Southwest Airlines: how a breakage revenue estimate of $116 million changed fourth-quarter earnings numbers

Incorrect breakage revenue estimates may lead to overstated revenue and subsequent catch-up adjustments.

On January 30, 2025, Southwest Airlines (Ticker: LUV) reported earnings results for the fourth quarter ending December 31, 2024. Southwest’s GAAP revenue and EPS were $0.42, while the non-GAAP EPS was $0.56 – a difference of more than 30%.

According to Southwest, a breakage revenue adjustment of $116 million explains most of the difference. As I discussed with Market Watch, the adjustment was material because it affected revenue and led to a beat:

“Southwest Airlines’ $116 million breakage adjustment is material because it affects revenue and because it leads to a beat,” said Olga Usvyatsky, a former vice president for research at Audit Analytics and author of Deep Quarry, a Substack publication focused on accounting.”

Based on FactSet estimates analyzed by Market Watch, Southwest would miss revenue and EPS targets without the $116 million breakage adjustment:

“The move matters because the $116 million breakage revenue adjustment boosted the revenue number to $7.047 billion, which would put it ahead of the FactSet consensus of $6.959 billion, while the actual revenue number of $6.931 billion represented a miss of the consensus revenue target.”

Let’s look at the accounting issue that gave rise to this $116 million adjustment and see who else might be affected. Breakage revenue refers to a prepaid product or service not expected to be redeemed by the customer. In the third quarter of 2022, Southwest modified its flight credits policy amid the pandemic-related flight cancelations so the credits would no longer expire. Say it differently: the customers can redeem the credits indefinitely.

From Southwest’s 8-K filed on January 30, 2025:

“Represents a change in breakage revenue estimate related to flight credits the Company issued to Passengers during 2022 and prior. On July 28, 2022, the Company modified its policy and announced that all unexpired flight credits as of that date, including a significant volume of such credits issued to impacted Customers during the COVID-19 pandemic as the Company was making significant changes to its schedules based on fluctuating demand, will no longer have an expiration date and thus will be able to be redeemed by Customers indefinitely. This change in policy was considered a contract modification under ASC 606, Revenue from Contracts with Customers, and the Company accounted for such change prospectively in third quarter 2022.”

The customer-friendly change in redemption posed, nevertheless, an accounting challenge. As of the modification date, Southwest had $1.9 billion in unused credits set to expire:

“The Company’s balance of existing Customer flight credits as of the modification date was approximately $1.9 billion, including a portion of the extended flight credits issued during the early portion of the COVID-19 pandemic, that had been set to expire on September 7, 2022.”

While most of the $1.9 billion balance would likely be used after travel picks up after the pandemic, it is reasonable to assume that some credits would remain unused. But what portion? Based on Southwest’s disclosure, the Company estimated that customers would redeem most, if not all, of the credits by the end of 2023. Any redemptions beyond that would be immaterial, allowing the airline to recognize that amount for credits that are not expected to be used as revenue.

Sounds easy. However, the customers did use the never-expiring credits in 2024, forcing Southwest to reverse the previously recognized revenue.

“At that time, based on historical Customer behavior, the Company estimated that redemptions of these flight credits would have been reduced to an immaterial amount during 2024 and recognized breakage revenue in prior periods for these flight credits accordingly; however, based on actual Customer redemptions throughout 2024, as well as currently projected redemptions beyond 2024, the Company determined a reversal of a portion of this prior breakage revenue was warranted in the current period. This adjustment is not reflective of base business revenue trends in fourth quarter 2024 or beyond. See the Note Regarding Use of Non-GAAP Financial Measures for further information.”

From an accounting standpoint, the miscalculation of the redemption pattern led the airline to recognize too much revenue in the previous years – given the timing of the policy modification, mostly in 2023. (Note that Southwest treated the breakage revenue adjustment as a change in estimate and not as a correction of an error because, according to the Company, more accurate information about the redemption pattern was unavailable to Southwest when the policy was modified.)

Let’s turn from accounting to economics: based on the disclosure, Southwest expected the credits to be used before 2024. Does it mean the airline expected its customers to take at least one flight within a year or so of the credit issuance, but the customers didn’t? And if so, why? The disclosure is silent about the assumptions behind the estimate, and the answer could be anything from using loyalty points first to deteriorating brand loyalty. Arguably, answering these questions may help understand whether the adjustment was related to changing demand or just a one-off accounting change due to a complex estimating process.

My friend and frequent collaborator Francine McKenna wrote about breakage revenue for The Dig and Market Watch. Francine asked a different accounting question: is it appropriate, from accounting and regulatory perspectives, to remove a negative revenue-related adjustment to create a custom non-GAAP metric:

“They have adjusted revenue and created their own version of GAAP, a tailor-made accounting metric, which is a no-no,” she said.”

The breakage-related non-GAAP adjustments are uncommon. According to my analysis of data from Audit Analytics, in the past five years, eight NYSE and NASDAQ companies - including big names such as Marriott (Ticker: MAR) and Hilton (Ticker: HLT), reported breakage-related changes in estimates. While non-GAAP metrics are not defined in GAAP and companies may use different approaches to which adjustments to include, only two of the eight companies – Red Robin Gourmet Burgers (Ticker: RRGB) and Shake Shack (Ticker: SHAK) - adjusted their GAAP numbers to remove the impact of the breakage-related change in estimate.

None of the airlines besides Southwest had to adjust their estimates for breakage revenue. The explanation is likely simple: while other airlines, such as JetBlue and Delta, extended the redemption period of the customer’s credits, the credits were still bound by an expiration date. It is much easier to predict redemptions for a credit that expires in two years than for a credit that is valid indefinitely.

But what about other benefits that never expire, such as loyalty points for some airlines? According to the 10-K filings, as of December 31, 2023, Southwest, Delta, and JetBlue had a liability associated with their loyalty programs of $4.9 billion, $1.1 billion, and $8.4 billion, respectively.

Notably, for Delta and JetBlue, the estimates associated with loyalty program breakage were so material that their audit firm elected to include a Critical Audit Matter (CAM) in the 2023 audit opinions. According to the PCAOB, CAMs are audit-related matters that involve especially challenging, subjective, or complex audit judgments.

From Delta’s 2023 10-K (emphasis added):

“Loyalty Program - Mileage Breakage

Description of the Matter

At December 31, 2023 the Company’s aggregate current and noncurrent loyalty program deferred revenue balance was $8.4 billion. For the year ended December 31, 2023, the Company recognized $3.5 billion of revenue classified as loyalty travel awards within passenger revenue and $3.1 billion of revenue classified as loyalty program revenue within other revenue in the consolidated statement of operations. As disclosed in Note 2 to the consolidated financial statements, the Company defers revenue for mileage credits earned and recognizes loyalty travel awards in passenger revenue as the miles are redeemed and services are provided. In accounting for its loyalty program deferred revenue, the Company estimates the amount of mileage credits outstanding that are not expected to be redeemed (mileage breakage). The Company recognizes mileage breakage proportionally during the period in which the remaining mileage credits are redeemed. Under the Company’s loyalty program, mileage credits do not expire. Therefore, the Company uses statistical models to estimate mileage breakage based on historical redemption patterns.

Auditing the Company’s accounting for its loyalty program required significant estimation in determining the mileage breakage estimate for mileage credits. In particular, there is complexity and subjectivity in estimating mileage breakage based on expectations of future redemption patterns due to the absence of historical expirations as the Company’s mileage credits do not expire.”

From JetBlue’s 2023 10-K (emphasis added):

“Loyalty Program - Breakage

Description of the Matter

As discussed in Note 2 to the consolidated financial statements, under the customer loyalty program, the Company issues points to customers based upon the fare paid for a ticket purchase or through sales to business partners, including JetBlue’s co-branded credit card partners. The Company defers a portion of the transaction price allocable to points issued and recognizes revenue when the points are redeemed for travel. The Company estimates breakage for issued points using historical redemption patterns and records revenue for points that are not expected to be redeemed. Estimates of breakage are evaluated annually, and changes to breakage estimates prospectively impact Passenger revenue and Air traffic liability. The balance of the Company’s Air traffic liability associated with the loyalty program was $1.1 billion at December 31, 2023.

Auditing management’s estimates and calculations used in its accounting for the loyalty program is significant to our audit as the related impact to Passenger revenue and Air traffic liability is material and sensitive to changes in the breakage rate. The estimate of breakage by management requires the Company to forecast redemption patterns, which involves the application of judgment and estimation. As a result, auditing the Company’s accounting for the loyalty program breakage estimate was complex and highly judgmental.”

Southwest’s audit opinion did not include a breakage-related CAM. All three airlines are audited by Ernst & Young, LLP.

To summarize, estimating breakage revenue for never-expiring benefits, such as flight credits or loyalty program points, is inherently complex due to the difficulty in predicting future redemption patterns. In some cases, such as Southwest’s, the estimation difficulty may lead to changes in understanding how much revenue the Company should have recognized and subsequent catch-up adjustments.

For questions and data inquiries please contact olga@deepquarry.com.

Disclaimer: This newsletter does not provide investment advice. The views expressed in this newsletter are personal views of the authors based on their interpretation of publicly available information.