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 entitys 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. KPMGs 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 Fernandezs 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 worlds 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 MAS
Malaysia Airlines, the countrys 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 assets at fair value through profit and loss (including derivatives) Held to maturity (amortized cost) Loans and receivables (amortized cost) Available for sale financial assets (fair value through equity) Source: MASB Website, HDBSVR Financial Liabilities Financial liabilities at fair value through profit and loss (including derivatives) Other financial liabilities (amortized cost) Financial guarantee contracts Commitments to provide loans at below market interest rates

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 entitys 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 1 Type of hedging relationship and treatment according to accounting principles Type of hedging relationship Fair value hedge Treatment 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 The portion of the gain or loss on the operation 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 Asia

Air Asia only applied FRS 139 Financial Instruments for the Group and Companys 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 Investments With FRS 139 Reclassified as available for sale financial assets Non current Measured at cost Measured at fair value plus transaction investments Subject to impairment 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; or The 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 Recognised at fair value on date of financial statements inception (initial recognition and on inception. measurement) Re-measured at fair value (subsequent measurement) Intercompany Loans and advances Fair value that is lower than cost (initial loans were recorded at cost. measurement) Amortised cost (subsequent measurement) Loans and receivables Measured at invoice Fair value plus transaction costs (initial Noncurrent amount and subjected measurement) receivables to impairment Amortised cost using the effective Reclassified as loans interest method (subsequent and receivables measurement) Undiscounted amount Fair value (initial measurement) payable Amortised cost using the effective Noncurrent interest rate method (subsequent financial measurement) liabilities Source: Annual Report 2010, Air Asia Bhd, available at: Prior to FRS 139

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 139 FRS With FRS 139 Financial Assets 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 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. 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 liabilities 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.

Loans and Gross proceeds receivables receivables less provision for doubtful debts.

Available Cost less for sale impairment losses

Held to Cost less maturity impairment losses

Borrowing

Proceeds less directly attributable transaction costs

Derivative financial instruments Derivatives 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 hedge The 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 Asia Figure 1 Significant Accounting Policies

Source: Annual Report 2010, Air Asia Bhd, available at: Figure 2 Summary of Significant Accounting Policies

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

Figure 3 Summary of Significant Accounting Policies

Source: Annual Report 2010, Air Asia Bhd, available at: Figure 4 Significant Accounting Policies for Financial Assets

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

Figure 5 Significant Accounting Policies for Financial Assets

Source: Annual Report 2010, Air Asia Bhd, available at: Figure 6 Significant Accounting Policies for Financial Assets

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

Figure 7 Significant Accounting Policies for Derivative Financial Instruments

Source: Annual Report 2010, Air Asia Bhd, available at: Figure 8 Significant Accounting Policies for Derivative Financial Instruments

Source: Annual Report 2010, Air Asia Bhd, available at: Figure 9 Available for sale financial assets

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

Figure 10 Other investments

Source: Annual Report 2010, Air Asia Bhd, available at: Figure 11 Disclosure in the Financial Statements: Derivative Financial Instruments

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

Figure 12 Disclosure in the Financial Statements: Financial Instruments

Source: Annual Report 2010, Air Asia Bhd, available at: Figure 13 Disclosure in the Financial Statements: Financial Instruments

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

Malaysia Airlines (MAS) Figure 14 Significant accounting policies

Source: Annual Report 2009, http://ir.chartnexus.com/mas/report.php

Malaysia

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Figure 15 Significant accounting policies

Source: Annual Report 2009, http://ir.chartnexus.com/mas/report.php

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Figure 16 Significant accounting policies

Source: Annual Report 2009, http://ir.chartnexus.com/mas/report.php

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Figure 17 Significant accounting policies

Source: Annual Report 2009, http://ir.chartnexus.com/mas/report.php

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Figure 18

Source: Annual Report 2009, http://ir.chartnexus.com/mas/report.php Figure 19

Malaysia

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Source: Annual Report 2009, http://ir.chartnexus.com/mas/report.php

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Figure 20

Source: Annual Report 2009, http://ir.chartnexus.com/mas/report.php

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Figure 21

Source: Annual Report 2009, http://ir.chartnexus.com/mas/report.php

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Figure 22

Source: Annual Report 2009, http://ir.chartnexus.com/mas/report.php

Malaysia

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