Chapter 7

1590 users shared this document! click

Airline_Guide_-_Chapter_7[1].doc 1 AICPA Task Force
Airline Industry Guide Chapter 7 Financial Reporting and Disclosures T ABLE OF C ONTENTS I NTRODUCTION ................................................................................................................... 2 A CCOUNTING P OLICIES AND D ISCLOSURES ...................................................................... 3 Passenger and Other Revenue Recognition .................................................................. 3
Cargo Carriers Revenue Recognition ........................................................................... 4
Frequent Flyer Programs............................................................................................... 5 FFP Related Disclosures for Public Airlines (SEC)* ............................................. 6 Credit Card Holdbacks.................................................................................................. 7
Aircraft Acquisition Costs ............................................................................................ 8
Spare Parts .................................................................................................................... 8
Maintenance and Repair Costs...................................................................................... 8
Leases............................................................................................................................ 9 Lease Disclosure Considerations for Public Companies (SEC)* ........................... 9 Asset Impairment ........................................................................................................ 10
Restructuring and Special Charges ............................................................................. 11
Financing Arrangements............................................................................................. 13 Variable Interest Entities....................................................................................... 13
Derivative Instruments and Hedging Activities.................................................... 13
Commitments and Contingencies ......................................................................... 14 Capacity Purchase Agreements................................................................................... 15 Major Airline Disclosures..................................................................................... 15
Regional Airline Disclosures ................................................................................ 15 Aircargo Capacity Guarantees .................................................................................... 16
Segment Disclosures (SEC)*...................................................................................... 17 Operating Segments .............................................................................................. 17 Pensions ...................................................................................................................... 20
Risks and Uncertainties............................................................................................... 21
Sales Taxes.................................................................................................................. 23 O THER SEC D ISCLOSURES (SEC)*................................................................................. 23 Risk Factors ................................................................................................................ 23
Critical Accounting Policies, Judgments, and Estimates............................................ 24
Off-Balance Sheet Arrangements ............................................................................... 25
Tabular Disclosure of Contractual Obligations .......................................................... 26 Airline_Guide_-_Chapter_7[1].doc 2 AICPA Task Force
Airline Industry Guide Chapter 7 Financial Reporting and Disclosures Introduction This chapter discusses financial statement presentation and disclosure considerations as they relate to the airline industry. Airline industry disclosure topics are also included in other chapters of this Guide. Disclosure topics covered in this chapter are those that are either significant or unique to the airline industry, or are unique in an airline-specific application. The discussion in this chapter does not include other financial statement disclosures required by generally accepted accounting principles (GAAP) that are not unique to the airline industry.
The disclosures discussed in this chapter that are identified with an asterisk (*) are applicable to companies subject to Securities and Exchange Commission (SEC) reporting requirements that prepare their financial statements in conformity with GAAP pursuant to the SEC’s Proxy Rules (Regulation 14A). Although AcSEC encourages the disclosure of those items by non-SEC reporting airlines, items that are identified with an asterisk are not required to be disclosed by non-SEC reporting airlines. In this chapter, a company that is required to file financial statements with the SEC is referred to as a public company. It includes publicly held entities (including entities with publicly traded debt) as well as privately held companies whose financial statements are being included in an SEC filing (e.g., as a result of a business combination or an IPO). All other disclosures discussed in this chapter are applicable to all airlines (both SEC- reporting and non-SEC reporting). Some of those disclosures are required by authoritative literature and, therefore, should be included, if applicable, in financial statements prepared in conformity with GAAP. This chapter also discusses a number of Airline_Guide_-_Chapter_7[1].doc 3 disclosure items that are not explicitly required by authoritative literature. AcSEC believes, however, that such disclosures are good industry practice and, therefore, recommends that airlines include them in their financial statements, if applicable. To distinguish such recommended disclosure items from the ones that are required, recommended disclosures are clearly identified in this chapter as being “encouraged” or “recommended.” Accounting Policies and Disclosures As required by Accounting Principles Board (APB) Opinion No. 22, Disclosure of Accounting Policies, disclosure of accounting policies should identify and describe the accounting principles followed by the reporting entity and the methods of applying those principles that materially affect the determination of financial position, cash flows, or results of operations. The financial statements should disclose accounting policies that involve a selection from existing alternatives, principles and methods peculiar to the industry, or unusual or innovative applications of generally acceptable accounting principles. Following are the areas typically considered in the selection and application of accounting policies related to airlines. Disclosures related to accounting policies that are required or recommended for airlines are also identified. Passenger and Other Revenue Recognition A detailed discussion of the passenger revenue recognition processes and the related accounting issues for passenger-ticket and other service activities is included in Chapter 3 of this Guide. Pursuant to APB Opinion No. 22, an airline should disclose its accounting policy for the recognition of revenue. Paragraph 12 of APB Opinion No. 22 states that "the disclosure should encompass important judgments as to appropriateness of principles relating to recognition of revenue . . . ." Passenger and other revenue recognition involves the use of judgments and estimates, which may have a significant effect on the airline’s results. AcSEC believes the disclosure of significant accounting policies should include sufficient detail to allow users of the financial statements to understand the revenue recognition Airline_Guide_-_Chapter_7[1].doc 4 policies including the timing of when revenue is recognized, and AcSEC recommends that the disclosure include the methods used by management to develop estimates. Unused tickets represent the main component of air traffic liability, and certain unused tickets are recognized in revenue using estimates. Significant changes in business conditions, passenger behavior, or both that affect these estimates could have a material effect on the financial statements. Accordingly, airlines should make any disclosures required by AICPA Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties (SOP 94-6). In addition, AcSEC recommends that airlines’ policy disclosures for unused tickets discuss revenue breakage and highlight the use of estimates, historical experience factors, expiration dates, or other relevant data regarding the ticket terms and conditions. For public companies, SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition, provides that “Because revenue recognition generally involves some level of judgment, the staff believes that a registrant should always disclose its revenue recognition policy. If a company has different policies for different types of revenue transactions, the policy for each material type of transaction should be disclosed.” An airline’s major source of revenue relates to the sale of passenger tickets. Other sources of revenue may include the sale of miles to frequent flyer program participants (see the “Frequent Flyer Programs” section below for further discussion), code sharing agreements with other airlines, and other fees such as change fees. If revenue related to code sharing arrangements is material, an airline is encouraged to include a description of where the revenue and the associated costs are presented in the statement of operations. (SEC)* Cargo Carriers Revenue Recognition A detailed discussion of the cargo revenue recognition processes and the related accounting issues for aircargo activities is included in Chapter 8 of this Guide. As indicated in the “Passenger and Other Revenue Recognition” section, SAB No. 104 requires that public companies disclose their method of revenue recognition related to Airline_Guide_-_Chapter_7[1].doc 5 each major type of revenue-generating activity, which for cargo carriers typically includes package delivery, freight services, and logistics contracts. (SEC)* Because under EITF Issue No. 91-9, “Revenue Recognition for Freight Services in Process,” cargo airlines are allowed to select from four alternative acceptable methods of revenue recognition for in-transit shipments, consistent with the requirements of APB Opinion No. 22, cargo carriers should disclose the method applied including the nature and significance of the estimation process. Airlines should also make any disclosures required by AICPA Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties (SOP 94-6). AcSEC recommends that cargo carriers include a discussion of estimates derived by management relating to delivery costs, and adjustments to revenue and accounts receivable relating to items such as money-back service guarantees and billing corrections. Transportation services may be provided by independent contractors. If material, consistent with the requirements of APB Opinion No. 22, an airline should disclose the method of revenue recognition related to logistics contracts where the company is considered either the principal (gross presentation) or the agent (net presentation) under EITF Issue No. 99-19, “Reporting Revenue Gross as a Principal Versus Net as an Agent.” AcSEC also recommends disclosing components of revenue recorded on a net basis. Frequent Flyer Programs A detailed discussion of frequent flyer programs (FFPs) and the related accounting issues is included in Chapter 3 of this Guide. The policies and estimation methods used to recognize service to be provided under FFPs have a significant effect on the measurement and recognition of revenue and costs related to those programs. Because there are two acceptable methods of accounting for FFPs, c</b>onsistent with the requirements of APB Opinion No. 22, airlines should disclose the method adopted—that is, the incremental cost or the deferred revenue approach. Airlines should also disclose material changes in Airline_Guide_-_Chapter_7[1].doc 6 estimates related to FFPs in accordance with FASB Statement No. 154, Accounting Changes and Error Corrections. In addition, AcSEC recommends that airlines include the following disclosures in their financial statements in relation to FFPs: • A description of the terms of the FFP. • If the incremental cost method is used, a description of the principal costs that are included in the determination of incremental cost and whether a liability is recorded for partially earned awards or only when members of the FFP have accumulated sufficient points/segments to obtain a free travel award. • If the deferred revenue method is used, a description of the method of calculating that portion of the revenue that is deferred. • The method of accounting for awards to be provided by other airlines and non-air travel rewards. • For revenue from sales of frequent flyer miles or points, the classification of the marketing and travel components. • Disclosures related to the prepurchase of miles by a third party. In addition, in accordance with SAB No. 104, for sales transactions that have multiple units of accounting (such as sales of frequent flyer miles or points), public airlines should state clearly in their accounting policy disclosures the accounting policy for each unit of accounting as well as how the units of accounting are determined and valued. (SEC)* FFP Related Disclosures for Public Airlines (SEC)*
In a letter sent to publicly held airlines in 1991, the SEC staff requested that disclosures concerning frequent flyer travel award programs be included in SEC filings. These disclosures are typically shown in the description-of-the-business section of the airline’s SEC filings, although they may be included in the financial statements or in the Management’s Discussion and Analysis (MD&A) section. Material changes in interim periods should be disclosed in quarterly reports on Form 10-Q. The disclosure items requested by the SEC were: • The significant terms of any frequent flyer and other free travel award programs sponsored by the airline. Airline_Guide_-_Chapter_7[1].doc 7 • The method of accounting for the programs, including the method of accounting for nontravel awards redeemed under the programs. • If the incremental cost method is used, each material category of cost included in its measurement. In addition, a clear description of when the accrual is made and how the cost is estimated should be provided. If the liability established for provision of future services under the programs does not include a margin representing contribution to overhead or profit, that fact should be disclosed. The amount of the recorded liability or expense should be disclosed if it is material. • The number of free travel awards outstanding at each balance sheet date (expressed in terms of mileage, equivalent revenue value, points, trips, or other similar measure). If the number of the awards outstanding does not include partially earned awards, the effect of this exclusion should be quantified. • The number of awards expected to be redeemed for purposes of estimating the liability recorded by the airline at each balance-sheet date. This may be expressed as a percentage of total awards outstanding. This disclosure should be accompanied by a description of the factors accounting for the difference between awards outstanding and awards expected to be redeemed, quantified to the extent practicable. The discussion should explain any material change in the ratio of expected redemptions to total outstanding awards that has occurred or may reasonably be expected to occur. • The number of awards actually redeemed in the periods presented. • The amount of free travel award usage expressed as a percentage of passenger miles flown for each period presented. • If the displacement of revenue customers is reasonably likely and may materially affect liquidity or operating results, emerging trends should be described in the MD&A section of the annual report. Credit Card Holdbacks Chapter 3 of this Guide provides a discussion of the accounting for credit card holdbacks. If these amounts are material, airlines are encouraged to disclose the nature and terms of Airline_Guide_-_Chapter_7[1].doc 8 the arrangements, the balance of the holdbacks, and where the holdbacks are presented in the statement of financial position. Aircraft Acquisition Costs Fixed assets and related accounting issues are discussed in Chapter 4 of this Guide. If costs associated with the acquisition of aircraft and aircraft-related costs are material to an airline’s financial statements, the airline should disclose its policies for accounting for such costs in accordance with APB Opinion No. 22. Spare Parts Spare parts and related accounting issues are discussed in Chapter 4 of this Guide. If spare parts are material to the airline’s financial statements, consistent with the requirements of APB Opinion No. 22, the airline should disclose its accounting policy, including the method used to value its spare parts and supplies as well as the method used to establish an allowance for obsolescence, including residual value assumptions. Maintenance and Repair Costs The acceptable methods of accounting for maintenance and repair costs are described in Chapter 4. FASB Staff Position AUG AIR-1, Accounting for Planned Major Maintenance Activities, requires disclosure of the method of accounting for planned major maintenance activities selected by an airline. Public airlines should also refer to EITF Topic D-88, Planned Major Maintenance Activities, for additional disclosure considerations. If the airline has contracted for maintenance on a basis other than for services as rendered (e.g., power-by-the-hour contracts), disclosures are encouraged to be made in sufficient detail to identify the method of determining payments under the contract, how the maintenance costs are recognized, and whether there are contingencies in the contract. Airline_Guide_-_Chapter_7[1].doc 9 If an airline has lease agreements that require deposits or supplemental rent to be paid to the lessor that are to be used to reimburse the airline or third-party providers for maintenance of leased aircraft, the airline is encouraged to disclose how those payments are accounted for and where the related expense is classified in the statement of operations. If the airline has applied the deposit or prepaid expense method of accounting described in Chapter 4, AcSEC believes the airline also should consider disclosing the balance of the prepaid expense account as of the balance sheet date. Leases A detailed discussion of leases and the related accounting issues is included in Chapter 4 of this Guide. Paragraph 16 of FASB Statement No. 13, Accounting for Leases, provides the required disclosures for leases in the financial statements of a lessee. Lease Disclosure Considerations for Public Companies (SEC)*
In a 2005 letter to the AICPA, the Chief Accountant of the SEC emphasized that registrants should ensure that the disclosures regarding both operating and capital leases clearly and concisely address the material terms of and accounting for leases. These disclosures should provide basic descriptive information about material leases, usual contract terms, and specific provisions in leases relating to rent increases, rent holidays, contingent rents, and leasehold incentives. The accounting for leases should be clearly described in the notes to the financial statements and in the discussion of critical accounting policies in MD&A, if appropriate. Known likely trends or uncertainties in future rent or amortization expense that could materially affect future operating results or cash flows should be addressed in MD&A. The disclosures should address all of the following: 1. Material lease agreements or arrangements 2. The essential provisions of material leases, including the original term, renewal periods, reasonably assured rent escalations, rent holidays, contingent rent, rent concessions, leasehold improvement incentives, and unusual provisions or conditions 3. The accounting policies for leases, including the treatment of each of the above components of lease agreements Airline_Guide_-_Chapter_7[1].doc 10 4. The basis on which contingent rental payment are determined with specificity, not generality 5. The amortization period of material leasehold improvements made either at the inception of the lease or during the lease term, and how the amortization period relates to the initial lease term Asset Impairment Issues related to the impairment of long-lived assets are discussed in Chapter 4 of this Guide. Under FASB Statement No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, airlines are required to perform an impairment test if events indicate that the asset’s carrying amount may not be recoverable. Events or circumstances leading to an impairment of long-lived assets may include grounding or acceleration of aircraft retirement dates, regulatory changes, terrorist activities, significant negative industry or economic trends, significant changes in the use of the assets, or reduced passenger traffic and yields. AcSEC recommends that an airline’s policy for the evaluation of the carrying amounts of long-lived assets be disclosed in the notes to the financial statements, including a description of how the airline measures an impairment loss. Paragraphs 25 and 26 of FASB Statement No. 144 set forth disclosure requirements for impairment losses on long-lived assets to be held and used. If an impairment loss related to long-lived assets classified as held for use is included in the financial statements, the airline’s disclosures shall include (a) a description of the impaired long-lived asset (asset group) and the facts and circumstances leading to the impairment, (b) if not separately presented on the face of the statement, the amount of the impairment loss and the caption in the statement of operations that includes that loss, (c) the method or methods for determining fair value (whether based on a quoted market price, prices for similar assets, or another valuation technique), (d) if applicable, the segment in which the impaired long-lived asset (asset group) is reported under FASB Statement No. 131, Disclosures about Segments of Enterprise and Related Information. AcSEC encourages airlines to consider also disclosing the following matters: Airline_Guide_-_Chapter_7[1].doc 11 • Future plans for the impaired assets • The method for determining the lowest level at which assets are tested for impairment • Management’s policies for the review of the estimated useful lives and salvage values for aircraft and spare parts • Significant assumptions used by management to estimate the fair value of the assets and the future cash flows, including discount rate, asset utilization, service life of the asset and estimated salvage value • Significant factors that indicated assets may be impaired and influenced the timing of loss recognition • Anticipated fleet retirement or replacement schedules and pending aircraft orders Restructuring and Special Charges Due to a variety of economic and competitive factors, airlines may decide to reduce operations, exit certain markets, retire a fleet of aircraft, or otherwise exit operating activities or dispose of long-lived assets. FASB Statement No. 146, Accounting for Costs Associated with Exit or Disposal Activities, sets forth reporting and disclosure requirements for exit and disposal activities. SAB No. 100, Restructuring and Impairment Charges, provides guidance regarding the extent of disclosures that should be included in MD&A related to restructuring and special charges. The SEC staff believes that it is necessary for a public company to present material exit and involuntary termination charges in tabular form, with the related liability balances and activity (e.g., beginning balance, new charges, cash payments, other adjustments with explanations, and ending balances) from balance sheet date to balance sheet date in order to explain fully the components and effects of significant restructuring charges. The SEC staff also stated its beliefs that MD&A should include discussion of the events and decisions that gave rise to the exit costs and exit plan, and the likely effects of management's plans on financial position, future operating results, and liquidity unless it is determined that a material effect is not reasonably likely to occur. This discussion should include whether the cost savings are expected to be offset by Airline_Guide_-_Chapter_7[1].doc 12 anticipated increases in other expenses or reduced revenues and clearly identify the income statement line items to be affected. Registrants should identify the periods in which material cash outlays are anticipated and the expected source of their funding. Registrants should also discuss material revisions to exit plans, exit costs, or the timing of the plan's execution, including the nature and reasons for the revisions. For exit costs and involuntary employee termination benefits relating to multiple exit plans, presentation of separate information for each individual exit plan that has a material effect on the balance sheet, results of operations, or cash flows generally is appropriate. (SEC)* The SEC staff also has noted that the economic or other events that cause a registrant to consider or adopt an exit plan, or both, or that impair the carrying amount of assets generally occur over time. Accordingly, the SEC staff believes that, as those events and the resulting trends and uncertainties evolve, they often will meet the requirement for disclosure pursuant to the MD&A rules prior to the period in which the exit costs and liabilities are recorded pursuant to GAAP. Additionally, whether or not currently recognizable in the financial statements, material exit or involuntary termination costs that affect a known trend, demand, commitment, event, or uncertainty to management, should be disclosed in MD&A (e.g., employee termination costs when the number of personnel to be terminated has been identified but the job classifications or functions and locations have not). (SEC)* In periods subsequent to the initiation date, material changes and activity in the liability balances of each significant type of exit cost and involuntary employee termination benefits (either as a result of expenditures or changes in/reversals of estimates of the fair value of the liability) should be disclosed in the notes to the interim and annual financial statements and discussed in MD&A. Additionally, if actual savings anticipated by the exit plan are not achieved as expected or are achieved in periods other than as expected, MD&A should discuss that outcome, its reasons, and its likely effects on future operating results and liquidity. See the text of SAB No. 100 for details of the required disclosures. (SEC)* Airline_Guide_-_Chapter_7[1].doc 13 With respect to "special charges," the SEC staff has indicated its expectation that, to the extent that an airline takes a “special” charge not otherwise qualifying as a restructuring charge, disclosures similar to those accompanying a restructuring charge should be provided. (SEC)* Financing Arrangements Variable Interest Entities Airlines may have arrangements that need to be evaluated under the requirements of FASB Interpretation No. 46R, Consolidation of Variable Interest Entities (revised December 2003) (FIN 46R). Examples include capacity purchase agreements with regional carriers; aircraft leases that contain residual value guarantees or fixed price purchase options; financings using enhanced equipment trust certificates, and airport fuel facility consortiums. Common structures and the related accounting issues are discussed in Chapter 6. Paragraphs 23 through 26 of FIN 46R set forth disclosure requirements for airlines that have a variable interest in a variable interest entity. In addition, to construct major airport facilities, airlines use special purpose revenue bond financings in which bonds are issued by municipalities or government/airport authorities or finance vehicles of these entities. These entities are variable interest entities; however, governmental organizations may not be consolidated under FIN 46R. Derivative Instruments and Hedging Activities Airlines enter into a wide variety of derivative instrument transactions in order to manage varying risks, including fuel price risk, interest rate risk, and foreign currency exchange rate risk. Chapter 6 discusses fuel hedging and related accounting issues. Paragraphs 44 and 45 of FASB Statement No. 133, Accounting for Derivative Instruments and Hedging Activities, set forth disclosure requirements for derivative instruments. In accordance with paragraph 44 of FASB Statement No. 133, an airline that uses derivative instruments should disclose its objectives for holding or issuing those Airline_Guide_-_Chapter_7[1].doc 14 instruments, the context needed to understand those objectives, and its strategies for achieving those objectives. The description shall distinguish between derivative instruments (and nonderivative instruments) designated as fair value hedging instruments, derivative instruments designated as cash flow hedging instruments, derivative instruments (and nonderivative instruments) designated as hedging instruments for hedges of the foreign currency exposure of a net investment in a foreign operation, and all other derivatives. The disclosure also shall indicate the entity’s risk management policy for each type of hedge, including a description of the items or transactions for which risks are hedged. For derivative instruments not designated as hedging instruments, the disclosure shall indicate the purpose of the derivative activity. Airlines are encouraged to discuss their objectives and strategies in the context of their overall risk management profile. For SEC registrants, Regulation S-X, Rule 4-08(n) contains financial statement requirements for derivative instruments and hedging activities. (SEC)* Commitments and Contingencies An airline needs to evaluate its agreements and relationships with third parties to ensure its material contractual obligations and contingent liabilities are adequately disclosed in the notes to the financial statements. Commitments and contingencies typically disclosed by airlines include purchase commitments, including orders for aircraft and fuel purchase commitments, capacity purchase agreements, legal and environmental matters, lease arrangements, general guarantees and indemnifications, collective bargaining agreements, and other employee matters. FASB Interpretation No. 45, Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34, provides guidance on the disclosures to be made by a company in its interim and annual financial statements about its obligations under certain guarantees and indemnifications that it has issued. Airline_Guide_-_Chapter_7[1].doc 15 Capacity Purchase Agreements Major Airline Disclosures Major airlines typically contract with regional airlines to provide connecting service into the major airline’s hub. These services are typically provided for under prorate or capacity purchase arrangements. A detailed discussion of prorate and capacity purchase arrangements and the related accounting issues is included in Chapter 9 of this Guide. AcSEC recommends that the major airlines disclose the following with respect to capacity purchase agreements: • The nature and terms of the agreement. • Any termination provisions. • Any minimum contractual commitments. • The statement of operations caption that includes the costs associated with a lease contained within a capacity purchase agreement. • A description of any contractual payments made to the regional along with a description of the arrangement. • If the major airline has a call option to acquire aircraft from the regional airline, the nature and terms of the arrangement, including conditions under which the option is exercisable. Regional Airline Disclosures Regional airlines typically contract with major airlines to provide connecting service into the major airline’s hub. These contracts are generally provided under prorate or capacity purchase arrangements. The accounting considerations for recognition and measurement of revenues and costs under prorate and capacity purchase agreements are discussed in Chapter 9. Because the determination of the appropriate presentation method is driven by the nature and terms of the contracts involved (the regional’s contract with the major and the Airline_Guide_-_Chapter_7[1].doc 16 contract to obtain the services), the same types of pass-through costs may be presented differently by different carriers. For example, based on different contractual relationships, one regional carrier may net fuel costs while another may reflect those costs and the related revenue on a gross basis. With respect to pass-through costs, AcSEC recommends that regional airlines consider making the following disclosures in the notes to their financial statements to assist readers in better understanding the regional’s financial statements: • The nature, terms, and amounts (which may require estimations and allocations) of contractual arrangements between the regional and major • Costs that would ordinarily be required to be incurred in the operation of the regional airline consistent with service requirements of the capacity purchase agreement that are not being incurred because they are absorbed by the major, such as fuel obtained from the major without charge • Gross transaction volume for revenue reported net, if reasonably determinable in accordance with paragraph 20 of EITF 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent” Airlines should also make any related-party disclosures required under FASB Statement No. 57, Related Party Disclosures. Aircargo Capacity Guarantees As discussed in Chapter 8, some aircargo carriers provide aircraft, crew, maintenance, and insurance (ACMI) services to other aircargo carriers. Under these ACMI contracts, customers receive dedicated aircraft capacity in exchange for a guaranteed minimum level of operation, which are generally expressed on an annual basis in the contract. AcSEC recommends that cargo carriers consider including the following disclosures in the notes to their financial statements to assist readers in better understanding their financial statements: • A description of the carrier’s revenue recognition policies related to AMCI contracts, including discussion of minimum payments and penalties Airline_Guide_-_Chapter_7[1].doc 17 • A description of typical AMCI contractual terms as well as any unusual terms related to significant contracts, and information regarding the timing and payment of minimum contractual amounts and penalties • The percentage of revenue generated from AMCI contracts • A discussion of expenses absorbed by the customer rather than the service provider under the terms of the contracts • Future contractual minimum revenues expected from AMCI contracts Segment Disclosures (SEC)* FASB Statement No 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. Operating Segments An operating segment is defined in FASB Statement No. 131 as a component of an enterprise: a. That engages in business activities from which it may earn revenues and incur expenses (including revenues and expenses relating to
transactions with other components of the same enterprise), b. Whose operating results are regularly reviewed by the enterprise's chief operating decision maker to make decisions about resources to be
allocated to the segment and assess its performance, and c. For which discrete financial information is available. FASB Statement No. 131 provides aggregation criteria and quantitative thresholds for determining which operating segments should be reported separately in the financial Airline_Guide_-_Chapter_7[1].doc 18 statements. Airline operations are often managed as a single business unit: air transportation, which includes the common carriage of passengers, freight and mail over routes authorized by the DOT. Accordingly, many airlines disclose only a single reportable segment. Some airlines manage their operations on a geographical basis, in which case each geographical operation might be considered a separately reportable segment. Airlines often allocate operating revenues to geographic reportable segments based on the origin and destination of their flight segments. Information necessary to meet certain segment and geographical area disclosure requirements of FASB Statement No. 131 may, in some instances, be similar to that which airlines report to the DOT on Form 41. (See Chapter 10 for a further discussion of DOT Form 41.) As much of an airline's tangible operating equipment can be deployed across geographic markets, airlines often do not assign long- lived assets to geographical areas. When assets are assigned, certain assets, such as inventory and other ground facilities, may be directly attributable to a reporting segment and, therefore, are identified directly with that segment. Other assets are generally used in more than one segment, and can be allocated to the segments by applying ratios similar to those used in the allocation of expenses. According to paragraph 26 of FASB Statement No. 131, an airline is required to disclose the factors used to identify the enterprise’s reportable segments and the types of products and services from which each reportable segment derives its revenues. The following highlights some of the factors that may be considered by the major, regional, and cargo carriers when identifying potential operating segments: Major Airlines – If the major airline carrier operates a regional airline, a low cost airline, or an all-cargo fleet within the larger airline, that operating unit should be evaluated to determine whether it qualifies as a separate operating segment. Airline_Guide_-_Chapter_7[1].doc 19 Regional Airlines - If the regional airline has different types of revenue arrangements (for example, prorate and capacity purchase agreements), it needs to determine if the different revenue arrangements constitute separate reportable segments. In certain situations, regional airlines may have multiple operating segments if they segregate revenue sources into separate operating subsidiaries. In order to comply with limitations imposed by their capacity purchase partners, regional airlines often form separate operating subsidiaries organized around Air Carrier Certificates issued by the DOT (“operating certificates”). These limitations, called scope restrictions, are imposed by the collective bargaining agreements at the mainline carriers and typically specify the size of the aircraft that may be flown under the operating certificate of affiliated carriers. In order to comply with these limitations, the regional carrier may be required to segregate its aircraft by size or code-share partner, or both, under separate operating certificates. In so doing, the regional carrier may also be segregating revenue sources by reporting subsidiary, if it was to have revenue derived from revenue prorate agreements in one reporting subsidiary and revenue derived from capacity purchase agreements in another reporting subsidiary. This arrangement would create multiple operating segments if the tests in FASB Statement No. 131 were met. Cargo Carriers - Cargo carriers typically segment their business using functional or geographic criteria, or some hybrid thereof. Functionally, an airline might segregate operations that include delivery of cargo from forwarding services and logistics operations. Operations that deliver via aircraft or other express transportation may be segregated from ground delivery. Geographically, a business might segregate domestic operations from international, or by a method of regional delineation. Often a company may segregate its operations using functional criteria, and further segregate using geographic criteria; for example, package operations may be broken into both domestic and international package operations. All Carriers - In addition, carriers may have various subsidiaries or other business units that contribute to the operations of the airline; for example, they may have separate Airline_Guide_-_Chapter_7[1].doc 20 subsidiaries/businesses for the repair and maintenance of aircraft, food service, hotels, procurement of spare parts, or procurement of insurance. These operations need to be evaluated in accordance with FASB Statement No. 131 to determine if they should be reported separately. Pensions Pension obligations and costs are significant to many airlines. A detailed discussion of pensions is included in Chapter 5 of this Guide. For financial statement disclosure requirements for defined benefit plans, readers should refer to FASB Statement No. 132 (revised 2003), Employers’ Disclosures about Pensions and Other Postretirement Benefits - an amendment of FASB Statements No. 87, 88 and 106, as amended by FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88, 106, and 132(R). 1 Changes in capital markets and interest rates can significantly affect the market value of employee benefit plan assets, as well as the assumptions used in determining the plan obligations, funded status, and expected future employer contributions. According to FASB Statement No. 132, an airline should explain any significant changes made to assumptions and give reasonable explanation concerning assumptions made. FASB Statement No. 132(R) requires disclosure of the benefits (as of the date of the latest statement of financial position presented) expected to be paid in each of the next five 1 * On September 29, 2006, the FASB issued FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans - an amendment of FASB Statements No. 87, 88,
106, and 132(R). FASB Statement No. 158 requires an employer to: • Recognize in its statement of financial position an asset for a plan’s overfunded status or a liability
for a plan’s underfunded status. • Measure a plan’s assets and its obligations that determine its funded status as of the end of the
employer’s fiscal year (with limited exceptions). • Recognize changes in the funded status of a defined benefit postretirement plan in the year in
which the changes occur. Those changes will be reported in comprehensive income of a business
entity and in changes in net assets of a not-for-profit organization. FASB Statement No. 158 applies to plan sponsors that are public and private companies and
nongovernmental not-for-profit organizations. The requirement to recognize the funded status of a benefit
plan and the disclosure requirements are effective as of the end of the fiscal year ending after December 15,
2006, for entities with publicly traded equity securities, and at the end of the fiscal year ending after June
15, 2007, for all other entities. The requirement to measure plan assets and benefit obligations as of the date
of the employer’s fiscal year-end statement of financial position is effective for fiscal years ending after
December 15, 2008. Airline_Guide_-_Chapter_7[1].doc 21 fiscal years, and in the aggregate for the five fiscal years thereafter. Additionally, an airline is required to provide its best estimate, as soon as it can reasonably be determined, of contributions expected to be paid to the plan during the next fiscal year beginning after the date of the latest statement of financial position presented. Estimated contributions may be presented in the aggregate combining: (i) contributions required by funding regulations or laws, (ii) discretionary contributions, and (iii) noncash contributions. According to SEC Financial Reporting Release No. 60, Cautionary Advice Regarding Disclosure About Critical Accounting Policies, if activity within an existing plan, such as earnings or returns on invested plan assets, has a material impact on the company's liquidity, capital resources, or results of operations, that activity should be discussed in MD&A. (SEC)* Risks and Uncertainties In accordance with SOP 94-6, Disclosure of Certain Significant Risks and Uncertainties, entities are required to provide disclosures in their financial statements about the risks and uncertainties existing as of the date of those statements in the following areas: nature of operations, use of estimates in the preparation of financial statements, certain significant estimates, and current vulnerability due to certain concentrations. These four areas of disclosure are not mutually exclusive. The information required by some may overlap. Accordingly, the disclosures required by SOP 94-6 may be combined in various ways, grouped together, or placed in diverse parts of the financial statements, or included as part of the disclosures made pursuant to the requirements of other authoritative pronouncements. Disclosures in SEC filings regarding risk factors are discussed later in this chapter. In accordance with the requirements of SOP 94-6, an airline, like entities in other industries, should provide a brief description of the nature of its operations, and a statement regarding the use of estimates in the preparation of financial statements. Disclosures regarding significant estimates may be made in the context of related Airline_Guide_-_Chapter_7[1].doc 22 disclosures, for example, in disclosures about impairment of assets, valuation of deferred tax assets, litigation-related obligations, and revenue breakage. Vulnerability from concentrations arises because an entity is exposed to risk of loss greater than it would have had it mitigated its risk through diversification. Such risks of loss manifest themselves differently, depending on the nature of the concentration, and vary in significance. SOP 94-6 provides that certain concentrations should be disclosed if all of the following conditions are met: (1) the concentration exists at the date of the financial statements, (2) the concentration makes the enterprise vulnerable to the risk of near-term severe impact, and (3) it is at least reasonably possible that the events that could cause the severe impact will occur in the near term. In the airline industry, concentrations arise, for example, in the availability of labor resources or, especially at regional carriers, as a result of capacity purchase agreements. SOP 94-6 provides that, for concentrations of labor subject to collective bargaining agreements (CBAs), disclosure should include both the percentage of the labor force covered by a collective bargaining agreement and the percentage of the labor force covered by a collective bargaining agreement that will expire within one year. Additionally, AcSEC recommends that airlines with labor force subject to CBAs disclose each employee group covered under a CBA, the amendable dates of the respective contracts, which contracts are open for negotiations, and the airline’s accounting policy for expected retroactive wage increases under new or amended contracts. (A detailed discussion of issues related to labor relations, including amendable labor contracts, is included in Chapter 5 of this Guide.) AcSEC encourages regional airlines with capacity purchase agreements to discuss the stability of their major airline partner regardless of whether the disclosure criteria in SOP 94-6 are met. Airline_Guide_-_Chapter_7[1].doc 23 Sales Taxes A detailed discussion of the types of taxes and fees relating to the airline industry is included in Chapter 3. EITF 06-3, “How Taxes Collected from Customers and Remitted to Government Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation),” requires disclosure of the accounting policy for any tax assessed by a governmental authority that is both imposed on and concurrent with a specific revenue producing transaction between a seller and a customer (i.e., gross or net basis). For taxes reported on a gross basis, an airline should disclose the amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented if those amounts are significant. The disclosure of those taxes can be done on an aggregate basis. Other SEC Disclosures (SEC)* Risk Factors Regulation S-K, Item 503(c), requires disclosure of significant business risk factors in SEC filings. A number of business risks exist in the airline industry, including the following: • General economic conditions • Geopolitical risks • Competition • Regulation • International operations • Service interruptions • Price and availability of fuel • Labor costs • Pension and other postretirement obligations • Insurance availability and costs • Security costs and operational constraints Airline_Guide_-_Chapter_7[1].doc 24 • Significant operating losses • High levels of debt • Interest rate changes • Liquidity and airline bankruptcies • Potential technology failures • Safety issues • Dependence on key personnel • Reliance on a limited number of suppliers • Aircraft utilization Although this list is not complete, these and other risks in the airline industry should be considered for disclosure. Critical Accounting Policies, Judgments, and Estimates In a December 12, 2001 release, the Securities Exchange Commission encouraged companies to provide in MD&A full explanations, in plain English, of their "critical accounting policies," the judgments and uncertainties affecting the application of those policies, and the likelihood that materially different amounts would be reported under different conditions or using different assumptions. In May 2002, the SEC published a proposed rule (release no. 33-8098) requiring certain disclosures relating to accounting estimates and initial application of accounting policies. In December 2003, the SEC issued Release 33-8350, which is an interpretation providing guidance regarding MD&A disclosures. Included in that interpretation is a section regarding accounting estimates and assumptions that may be material due to the levels of subjectivity and judgment necessary to account for highly uncertain matters or the susceptibility of such matters to change, and that have a material impact on financial condition or operating performance. The release states that companies should consider enhanced discussion and analysis of these critical accounting estimates and assumptions that (a) supplements, but does not duplicate, the description of accounting policies in the notes to the financial statements and (b) provides greater insight into the quality and variability of information regarding Airline_Guide_-_Chapter_7[1].doc 25 financial condition and operating performance. Readers should be alert to any final rules or additional interpretive materials published by the SEC. An airline should evaluate its accounting policies and significant estimates to determine which ones should be identified as critical accounting policies, judgments, and estimates. Typically, airlines consider the following in their evaluation: • Revenue recognition (passenger and cargo) • Long-lived assets, including impairment • Maintenance policies • Frequent flyer programs • Employee benefit plans • Goodwill and intangible assets • Derivative financial instruments • Others as deemed significant to the reporting entity Off-Balance Sheet Arrangements Regulation S-K, Item 303(a)(4), contains MD&A disclosure requirements for off-balance sheet arrangements. The material facts and circumstances of off-balance-sheet arrangements such as guarantees, certain derivatives, retained interests, and variable interests should be disclosed in a separately captioned section of MD&A. The purpose of this disclosure is to provide investors with a clear understanding of the arrangements and their material effects on financial condition, changes in financial condition, revenues and expenses, results of operations, liquidity, capital expenditures, and capital resources. MD&A should also include other information that the company believes is necessary for an understanding of its off-balance-sheet arrangements and the specified material effects. More specifically, a company should disclose all of the following: a. The nature and business purpose of the off-balance-sheet arrangements b. The importance of off-balance-sheet arrangements to liquidity, capital resources, market risk support, credit risk support, or other benefits Airline_Guide_-_Chapter_7[1].doc 26 c. The overall magnitude of a company’s off-balance-sheet activities, the specific material impact of the arrangements on a company, and the circumstances that could cause material contingent obligations or liabilities to come to fruition d. Any known event, demand, commitment, trend, or uncertainty that will, or is reasonably likely to, result in the termination, or material reduction in availability to the company, of its off-balance-sheet arrangements that provide the company with material benefits The disclosure should cover the most recent fiscal year, but it should also address changes from the previous year. MD&A in quarterly reports should inform investors about material changes in the year-end disclosures. Tabular Disclosure of Contractual Obligations Regulation S-K, Item 303(a)(5) contains a requirement to disclose information related to contractual obligations. Disclosure is required in a tabular format of amounts of payments due under specified contractual obligations. The amounts are to be aggregated by category of contractual obligation, for specified time periods. The company must present the information in a table, but can determine where within the MD&A to include the table. The information should be as of the latest fiscal year-end balance sheet date, and the table should include separate disclosure of contractual obligations for long-term debt, including interest, capital lease obligations, operating lease obligations, purchase obligations, including orders for aircraft, and, collectively, other long-term liabilities reflected on the company’s balance sheet in accordance with GAAP. The obligations should be disclosed in total for each category, and by period due, grouped by due in less than 1 year, 1-3 years, 3-5 years, and more than five years. MD&A in quarterly reports need not include this table. However, companies are expected to disclose material changes outside the ordinary course of business that arise during the interim period. Preparers should use judgment in determining the purchase obligations and other obligations to be included, and should include appropriate disclosure clearly describing items included and items excluded. In addition to items discussed above, airlines should Airline_Guide_-_Chapter_7[1].doc 27 include other items, if material, in the table of aggregate contractual obligations such as funding requirements for retirement plans and capacity purchase agreements.