fair value and its impact on the airlines industry of malaysia

Fair value and its impact on the Airlines industry of Malaysia

Prologue

24th November 2009 – “Banks, Airlines to Feel the Most Impact with FRS 139”Source: BERNAMA

According to the report by BERNAMA, the banking sector and aviation industry would experience the most impact with the implementation of the Malaysian Accounting Standards Board's Financial Reporting Standard (FRS) 139 which will take effect Jan 1, 2010. FRS 139 which would also require the valuation of many financial instruments to be done on a fair value basis according to the Dr.Nordin Zain who is the Executive Director of Deloitte Kassim Chan.

Introduction

The issue of fair value in financial reporting has been a matter of great discussion and created controversy in the recent global financial crisis. Among the concerns expressed were in a number of areas that include the fair value measurement in the absence of active markets and the use of market prices below an entity’s estimate of the long-run intrinsic value of an instrument. Generally, the issues raised are related to the fair value measurement and the requirement to use fair value for recognition or disclosure.

The airline industry has been faced with increasingly complex accounting requirements with the transition to IFRS and changes in U.S. GAAP reporting over the past few years.

The companies in the U.S. has experienced significant changes with the introduction of the Sarbanes-Oxley legislation and reporting under Section 404, with many U.S. foreign private issuers reporting under this framework for the first time this coming year. The risk of ‘getting it wrong’ from an accounting or internal control perspective has never been higher and regulators in many countries have been more active and willing to challenge accounting treatments.

The transition to IFRS by European and certain Asia-Pacific carriers has set airlines on a path toward harmonization of financial reporting. The reporting KPMG has surveyed, demonstrates that global airlines transitioning to IFRS have made similar adjustments in their financial statements. KPMG’s survey also highlights that IFRS transition adjustments have been significant in terms of their size and nature on the balance sheet and the income statement in the areas of recognition and measurement of financial instruments, property, plant and equipment, revenue recognition and accounting for post- employment benefits.

The on-going transition to IFRS and the increasing trend to a fair value measurement basis would lead to greater volatility for the airlines industry. In general, airlines are exposed to changes in fuel price, foreign exchange rates and interest rates. Accounting

for hedging activities is burdensome and would usually lead to some volatility in the profit and loss mainly when hedge accounting requirements are not met and therefore the fair value of the derivative is marked to market through the profit or loss. Companies in the airline industry generally have higher cash flow volatilities and higher asset bases compared to many other industries, which leave them vulnerable to asset impairment if there are sudden demand shocks.

This case would examine the impact of the adoption of FRS 139 Financial Statements on two major companies in the aviation industry in Malaysia, Air Asia and Malaysia Airlines.

About Air Asia

Air Asia was established in 1993 and began operations on 18 November 1996. It was originally founded by a government-owned conglomerate, DRB-Hicom. On 2 December 2001 the heavily-indebted airline was bought by former Time Warner executive Tony Fernandez’s company Tune Air Sdn Bhd for the token sum of one ringgit (about USD 0.26 at the time) with USD 11 million (MYR 40 million) worth of debts. Fernandez turned the company around, producing a profit in 2002 and launching new routes from its hub in Kuala Lumpur, undercutting former monopoly operator Malaysia Airlines with promotional fares as low as MYR 1 (USD 0.27).Since 2001, Air Asia has rapidly broken down travel norms around the globe and has risen to become the world’s best. With a route network that spans through more than 20 countries, Air Asia continues to pave the way for low-cost aviation through its innovative solutions, efficient processes and a passionate approach to business. With the support of its associate companies, AirAsia X, Thai AirAsia and Indonesia AirAsia, Air Asia is set to take low-cost flying to an all new high with the underlying belief of “Now Everyone Can Fly".

About MASMalaysia Airlines, the country’s national carrier, was first incorporated as Malayan Airways Limited (MAL) on 12 October 1937. Today, Malaysia Airlines flies an average of 43,000 passengers daily to some 100 destinations worldwide and holds a lengthy record of service and best practices excellence. It was the recipient of the inaugural "World's Best Cabin Staff" award by Skytrax,UK in 2001 and continued to retain this title for 2002-2004, 2007 and 2009 - the most for any airline. In 2010, Malaysia Airlines was recognised as the ‘World's Leading Airline to Asia’, ‘Asia's Leading Airline’ and ‘Asia's Leading Business Class Airline’ by World Travel Awards (WTA). This year, WTA honoured Malaysia Airlines as ‘Asia's Leading Airline’ and ‘Asia's Leading Airline Lounge’. The national carrier's engineering subsidiary, Malaysian Aerospace Engineering (MAE), has also been acknowledged as the top airline affiliated Maintenance and Repair Organisation (MRO) in the world by Aviation Week's Overhaul & Maintenance magazine.

About FRS 139 FRS 139 Financial Instruments: recognition and measurement is a new standard that became effective on 1st January 2010 in Malaysia. It is a central and complex standard in the series of Financial Reporting Standards (FRS) and it has linkages to many other standards and interpretations which includes all companies.

In essence, FRS 139 details out the accounting principles for (a) recognition and measurement of financial instruments and (b) the application of hedge accounting.

Categories of Financial Instruments under FRS 139

Financial Assets Financial LiabilitiesFinancial assets at fair value through profit and loss (including derivatives)

Financial liabilities at fair value through profit and loss (including derivatives)

Held to maturity (amortized cost) Other financial liabilities (amortized cost)Loans and receivables (amortized cost) Financial guarantee contractsAvailable for sale financial assets (fair value through equity)

Commitments to provide loans at below – market interest rates

Source: MASB Website, HDBSVR

The implications from hedge accounting FRS 139 would require all companies (including banks) to recognise and measure derivative contracts. Therefore, these items would be captured and marked to market at each balance sheet date with their fair value changes reflected either in the income statement or equity in the balance sheet, instead of being treated as off balance sheet items previously. Derivatives would be carried as assets when fair value is positive and as liabilities when fair value is negative.

In order to qualify for hedge accounting, the hedge must relate to a specific, identifiable and designated risk and must ultimately affect the entity’s profit and loss. Hedge accounting will recognise the offsetting effects on profit or loss of changes in the fair values of the hedging instrument and the hedged item.

On the other hand, when derivatives do not qualify for hedge accounting, it would be classified at fair value through profit and loss with any gains or losses arising from changes in fair value that are recognized in the income statement.

The impact of hedge accounting would be dependent on the type of hedging relationships and the effectiveness of the hedge selected. This would determine the eventual accounting treatments that would be required when recognizing the gains and losses either in the income statement or in equity. The following table would explain the accounting rules for hedge accounting.

Table 1Type of hedging relationship and treatment according to accounting principles

Type of hedging relationship TreatmentFair value hedge Gain or loss from remeasuring the

hedging instrument at fair value to be recognised in profit or loss.Gain or loss on the hedged item attributable to the hedged risk to be recognised in profit or loss.

Cash flow hedge The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge to be recognised directly in equity. Amounts taken to equity are transferred to income statement when the hedged transaction affects profit or loss.The ineffective portion of the gain or loss on the hedging instrument to be recognised in profit or loss.

Hedge of a net investment in a foreign operation

The portion of the gain or loss on the hedging instrument that is determined to be an effective hedge shall be recognised directly in equity.The ineffective portion to be recognised in profit or loss.

Hedge accounting, specifically cash flow hedge relationship would be use by companies who uses derivatives like fuel hedging contracts, foreign currency hedging contracts, interest rate hedging contracts as a risk management tool in order to mitigate and manage the operating and financial risks. The use of hedging mechanisms would cause volatility in reported earnings from quarter to quarter.

The airlines industry would use hedge accounting in their financial statements since they hold derivatives to mitigate risks within the business. Both Malaysia Airlines and Air Asia utilizes these derivatives that can be found in their financial statements published.

Impact of FRS 139 on Air AsiaAir Asia only applied FRS 139 Financial Instruments for the Group and Company’s financial year beginning on or after 1st January 2010. Therefore the effect of FRS 139 can only be reported in the Annual Report for year 2010 as opposed to MAS who early adopted FRS 139 in their financial statements and the effects has been reported in the Annual Report for year 2009.

The adoption of FRS 139 has resulted in several changes to the accounting policies which are related to the recognition and measurement of financial instruments. The annual report stated that comparatives for financial instruments were not adjusted therefore suggested that the corresponding balance shall not be comparable.

Among the significant changes in accounting policies were for investments, derivatives, intercompany loans and loans and receivables.

Items Prior to FRS 139 With FRS 139Investments

Non – current investments

Measured at costSubject to impairment

Reclassified as available for sale financial assetsMeasured at fair value plus transaction costs (initial measurement)Fair value or cost less impairment losses* (subsequent measurement)*If fair value cannot be reliably measured due to the variability in the range of reasonable fair value estimates which is significant for the investments; orThe probabilities of the various estimates within the range cannot be reasonably assessed and used in the estimation of fair value.

Derivatives Not recognised in the financial statements on inception.

Recognised at fair value on date of inception (initial recognition and measurement)Re-measured at fair value (subsequent measurement)

Intercompany loans

Loans and advances were recorded at cost.

Fair value that is lower than cost (initial measurement)Amortised cost (subsequent measurement)

Loans and receivablesNoncurrent receivables

Noncurrent financial liabilities

Measured at invoice amount and subjected to impairmentReclassified as loans and receivablesUndiscounted amount payable

Fair value plus transaction costs (initial measurement)Amortised cost using the effective interest method (subsequent measurement)Fair value (initial measurement)Amortised cost using the effective interest rate method (subsequent measurement)

Source: Annual Report 2010, Air Asia Bhd, available at:

Impact of FRS 139

Source:

Impact of Total Derivatives

Source:

Impact on reserves

Source:

Impact of FRS 139 on Malaysian Airlines (MAS)

Malaysia Airlines early adopted FRS 139 Financial Instruments that took affect from 1st January 2009. The early adoption of FRS 139 gave rise to significant changes in the accounting policies of the group. The principal changes in policies of accounting as well as the effects from the adoption of FRS 139 will be discussed as follows: -

Financial instruments at initial recognition are recorded at fair value. Subsequent measurement of the instruments at the balance sheet would reflect the designation of the financial instrument. MAS determine the classification at initial recognition and will re – evaluate the designation at the end of each year except for financial instruments that are measured at fair value through profit or loss.

Item Prior to FRS 139

With FRS 139

Financial AssetsLoans and receivables

Gross proceeds receivables less provision for doubtful debts.

Fair value (initial measurement)Amortised cost using effective interest rate method (subsequent measurement)The gains and losses are recognised in the consolidated income statement when the loans and receivables are derecognised, impaired or through the amortization process.

Available – for – sale

Cost less impairment losses

Available – for – sale financial asset would be measured according to (a) at fair value initially and subsequently with unrealised gains or losses recognised directly in equity until the investment is derecognised or impaired or (b) at cost if the unquoted equity instrument is not carried at fair value because its fair value cannot be reliably measured.

Held – to – maturity

Cost less impairment losses

Fair value (initial measurement)Amortised cost using the effective interest rate method (subsequent measurement)Gains and losses recognised in the consolidated income statement when the investments are derecognised, impaired or through the amortisation process

Financial liabilitiesBorrowing Proceeds less

directly attributable transaction costs

Fair value plus directly attributable transaction costs (initial measurement)Amortised cost using the effective interest rate method (subsequent measurement)Gains and losses are recognised in the consolidated income statement when the liabilities are derecognised or through the amortisation process.

Derivative financial instrumentsDerivatives were not recognised in the financial statements prior to 1st January 2009. Under FRS 139 derivatives are required to be recognised initially at fair value on the date the derivative contract is entered into and subsequently at fair value at each balance sheet date. Derivatives would be carried as assets when fair value is positive and as liabilities when fair value is negative.Derivatives that do not qualify for hedge accounting will be classified at fair value through profit and loss with any gains or losses arising from changes in fair value on these derivatives being recognised in the income statement. When derivatives do qualify for hedge accounting, recognition of any resultant gain or loss would be dependent on the nature of item being hedge as follows:

Cash flow hedgeThe effective portion of the gain or loss on the hedging instrument is recognised directly in equity, while an ineffective portion is recognised immediately in the income statement. Amounts taken to equity are transferred to the income statement when the hedged transaction affects profit or loss such as when the hedged financial expense is recognised or when a forecast sale occurs. When the hedged item is the cost of a non – financial asset or non – financial liability, the amounts taken to equity are transferred to the initial carrying amount of a non – financial asset or liability.

If the forecast transaction is no longer expected to occur, amounts previously recognised in equity are transferred to the income statement. If the hedging instrument expires or is sold, terminated or exercised without replacement or rollover, or if its designation as a hedge is revoked, amounts previously recognised in equity remain in equity until the forecast transaction occurs.

Air AsiaFigure 1

Significant Accounting Policies


Figure 2Summary of Significant Accounting Policies


Figure 3

Summary of Significant Accounting Policies


Figure 4Significant Accounting Policies for Financial Assets


Figure 7Significant Accounting Policies for Derivative Financial Instruments


Figure 8Significant Accounting Policies for Derivative Financial Instruments


Figure 9Available – for – sale financial assets


Figure 10Other investments


Figure 11Disclosure in the Financial Statements: Derivative Financial Instruments


Figure 12Disclosure in the Financial Statements: Financial Instruments


Figure 13Disclosure in the Financial Statements: Financial Instruments


Malaysia Airlines (MAS)Figure 14Significant accounting policies

Source: Annual Report 2009, Malaysia Airlines, available at: http://ir.chartnexus.com/mas/report.php

Figure 15Significant accounting policies


Figure 18


Figure 19


Figure 20


Figure 21


Figure 22


How Fair Is Fair-Value Accounting?Liz Moyer, 06.25.08http://www.forbes.com/2008/06/24/accounting-banking-sec-biz-cx_lm_0625sec.htmlhttp://www.mia.org.my/new/news_details.asp?ID=829http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/first-impressions/Documents/first-impressions-fair-value-measurement.pdfhttp://www.sba.pdx.edu/faculty/danr/danraccess/courses/fin562/hedging_case_crj_submission.pdfhttp://www4.gsb.columbia.edu/null?&exclusive=filemgr.download&file_id=3822http://issuu.com/louisli/docs/kpmg-s-disclosures-hanbook-2005---accounting-and-f#download

http://www.kpmg.com/Global/en/Search/Pages/Results.aspx?k=airlines&u=http%3A%2F%2Fwww%2Ekpmg%2Ecom%2Fglobal%2Fen&redirect=false&start1=1

http://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/2008-Airline-disclosures-handbook.pdf

http://ir.chartnexus.com/mas/report.php