Managers do not want to show low net income because it may cause investors to
overreact and result in negative stock price changes. When there are information
asymmetries between managers and outsiders, and when accounting is imperfect, the
managerial decision not to recognize expenses may affect investors’ perceptions
favorably (at least temporarily);
3.
Corporate managers’ bonuses may be tied to the target net income of the airline
company. Managers are not likely to choose accounting methods which will lower net
income;
4.
An airline company may have debt covenants which require the company to maintain
certain accounting ratios. Suppose that the company is close to violating their
profitability ratios, managers will choose not to recognize expenses related to the
company’s frequent flyer program.
Question 4
Fred argues: “The standards that I like most are the ones that eliminate all management
discretion in reporting - that way I get uniform numbers across all companies and don’t
have to worry about doing accounting analysis”. Do you agree? Why or why not?
Agreeing with Fred is not a good idea because the delegation of financial reporting decisions
to corporate managers may provide an opportunity for managers to convey their superior
information to investors. Corporate managers are typically better than outsiders at
interpreting their firms’ current condition and forecasting future performance. Since
managers have better knowledge of the company, they have the potential to choose
appropriate accounting methods and accruals which portray business transactions more
accurately. Note that accrual accounting not only requires managers to record past events but
also to make forecasts of future effects of those events. If all discretion in accounting is
eliminated, managers will be unable to reflect their superior information in their accounting
choices.
Question 6
Many firms recognize revenues at the point of shipment. This provides an incentive to
accelerate revenues by shipping goods at the end of the quarter. Consider two
companies, one of which ships its products evenly throughout the quarter, and the
second of which ships all its products in the last two weeks of the quarter. Each
company pays thirty days after receiving shipment. How can you distinguish these
companies using accounting ratios?
There is no difference between the two companies in their income statements. Both
companies have the same amount of revenues and expenses. However, the two companies
are different in their balance sheets. Assuming that all other things are equal, the company
which sells product evenly has a higher cash and a lower account receivable balance at the
quarter-end than the company which ships all products in the last two weeks. The following
accounting ratios can be used to differentiate the two companies:



Accounts Receivable Turnover (Sales/Accounts Receivable):
The company with even sales will have a higher accounts receivable turnover ratio;
Days Receivable (Accounts Receivable/Average Sales per Day):
The company with even sales will show lower days’ receivable;
Cash Ratio (Cash + Short-Term Investments/Current Liabilities):
The company with even sales will have a higher cash ratio;