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CASE: A-231 DATE: 07/01/17

Emily Booth, Professor Elizabeth Blankespoor, and Jaclyn Foroughi, CFA, prepared this case as the basis for class discussion rather than to illustrate either effective or ineffective handling of an administrative situation.

Copyright © 2017 by the Board of Trustees of the Leland Stanford Junior University. Publicly available cases are distributed through Harvard Business Publishing at hbsp.harvard.edu and The Case Centre at thecasecentre.org; please contact them to order copies and request permission to reproduce materials. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means –– electronic, mechanical, photocopying, recording, or otherwise –– without the permission of the Stanford Graduate School of Business. Every effort has been made to respect copyright and to contact copyright holders as appropriate. If you are a copyright holder and have concerns, please contact the Case Writing Office at [email protected] or write to Case Writing Office, Stanford Graduate School of Business, Knight Management Center, 655 Knight Way, Stanford University, Stanford, CA 94305-5015.

JETBLUE AND THE NEW REVENUE RECOGNITION STANDARD

The core principle of Topic 606 is that an entity should recognize revenue to depict the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.

—Financial Accounting Standards Board (FASB) Accounting Standards Codification® (ASC) 606-10-05-31

In May 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued a converged standard on revenue recognition (ASC Topic 606 and IFRS 15, respectively) aimed at ameliorating difficulties associated with determining when to recognize revenue and at what amount. Prior revenue recognition standards applied broad concepts together with a variety of requirements for specific industries or types of transactions, sometimes resulting in divergent accounting for economically similar transactions.2 In contrast, the new standard outlined a single comprehensive model to use in accounting for revenue from contracts with customers. Although the new standard simplified the guidelines down to one framework, it also generally required firms to use more judgment and estimation than prior guidance.

1 Financial Accounting Standards Board, “Revenue from Contracts with Customers (Topic 606),” Financial Accounting Series, No. 2014-09, May 2014, p. 2. 2 The original effective date for the converged guidance was January 1, 2017, for calendar-year public business entities while private companies were given an additional year to implement the new standard. In August 2015, FASB deferred the effective date of the new revenue recognition standard by one year, with early adoption permitted as of the original effective date. Due to the transitional nature of the implementation process, this case study refers to revenue recognition standards effective prior to the issuance of the new standard as “prior revenue recognition standards” although private companies were permitted to implement “prior” standards until the end of 2018.

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In its second quarter of 2014 financial statement filed with the Securities and Exchange Commission (SEC) in August 2014, New York-based airliner JetBlue Airways Corporation (JetBlue) [NASDAQ: JBLU] acknowledged the new revenue recognition standard. While it had yet to determine the full impact of adoption, changes were imminent.

THE NEW REVENUE RECOGNITION STANDARD

At its core, the new standard stated that revenue should be recognized when there is a transfer of promised goods or services to customers, and that the amount is what the firm expected to receive in exchange for those goods or services. To achieve this objective, the boards developed a five-step model:

Step 1: Identify the Contract(s) with a Customer A contract does not have to be written; instead, it can also be oral or implied. A contract does, however, need to create enforceable rights and obligations. In addition, the parties need to approve the contract and be committed to perform, and rights and payment terms must be identifiable. Finally, it must be probable that the firm will collect substantially all of the consideration. Step 2: Identify the Performance Obligations in the Contract The performance obligation is the primary unit of account and is used to determine how much revenue to recognize and when to recognize that revenue. After identifying the contract, the firm identifies what goods and services are promised in the contract, such as the sale of goods produced, resale of goods purchased, or performing a contractually agreed upon task for a customer. Promised goods or services are separate performance obligations if they are distinct (see Exhibit 1 for an illustration regarding distinct good or services). The promises can be oral, explicit in the contract, or can even be implied by customary business practices (e.g., if a firm sells a car and usually also provides free maintenance for the car, that could be considered a promise). After determining the promises in the contract, a company then determines if the promises are distinct. A promise can only be a performance obligation if it is distinct, meaning it is both: (1) capable of being distinct and (2) distinct in the context of the contact. Capable of being distinct A good or service is capable of being distinct if a customer can benefit from the good or service on its own (whether used, consumed, or sold) or with readily available resources. These could be resources sold separately by the firm or others in the market, or resources already provided by the firm in the contract. The timing of delivery of goods and services can also affect whether the customer can benefit from the good or service. For example, suppose a firm sells a television (TV) and a customized remote control. The firm only sells the TV and remote control together, and no one else sells either product. The customer can use the TV by manually turning it on and off without the remote, but the remote provides no value to the customer without the TV.

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JetBlue and the New Revenue Recognition Standard A-231

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 Case 1: The firm delivers the TV first, and the remote control second. In this case, there are two performance obligations. The customer benefits from the TV on its own and from the remote control using a readily available resource—the TV.

 Case 2: The entity delivers the remote control first, and the TV second. In this case, there is only one performance obligation. The remote control provides no benefit to the customer either on its own or with readily available resources (because the TV has not been delivered yet).

Distinct within the context of the contract The second part of being distinct is whether the good or service can be separated from other promises in the contract—distinct within the context of the contract. To determine this, the firm should identify what the customer actually expects to receive as the final product. Some contracts have promises for multiple goods, but the customer is not purchasing individual items—just one final item. To be separable, the items must not be any of the following: (1) an input to produce or deliver a combined final product, (2) a significant modification to another item in the contract, or (3) highly interrelated with other items in the contract. For example, when constructing a building, a contractor might design the building, clear the site, construct the structure, and install electrical and plumbing fixtures. Although the contractor sells these services individually, making them capable of being distinct, they are likely not distinct within the context of the contract. The contractor’s main service is to integrate these components and deliver a building, which suggests that the items are used as inputs for one final product. This means the building is one performance obligation. Customer options Contracts may include options for the customer to purchase additional goods or services at some point in the future. These options or marketing incentives are separate performance obligations if they provide a material right that the customer would not otherwise have (such as discounted or free services, hotel loyalty points, a year of “free” car maintenance, or contract renewal options). The performance obligation is the option itself, rather than the underlying goods and services for which the option represents. Revenue is recognized when future goods and services are transferred or when the option expires. Immaterial promises If a promise is immaterial from the customer’s perspective, the firm does not have to consider it as a separate performance obligation. Step 3: Determine the Transaction Price The transaction price is the amount an entity expects to be entitled to in exchange for transferring promised goods or services to a customer, excluding amounts collected on behalf of third parties. The transaction price is straightforward when the contract is for a fixed amount. For example, if a firm contracts with a customer to construct a building for $5,000, the transaction price is $5,000.

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JetBlue and the New Revenue Recognition Standard A-231

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The transaction price becomes more complex when the contract includes variable consideration, i.e., when the amount to be received is contingent on a future event and must be estimated (e.g., bonuses, refunds, rebates, discounts, and penalties). For example, a firm contracts with a customer to construct a building for $5,000, plus the entity will receive a $1,000 bonus if the job is finished before the end of the year. In this case, the transaction price could be either $5,000 or $6,000—the entity needs to estimate how much of the variable consideration to include ($0 or $1,000). The bonus is variable because it is contingent on a future event: finishing the building before the end of the year. The standard describes two methods to estimate variable consideration. Companies should use the method that better predicts the consideration based on its facts and circumstances, using all information that is reasonably available (historical, current, and forecast).  Expected value – the sum of the probability-weighted amounts in a range of possible

considerations. This approach may be appropriate if the entity has a large number of contracts with similar characteristics. Using the example above, the contractor will receive $5,000 for construction of the building plus a $1,000 bonus if completed by the end of the year, a $500 bonus if completed by the first quarter of next year, and a $100 bonus if completed by the second quarter of next year. The contractor believes there is a 70 percent chance of finishing by the end of the year, a 20 percent chance of finishing by the first quarter of next year, and a 10 percent chance of finishing by the second quarter of next year. The expected value is as follows:

$5,000 + $1,000 = $6,000 x 70% = $4,200 $5,000 + $500 = $5,500 x 20% = $1,100 $5,000 + $100 = $5,100 x 10% = $510 Total probability-weighted consideration = $5,810

 Most likely amount – the most likely amount in a range of possible outcomes. This may be

appropriate if the variable consideration has a discrete number of outcomes. In this example, the contractor either will or will not receive the bonus, depending on when the job is finished. If the contractor believes it is more likely that the job will be finished by the end of the year, the transaction price would be $6,000 ($5,000 + $1,000).

When determining the transaction price, management should assume that the contract will be fulfilled as agreed upon and not cancelled, renewed, or modified. In addition, variable consideration should only be included in the price to the extent that it is probable that a significant reversal in the amount of cumulative revenue recognized will not occur when the uncertainty associated with the variable consideration is resolved. When evaluating whether variable consideration should be included, firms should consider both the likelihood and magnitude of a revenue reversal. Step 4: Allocate the Transaction Price to the Performance Obligations in the Contract The new standard requires that the transaction price be allocated to each separate performance obligation based on relative standalone selling prices determined at contract inception and not

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adjusted to reflect subsequent changes in the standalone selling prices. The standalone selling price is the price at which a company would sell a promised good or service separately to a customer. Allocation based on standalone selling prices is generally consistent with prior practice, except the new standard no longer prescribes a hierarchy for estimating the standalone selling price. Step 5: Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation The new revenue recognition model is a control-based model, in which control means being able to direct the use of an asset and obtain substantially all the remaining benefits from the asset. Control is not the same as risks and rewards (although risks and rewards are a part of control), nor is it the same as culmination of an earnings process like prior revenue recognition. Revenue is recognized upon satisfaction of a performance obligation by transferring control of the promised good or service to a customer. Performance obligations are either satisfied over time or at a point in time. Generally, the sale of a good will be recognized at a point in time and the sale of a service will be recognized over time, but this is not always the case. A company transfers control of a good or service (and thus satisfies a performance obligation) over time if any one of the following criteria was met:  The customer simultaneously receives and consumes the benefits provided by the firm’s

performance as the firm performs. If the firm were to stop performing and another firm resumed the contract, would the new entity have to redo the first entity’s work? (e.g., services—the customer receives and consumes the benefit of the service as the entity performs)

 The firm’s performance creates or enhances an asset that the customer controls as the asset is created or enhanced. If the firm were to stop performing, would the customer be able to control the work that has been done to date? (e.g., a construction company contracts with a customer to build a house on land that the customer owns)

 The firm’s performance does not create an asset with an alternative use to the firm, and the firm has an enforceable right to payment for performance completed to date. If the customer suddenly canceled the contract, would the firm be able to sell the asset to another customer without incurring significant cost? (e.g., a firm creates a highly specialized asset for a customer)

If none of the above over-time criteria are met, then the performance obligation is satisfied at the point in time when the customer obtains control of the promised good or service. Unexercised Rights Firms that receive prepayments from customers should recognize a liability until the performance obligation has been satisfied. However, if the firm expects some customers not to exercise their right to the good or service, the firm should recognize the expected breakage amount as revenue in proportion to the pattern of rights exercised by the customer. Because breakage essentially causes the consideration for each performance obligation to be variable,

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JetBlue and the New Revenue Recognition Standard A-231

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revenue should only be recognized if it is probable there will not be a significant reversal of revenue. Contract Modifications Unlike prior U.S. Generally Accepted Accounting Principles (GAAP), the new standard also provides explicit guidance on accounting for contract modifications. A contract modification includes changes in the goods and services to be provided, the price, or both. If the new goods and services are distinct (as defined earlier) and are offered at the standalone selling price, they should be recognized as a separate contract. If they are distinct but not provided at the standalone selling price, the old contract has effectively been ended and a new contract created. Any unrecognized revenue from the old contract should be allocated to the remaining goods and services and recognized along with the new revenue over the new contract period. Finally, if the new goods and services are not distinct, the estimate of the price and the measure of progress are simply updated to incorporate the change in the contract. Disclosures Under prior U.S. GAAP, there are few requirements for revenue disclosures. This makes it extremely difficult for users to understand a firm’s revenues, as well as the judgments and estimates made in recognizing those revenues. The goal of the new disclosure requirements is to help users understand the nature, amount, timing, and uncertainty of revenue and cash flows from contracts with customers. Under the new standard, firms will provide qualitative and quantitative information about contracts with customers, significant judgments, and assets from capitalized costs.

AN ANALYSIS OF THE IMPACT ON JETBLUE

Overview of Revenue Sources and Revenue Recognition Policies

JetBlue was an American passenger carrier company that provided air transportation services across the United States, the Caribbean, and Latin America. JetBlue entered into several contracts with customers with the principal activity being traveling from one location to another. A single passenger revenue transaction could have contained three types of goods or services: the flight transportation, frequent flyer award miles, and ancillary services. Revenue for flight transportation was recognized either when transportation was provided or after the ticket or customer credit expired (where expiration of the ticket or credit without use was called “breakage”). If passengers did not show up to their flight, the ticket expired at the time of the flight. If passengers canceled a nonrefundable ticket prior to the flight, their flight credits were good for one year after the date of the flight. Tickets sold but not yet recognized as revenue and unexpired credits were included in air traffic liability on the consolidated balance sheets. JetBlue prepared its financial statements in accordance with U.S. GAAP (see Exhibit 2 for JetBlue’s 2015 financial statements).

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JetBlue and the New Revenue Recognition Standard A-231

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Pricing Model In June 2015, JetBlue launched its new pricing model, Fare Options. Customers could purchase tickets at one of three branded fares: Blue, Blue Plus, and Blue Flex. Each fare included different offerings such as free checked bags, reduced change fees, and additional TrueBlue® points (see Customer Loyalty Program below), with all fares inclusive of free in-flight entertainment, snacks and non-alcoholic beverages. JetBlue also provided a premium product called “Mint,” which offered customers a business-class experience. Customer Loyalty Program Under JetBlue’s frequent-flyer program, points were awarded based on dollars spent on a flight. According to JetBlue’s 2015 annual report:

TrueBlue® is JetBlue’s customer loyalty program designed to reward and recognize loyal customers. Members earn points based upon the amount paid for JetBlue flights and services from certain commercial partners. The points do not expire, the program has no black-out dates or seat restrictions, and any JetBlue destination can be booked if the TrueBlue® member has enough points to exchange for the value of an open seat. Mosaic® is an additional level for the most loyal customers who either (1) fly a minimum of 30 times with JetBlue and acquire at least 12,000 base flight points within a calendar year or (2) accumulate 15,000 base flight points within a calendar year. Over 1.4 million TrueBlue® one-way redemption awards were flown during 2015, representing approximately 4 percent of the total revenue passenger miles.3

Prior to introduction of the new standard, JetBlue accounted for loyalty programs using the incremental cost method, whereby it did not consider the issuance of loyalty points to be a component of revenue. JetBlue recorded a liability for the estimated incremental cost (which was usually less than the standalone selling price) of outstanding points earned from JetBlue purchases that were expected to be redeemed. Ancillary Services Passenger revenue included seat revenue and revenue from ancillary product offerings. In addition to the flight itself, JetBlue offered several upgrades and additions for its customers to purchase. EvenMore™ Space JetBlue’s largest ancillary product, the EvenMore™ Space seats, generated approximately $228 million in revenue in 2015. The EvenMore™ Space seats were available for purchase across all fleets, giving customers the opportunity to enjoy additional legroom, as well as early boarding access. Under prior revenue recognition guidance, fees paid to guarantee certain seat

3 JetBlue Airways Corporation 2015 Annual Report, http://blueir.investproductions.com/~/media/Files/J/Jetblue-IR- V2/Annual%20Reports/2015-ar-10k.pdf (July 16, 2017), p. 9.

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JetBlue and the New Revenue Recognition Standard A-231

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assignments and fees paid for the ability to board early were recognized at the time of service (i.e., the flight) as part of Passenger Revenue. Other Sources of Revenue The primary components of Other Revenue were the fees from reservation changes and excess baggage charged to customers. JetBlue also included the marketing component of TrueBlue® point sales, on-board product sales, charters, ground-handling fees of other airlines, and rental income. Fly-Fi™ Fly-Fi™ was JetBlue’s Internet product and was available on all flights. Unlike other airlines, which typically charged customers for in-flight Internet, JetBlue offered free Wi-Fi to its customers. Under prior guidance, companies that charged a fee for in-flight Internet access recognized revenue at the time of service (i.e., the flight). Companies that did not charge fees for Internet access did not recognize revenue, and simply recognized the costs of providing in-flight Wi-Fi. In-flight entertainment JetBlue offered all of its customers 36 complimentary channels of DIRECTV®. In addition, had the option to purchase JetBlue Features movies for $5 per movie on all domestic flights over 2 hours (there was no charge on all flights outside of the United States). Under prior guidance, companies who charged a fee for in-flight entertainment recognized revenue at the time of service (i.e., the flight). Companies that did not charge for these services did not recognize revenue, and simply recognized the costs of providing in-flight entertainment. Onboard purchases JetBlue offered snacks and non-alcoholic beverages to all its customers, and customers had the option to purchase premium beverage and food selections. JetBlue also provided its customers with the option to purchase additional products such as blankets, headphones, or pillows. “Mint” customers had access to complimentary premium food, premium beverages and products. Under prior guidance, companies that offered free snacks and beverages simply recognized the costs of the goods provided. Companies that charged for these items recognized revenue at the time of service (i.e., the flight). Excess baggage charges JetBlue’s fees for checked baggage varied by ticket purchased. Customers received two free checked bags with the Blue Flex fare, one free checked bag with the Blue Plus fare, and no free checked bags with the Blue fare. Additional checked bags over the allowed amount, overweight bags, and large bags all incurred additional fees. Under prior guidance, revenue was recognized for baggage fees at the time of service (i.e., the flight). Change fees Similar to baggage fees, JetBlue’s various fare options included the ability to change a reservation for free. Aside from the Blue Flex option, customers incurred a flat change fee and had to pay any difference in fare price. Under prior guidance, these fees were non-refundable

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JetBlue and the New Revenue Recognition Standard A-231

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and did not relate to the ticket price for any future change. Therefore, revenue was recognized at the time of service, which was the time the change was created, pre-flight. Study Questions 1. For each of the following topics, describe the prior accounting, the likely changes (if any) the new revenue recognition standard will require, and the potential impact of those changes on patterns of revenue recognition. Indicate the general direction of impacts; do not try to quantify the change amounts):  Flight Transportation (for tickets used and for ticket/credit “breakage”) (Hint: Focus on

Unexercised Rights in the new model for breakage)  Loyalty Program (Hint: Focus on Step 2 of the new model)  Ancillary Services and Other Revenue (Hint: Focus on Step 2 of the new model, and

Contract Modifications as well for change fees specifically)

2. Where are the areas for discretion and judgment (and opportunities for earnings management)? 3. Will the new revenue standard provide more decision-useful information than prior U.S. GAAP?

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JetBlue and the New Revenue Recognition Standard A-231

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Exhibit 1 Determining Whether Goods or Services are Distinct

Source: Compiled by authors.

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JetBlue and the New Revenue Recognition Standard A-231

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Exhibit 2 JetBlue’s 2015 Financial Statements and Disclosures of Revenue Amounts

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