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Table of Contents Table of Contents1 Introduction. Decisions and Accounting. 2 Aircraft development. 6 Airport Receivables & passenger fees collection. 8 Airlines Bodies participation. How ARC uses Ratio analysis to protect members10 Fuel hedging – Cost saving or Gamble? 13 Collective bargaining, financial statements on the bargaining table. 15 In-house or Outsource services – Caribbean Airlines Case – M&E & Revenue Accounting16 How do Airlines use CM and CVP? 19 Fleet change and fleet type24

Critical Analysis; what does the accounting information mean – Low cost airlines26 Bibliography28 Appendices29 1. The Aviation industry29 2. IATA enhancement Financing services29 3. Airline Reporting Corporation, Carrier Financial Statement29 Introduction. Decisions and Accounting. The aviation industry has been for the last decade one of the most dynamic industries in the world. The business structure of the aviation industry has evolved into one in which each major stakeholder can have a distinct impact on its fortunes.

The aviation industry is not only the airline companies, it also includes airports that are either managed by regulatory government bodies or private companies, the cargo and express freight and package delivery companies, Passenger and Ramp handling companies, customer reservation system providers, aircraft manufacturers and aircraft leasing and financing companies, just to name a few of the major player.

Recently the aviation industry has come to born some new players in recent years the push towards globalization and improvements in worldwide IT infrastructure and airport security requirements due the drug trade and terrorism, such and revenue accounting providers, outsourced aircraft maintenance and airport security and training providers. Appendix 1 presents a breakdown of the aviation industry. Before we dive further into any analysis, let’s understand three important elements of our topic. 1)Decision making 2)Information 3)Accounting A decision is a choice, a choice between available alternatives.

Decision making is the process of identifying problems and opportunities and resolving them (Daft 1993). The key word in the last sentence would definitely be process. The decision making process can illustrated below (Daft 1993) One of the key ingredients to this process is information. Information is data that are meaningful and alter the receiver’s understanding of events and facts (Daft 1993). For information to be useful it must have certain characteristics. It must be of good quality, which is the source data must be accurate and reliable. It needs to be timely.

The sooner you have information on events, the faster it can be used in the decision making process. There would be no use to information on situations that have gone and cannot be changed. Completeness is a must for information, incomplete information in the decision process can lead to a non-optimal decision. The information must also be relevant. It should pertain to the problem at hand. It should not contain information that the user does not need for the present decision as this would slow down the decision making process as the user has to sort out for information relevant to the situation.

Accounting as described by the American Accounting Association is as following: “the process of identifying, measuring and communicating economic information to permit informed judgements and decisions by users of the information” (tutor2u. net) Accounting is generally split into two areas, Financial accounting and Management accounting. Financial Accounts: geared toward external users of accounting information Management Accounts: aimed more at internal users of accounting information Although there is a difference in the type of nformation presented in financial and management accounts, the underlying objective is the same – to satisfy the information needs of the user. Below briefly looks at the differences. It is also understood in producing accounting information that is useful; it should have the following characteristics. a. Understandable – information in such a way that it will be understandable to users. b. Relevance – must assist a user in the context of making a decision c. Consistency – consistent treatment of similar items and application of accounting policies d.

Comparability – compare similar companies in the same industry group. e. Reliability – information that is presented is truthful, accurate, complete and capable of being verified f. Objectivity – information is prepared and reported in a “neutral” way. Aircraft development. When we think of aviation, an aircraft flying high is the first picture that comes to mind and what not a better place to start an assessment of accounting information for decision making. Aircraft development is a major cost investment with cost running into the billions of US dollars.

The current major aircraft manufactures are Boeing Corporation, Airbus and Bombardier. This process involves capital budgeting accounting that provides decisions of whether the development project will be feasible. However what is going to highlighted here is the importance of analysis of financial statements, are on development projects. Lets go back into the early 1970’s and assess how poor financial analysis on the development of the Lockheed Tristar three engine wide body aircraft by Lockheed Corp and Roll-Royce Plc lead to the demise of an aircraft that in its era was technologically ahead of it’s time.

It illustrates the importance of a healthy balance sheet and cash flow statement. Ratio analysis has become the standard to benchmark strong financial position and performance. Somehow both Lockheed and Roll-Royce forgot that liquidity was the backbone for business survival. They both went into an arrangement that was financial suicide. Based on a request in 1966 by American Airlines to development a medium range jet with a 300 plus passenger capacity, Lockheed started development of an aircraft that on completion was the Lockheed Tristar .

The development of the engines was to be designed and built by Roll-Royce Plc in UK (www. pbs. org). Development cost meant for Lockheed investing in increased inventory and building up funds in Work in Progress inventory as they started work in building aircraft and so too was Roll-Royce. This must have looked well for their current ratio as these values would be classified as current assets (current asset/current liabilities). But an analysis of their acid-test ratio (cash equivalents/current liabilities) would have shown their investment with no corresponding cash inflow was leading to detrimental liquidity problems.

Cash flow analysis must have been showing cash outflows on investing activities and no cash inflows on operation activities. Roll-Royce was the first in this project to be driven into bankruptcy, from liquidity problems before any planes could take to the air. This only worsens Lockheed situation since no aircraft can be sold without an engine. Lockheed and Royce were the first major cases of Government bails outs in the aviation industry. The British government demanded the project on Roy-Royce side could only be completed by Lockheed proving that it was financial sound, obviously they could not.

US congress provided a US$ 250 million dollar loan to Lockheed and the first Tristar flew in November 1970. Unfortunately for Lockheed the economy had slowed down and sales demand fell. It never saw a health return on assets (ROA) which included the development cost on the Tristar. By 1981 it had loss over US$2. 5 billion on its commercial aerospace line and eventual discontinued it (Greenwald et al 1981). Today’s manufactures have learnt from Lockheed experience. Most aircraft development are handled different and it is based on expression of interest and cash deposits on orders.

This helps protect manufactures from the liquidity issues associated with development cost and sales on completion. These deposit on the balance sheet off-set the effect of inventory and work in progress on liquidity analysis. Airport Receivables & passenger fees collection. Airports have made considerable investments in airport upgrades over the years. Runway upkeep, runway extension and parking spaces to encourage bigger capacity aircraft, improved cargo facilities, invested in automated gateways and added concourse. To recover these cost airports charge landing ees, concourse fees and passengers or facility charges to airlines. Over the years many airports have seen it more difficult to collect on their receivables. The accountants looks at the balance sheet and the financial analysis shows slower receivables turnover rates (net credit sales/average net receivables) and longer number of days in accounts receivable (number of days in business year/accounts receivables turnover), indicating longer periods in collecting on outstanding receivables. This then translates into cash flow management problems.

The Airports unfortunately are in the receivable business, it’s just how the process works. Most fees charged by the airports are by per passenger or per landing, there are calculated monthly after all aircraft have landed and passengers have de-planed and en-planed. Now the painful process of tracking down payments begins. Uncertain times brings with it risk the airline industries has been in constant state of uncertainly, therefore the risk of an airline or number of airlines having months of unpaid invoices, is highly likely.

Airport Authority of Trinidad & Tobago (AATT) has taken the decision to avoid the cash flow issues and cost associated with lower receivable turnover and below acceptable quick-ratio by enrolling in the International Air Transport Association Enhancement & Financing Services (IATA E&F services). IATA E&F services as outlined in appendix 2, has become the tool for many airports to manage billing, receivables, and cash management (IATA. org).

It does come at a cost to AATT to have IATA E&F services generate invoices and settle payments; however the cost of the corresponding risk of non-settlement on collecting is offset by such prudent decisions. Grantly Adams Airports in Barbados has also made the decision to go the same route as AATT to settle their passenger charges. Again these relatively small airlines main source of cash inflows or revenues are from these charges to airlines.

Therefore it is important that they constantly manage the efficiency of their credit & collection management, if they have to source funding for expanding and regular upkeep of the terminal and runways out of operating activities. Airlines Bodies participation. How ARC uses Ratio analysis to protect members Airlines bodies are an integral part of the aviation industry, their services facilitating the efficient functioning of the airlines industry, Airports, Travel agents and Global distribution systems providers (those are the companies behind the reservation systems).

With hundred of members with interlaced financial transactions it is imperative that systems to monitor financial adherence be implemented. Let’s look at how Airline Reporting Corporation (ARC) has used a quarterly reporting system utilising ratio analysis to ensure financial compliance by members. But why is this process so important? Airlines bodies like ARC allow for the effective function of the airline industry. ARC is the reporting body for all travel agents in the USA.

They are responsible to ensure that all ARC registered travel agents make payments collected on tickets sales to them and they then distribute these funds to the respective airlines. But ticketing rules have a little catch to it. Since on many occasions a passenger may need to travel on two airlines to reach they destination, however ticketing rules dictate that the first travelled airline will receive all the cash for the full trip and the other airlines then have to bill the first airlines for their funds. Exciting isn’t it?

It meant that ARC has a direct responsibility to ensure that each airlines member is financial stable and what better means of assessing information to make a decisions on each member than to use some ratio analysis. This is done by making it compulsory for each airline member submit quarterly a Carrier Financial Statement, see appendix 3 The statement requires each member to complete information on there quarterly financial statements. The form then evaluates an airline performance based on eight (8) ratios and standard performance for each one.

Lets examine what each ratio is seeking to determine and evaluate. 1. Net Profit margin percentage – This seeks to examine what percentage of revenue will end up as profit of loss. Therefore a high positive percentage will indicate a profitable operation and a high negative percentage will indicate. The standard is actual negative 5%, and the environment and market conditions of the airlines industry has many making a loss, specifically at off peak periods. 2. Cash Flow as a Percent of cash expense – Here they evaluate how healthy you cash position is.

This helps ARC examine how much of the revenue is really been banked cash and not sitting in a receivable for collection. Since profit is Revenue less expenses, your Net profit margin and this ratio should move in the same direction. 3. Ratio of cash and short term investment to cash flow – Here this ratio look to see if you have enough cash flow to put aside a little to earn interest to help your net line. 4. Number of days cash flow expense in cash and short term investments – an evaluation must be done as to how fast your expenses burn the cash you receive for sales. . Cash and short term investments as a percentage of current liabilities – What this does is look at what percentage of cash can cover your current liabilities. Now the reason for this analysis has to do with the factor that the largest portion of airlines’ current liabilities is its unearned transportation revenue (UTR), which is in short a sale of tickets not yet flown by the passenger. In most cases the passenger can have the ticket refunded, therefore ARC would wish to examine if an airline can settle such refund claims. 6.

Current Assets as a percent of current liabilities – A standard working capital percentage used across various industries to examine liquidity 7. Ratio of operating revenue to current liabilities – Interesting little ratio here, but ARC wants to uncover how much of the revenue generated is link to you increasing your liabilities. For instance maybe you have not been paying you invoices, such as landing fees or lease. So you could be showing a profit, but have problems managing your payables. 8. Percent of debt to debt plus equity – A gearing ratio that tells of your mix of financing.

Any airline that fails four (4) ratio will have to increase there cash reverse with ARC, in most cases this is done by holding that amount of travel agent sales collected. Airlines who do not submit timely statements will also have their cash reserve increased Fuel hedging – Cost saving or Gamble? Fuel cost to the airline industry has historical been between 10 -15% of operating cost (Airlines. org). As such senior management have always been concerned about any significant increase in price that would upset this delicate relationship with cost.

Monthly management accounts for an airline would clearly define all the elements of fuel cost. The total fuel cost for the month, the total fuel in US gals uplifted per month, the average price paid per US gals and what percentage of total cost fuel cost is. Airlines implement many methods to offset increases in fuel cost which many include, fare increases, fuel surcharges, flight plan changes and fuel hedges. Fuel hedges became a very popular method in the early 1990’s as the price of fuel started to make a steady increase along with the price of oil.

Airlines understood that the only way to really control your cost movement and not affect price increases to the customer was to get into hedge agreements to lock into fixed fuel prices. Airlines like Southwest Airline Corp. boasted about how their successful hedging programme ensured continued profitability, whilst those not hedged saw the pressures of rising fuel prices resulting in losses. The true nature of hedging is as much a decision tool for cost saving as it is an accounting gamble that can turn into a loss.

The president of Air France-KLM, Jean-Cyril Spinetta, had this to say about hedging (Ezard 2008), “We hedge to avoid too much volatility, but we take the risk of paying more than market price. ” The historical increase in oil and fuel prices which started in late 2007 and peaked about June 2008, saw all the major airlines jumping on the hedging train, even start up Caribbean Airlines out of Trinidad & Tobago was getting a hedge from the Government of Trinidad & Tobago. All the energy analyst and futures traders around the world were predicating increases until the end of 2008.

Every airline CEO and CFO were being halted for their efforts to secure hedges to stop the flow of losses. But then something started to happen from July 2008 into August 2008 and before anyone could adjust. A recession in all the major economies in the world, and the price of oil and fuel came tumbling down. By March 2009 the price of Oil was on average US$40 per barrel, about US$100 per barrel less than June 2008. Many airlines were locked into hedge contract between $100 – $120 per US gal, the hedge decision did not pay off. Below is a snapshot of the losses that some major airlines will incur based on their hedge decision (Dunn 2009);

The decision to hedge will still be a tool used in the airlines industry as the accounting data of increasing operating tells you that action must be taken, however it would be up to each airline management to determine the level of risk and how it may affect them in the future. Collective bargaining, financial statements on the bargaining table. The airlines industry is both capital and labour intensive and as such employee cost, once fuel cost is below certain prices is the largest cost item for an airline. The personnel in the airline industry are also heavily unionized. In 2008, according to Unionstats. om (airlines. org/jobs), an estimated 46. 4 percent of all workers in U. S. air transportation (passenger and cargo airlines) were covered by collective bargaining agreements, versus 8. 4 percent of all U. S. private sector employees. After the World Trade centre attacks on September 11, 2001, the airline industry faces challenges never seen before. Decreased passenger demand, increased security cost, a new gulf war, SARS and rising fuel prices to contend with. There was fall out and a number of airlines started to declared bankruptcy, United Airlines being the biggest in US to file.

But many used this process as a means to go after the unions and demand wage and benefit concession from employees. Armed with the company’s financial statements at the bargaining table airlines executives had balance sheets that showed insolvency and profit and loss statements with losses, pointing out reducing employee cost was the only means to survive. Employees in the airline industry know they have leverage, scab labour can’t come in and fly aircraft or operate handling equipment or use reservation systems to manage and check in passengers. The airlines knew that strikes just added to the cost.

Financial statements showing cost and number of employees per aircraft gave the airlines a real performance measure to bargain with. Analysis of the financials brought realization to the state of the industry financially and most of the unions conceded with pay cuts and concession to benefits such as work hours and turn around time frames. Many of the new collective agreements included profit sharing schemes. Airlines also bargained to write-off balance sheet liabilities such as accrued vacation as part of employee concessions. In-house or Outsource services – Caribbean Airlines Case – M&E & Revenue Accounting

Management accounting is one of the most important decision making tools in the airline industry. Cost management in uniquely tied to pricing and profitability and therefore management have constantly looked at methods to reduce cost. It’s the process of examining each cost element and understanding what drives the cost up or down, what is variable and what is fixed over activity levels. Outsourcing of services has become possible as certain companies have technical and operational advantages that allow them the do activates as a lower unit cost.

It may be because of labour cost in that region, better employee productivity, lower financing cost or better utilization of assets. Whatever it may be, airlines seek to tap into these services to save on operational cost as internal cost analysis measures that current cost of the in-house activity is more that the outsourced cost. We can assess to two decisions made by Caribbean Airlines Limited that centre on outsourcing and use of management accounts, carefully considering why it is important that all information of cost be included on your management accounts, and understand for which purpose the management accounts model was built.

One of the restructuring decisions on the closing of BWIA International Airlines and starting of the new legal entity Caribbean Airlines Limited was to outsource the passenger revenue accounting function. The decision was taken on the basis of the cost per passenger on the revenue accounting department of BWIA, that being total cost for Revenue account cost centre divided by number of revenue passengers (revenue accounting cost/ # of passengers) was most than the cost per passenger of a selected revenue accounting outsource provider.

However there was a lack of understanding of the outsource provider model in which costing was provided. The costing model was based for low cost airlines that had most if not all there purchases online and by credit card. Hence the promise to save cost and reduce headcount was solely on this assumption. The model on BWIA side was also misunderstood, revenue accounting cost centre cost included not only passenger revenue accounting cost, but it also included sales report auditing cost, refunds processing costs and cargo revenue processing cost.

The decision to outsource from the provider has cost Caribbean Airlines twice as much as it did in BWIA. Management accounting data is only as good as for the use it was intended for, any assumption that it can be applied to all scenarios could lead to an incorrect decision. On the other hand one of the major decisions in Caribbean Airlines Limited was to bring back the heavy maintenance of aircraft in-house. After years in BWIA of having this done by Delta in the US after attempts in BWIA showed to be more expensive in-house, a proper analysis of the management accounts information was done.

The analysis showed that the labour cost was killing them, due mainly to overtime cost in a unionized workforce. Caribbean Airlines offered an opportunity, no unions. Per hour labour rates were also lower than Delta. So why is it costing us more? The over time hours was the cause of the variance. An analysis of the hours showed that if we changed the work hours to 12 hour shifts at increased fixed salaries, more productive hours at a fixed rate can be used in costing the heavy maintenance. It has allowed the successful return of the heavy maintenance function at a lower cost back in-house for Caribbean Airlines.

So here we had a situation in which the management accounting cost model was fully understood and the appropriate decision made. How do Airlines use CM and CVP? Of all the accounting information, contribution margin (CM) and cost volume profit (CVP) analysis is the heart of the strategic and tactical management decisions of the airline industry. It impacts the following decisions; A. Market share retention B. Route expansion and reduction CM and CVP analysis starts with your understanding of variable cost, those that change with activity and fixed cost, those that do not change over an activity and or capacity level.

It involves transforming your income statement as illustrated below. And this can be further analysed by route as show below This is the heart of using accounting information to analyse strategic and current tactical decisions. Lets take market share retention. Aggressive competitors on a routes MIA & FLL as illustrated above, have decided to use price wars (offering reduced market fares) to lure customers and gain market share. Management has also decided to “fight fire with fire” and also reduce price, however the accounting information is telling us that this decision is not benefiting the company.

The fare price offered in the price war does not give a positive contribution to your overhead. In fact the more flights you offer at this market price to more you add to your total net loss. Here the management team must decide on which is more important from a strategic direction, market share or operating profitable routes. Maybe getting data on the price elasticity of the market can help in the decision on increasing price and how much of the market share you will really lose. Route expansion and reduction decisions are also made easy with CM analysis.

Look at route JFK, YYZ & CCS where we have positive contributions. Maybe we should start reducing the frequency of flights of the negative contribution routes where the aircraft type used is possible to switch on the positive contribution routes. Most airlines who strategic objectives are to fly profitable routes would make the tactical decision to reduce capacity (number of flights) or stop operating the route, since negative contribution is transferred into increased net loss. This was the case of Airlines Canada termination of services to Trinidad.

The price was to low and cost was too high to make a contribution on the service to Trinidad, but the service to Barbados continued as the price offered on the route was higher, even with the same cost structure as flying to Trinidad. CVP analysis is used to get more detailed analysis of the situation. It’s a little complicated as is involves the calculation of Available seat miles (ASM) and Revenue seat miles (RSM) to calculate your load factors, especially as there is accounting information involving multi-sector flights on the same aircraft.

Your cost of operating involves cost linked to the cost of operating the aircraft and cost related to the passengers on the aircraft. So you may have negative contribution per flight because of the load factor. Therefore airlines decide on measures to increase load factor to increase contribution and profitability on routes. Two decisions they usually make are to reduce flights, hence making less seats available and using aircrafts with less seating capacity. This would eliminate the effect of variable aircraft related cost and improve what is know in the industry as break even load factors, as the same travel demand is supplied with less apacity. It is a tool that has made the low-cost airlines sector successful in managing there operation. Fleet change and fleet type Fleet replacement is the one decision that involves a mix of both financial accounting information and management accounting information. Whether aircraft would be obtained by finance purchase or operating rent, it involves a process of heavy capital budgeting analysis, management accounting costing and balance sheet analysis to manage cash needs for a fleet replacement project and efficient inventory management.

Capital budgeting is the process of planning and assessing the value of decisions that lock finances and resources of a company into the long term. We find the management accounting information is needed to cost the future benefits of a fleet renewal. These benefits cost come in the form of increase revenue and savings and can include; a. Reduced annual maintenance cost b. Increased revenue form an aircraft with more seating capacity. c. Fuel saving from efficiency of aircraft engines d. Lower inventory requirements We also need to understand the cost of implementing the fleet change such as; a.

New training cost for crew and maintenance personnel b. Handling rates for type of aircraft c. Hanger upgrades. Maintenance tools upgrades From this information the capital budgeting process is further developed to determine Net Present Valves (NPV), pay back periods and internal rates of rates (IRR), so various fleet type options can have such analysis and management will then determine what is the best selection criteria on choosing a new fleet. Healthy balances sheets are also part of the fleet change process. Do you currently have excess stock for the old fleet?

Can it be sold at the current book value? Will I have to take an impairment loss? These questions must be answered. How does my debt service coverage ratio, free cash flow and gross profit ratio affect by ability to negotiate financing terms? There are many airlines presently that would like to change fleet; however they can’t get the financing or low aircraft rent rates. Fleet change planning also includes the process of cash management for the process, improving current and quick ratios, receivables turnover and inventory turnover all becomes part of the liquidity process if investing in new aircraft.

Critical Analysis; what does the accounting information mean – Low cost airlines The best way to conclude this discussing would be to give a critical perspective of this topic, since I have been a presenter of accounting information. The most important concept to remember is the accounting information is the result of decision making and external market factors. For instance the average price on your financial statements for a given route is a factor of internal pricing and seat management decisions as well as customer buying decisions.

Also cost reflected on your financial statements are also a result of spending decision, but also the effect of market forces and competition that make handling rates, landing rates and wages lower or higher depending on which region in the world you are. The term low cost airlines was coined about ten years ago, it emerged from the selling prices and cost structure of airlines that operate by selling low fares and have low operating cost. The accounting information of the low cost airlines has so much to do with the market of operating that have created a model of operation.

That is to say that market forces have allowed for the low cost structure to evolve. The effects to have BWIA, Air Jamaica, Liat and now Caribbean Airlines pattern the low cost structure has been a frustrating process. But should the focus of making the decisions be on becoming more like another business model based solely on comparison of accounting data, such as employee cost per aircraft and total cost per passenger mile. Should we not focus on taking advantage of the market information that do not always manifest itself in the accounting process, such as positioning, brand loyalty and customer service.

Its accounting data based on model, realized from market forces and not solely on unique decision making. For instance low cost airlines have lower employee cost due to the factor that there operate in markets and cultures where passengers have embraced the internet. Therefore the need for large reservation staff is not but eliminated. Accounting information should be used to manage and plan. Historical information used to develop meaning full and achievable budgets and used to control and monitor decision implementation.

Adam Pilarski, Senior vice-president at Avitas inc, a leading aviation consulting company had this to say about the use of low cost accounting information (Airline Finance 2009), “Low cost means lowest cost for a given business model. Some airlines have a model built on simplicity…other have a necessarily complex system with different aircraft types, various classes of service, interlining and connection, etc. Those airlines still pursue efficient cost controls but remember their primary mission. There is no way a legacy airlines airline can achieve cost of a true low cost carrier.

Neither should it try. They should have efficient cost controls to achieve the highest possible profits supported by good revenue. ” Bibliography Daft, Richard L. Management Third Edition 1993, Chapter 8. Managerial Decision Making Tutor2u. net. http://tutor2u. net/business/accounts/intro_accounting. htm PBS. org Chasing the Sun. http://www. pbs. org/kcet/chasingthesun/planes/l1011. html Greenwald, John, Jerry Hannifin-Washington, Joseph J. Kane-Burbank. Catch a Falling TriStar. http://www. time. com/time/magazine/article/0,9171,925159,00. html IATA. rg. IATA’s Enhancement & Financing Services. http://www. iata. org/ps/financial_services/enhancement. htm Airlines. org. energy/fuel. http://www. airlines. org/economics/energy/ Ezard, Kerry. Hedge Your bets. Airline Business September 2008 Dunn, Graham. Airlines Take another fuel hit. Airline Business March 2009-11-15 Airlines. org/jobs. http://www. airlines. org/economics/labor/ Airline Finance Journal 2009 Appendices 1. The Aviation industry 2. IATA enhancement Financing services 3. Airline Reporting Corporation, Carrier Financial Statement

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