Audit of Airline Industry - Assignment Example

Audit Industry Report The measurement of costs, such as unit revenue and unit cost for the Airline industry, are very relevant and of great importance when it comes to accounting and auditing. Furthermore, the relationship between both these factors plays a vital role in deciding how successful an airline is operating. Hence, apart form unit costs and unit margins, the measurement of unit margins hold equal importance in measuring the performance within the industry. In order to normalize these factors, and as a measure of capacity, to have aircraft fly all of the available seats are not that much of a measure of performance than taking into consideration the seats that are not occupied. As a comparison between two airlines, higher performance may just not be a measure of a better unit revenue as for many, the airliner may be facing a higher unit cost in contrast to others operating within the same industry. In parallel to all these factors, capital available for growth or horizontal and vertical integration of services is also a key factor to the industry’s long term success (Taneja, 1987). Many successful airliners may have to prefer long term gains and profits to measure their success and would plan to expand or integrate over a longer period of time. Specifically for the airline industry, growth may be accounted for in terms of the capacity for growth. Datamonitor.com (2007) reports that the United States airlines industry grew by more than 8 percent in 2006 which placed it at a combined value of more than $145 Billion. However, In order to grow, an airline and the industry itself would need more funding. The need for funding will be directly correlated to the performance of the company, as capital is generated form investors and for most equity investors, the airline may have to show growth in its equity over time. Moreover, apart the airline must also be a viable interest to the debt investors. For this to happen, and to conform with the debt investors, a more than reasonable ratio of debt-to-asset is required. Apart from the focus on these direct factors that influence investment, there are several other key factors that play a turning role in raising capital for the airline industry and more focus is placed on international expansion. To wage international expansion into the equity of an airline, a risk assessment factor has to be incorporated in the financial sheet of the airlines in such a way that it has to reflect more associated risks such as currency risks or political risks. These forms of risks are more appropriate for larger airliners which operate internationally and evolve to have not a particular dominating national home (Thompson, 2005). The airline industry may also have to follow many general principals as any other industry- with main objectives to seek profits. In lieu of these objectives, the airline industry may have to report its financials on the basis of the different markets it is operating in and the different types of innate or natural forms of competition it may face. This competition and factors associated with it may be influenced by a number of reasons and mainly- the other airlines operating in the same region and many other means of transport that provide both direct and indirect competition to the airline industry, such as the railroads and other over land transport services. For the airline industry it is of the extreme importance to take the share of the sales made in foreign markets as a proper percentage of the total revenue that is accumulated from all the different geographic regions outside the home country form which the company is operating on. Along with these considerations, the cost of fuel may be taken as a cost percentage of the overall operating expenditure. However, depreciation has to be excluded along with amortization and interest from the operational expenditure benchmark and financial analysis have to be moved towards gearing- which is a percentage of net debt to net debt plus equity. These become important implications of auditing and accounting for the airline industry (AICPA, 2007). Another financial benchmark that is used by the airline industry is the interest cover. This is the earnings that that incurred before interest and taxes and are further weighed as a division over the net interest expense. Since many airliners are working towards more long term goals and expansion and coherently the investors are looking for the parallel kind of information, long term debt is more resourceful information in judging the airline. This is taken to see in simplicity as being a percentage of non-current debt to total debt and is recommended as a useful tool by the AICPA (2007). Building on the performance of the airlines, investors are also looking for another key indicator which is the Revenue seat factor. This information is recalled form the statements as a percentage of revenue passenger kilometers to available seat kilometers. These ratios are simpler to follow and specifically can be calculated from the financials of any airline operating internationally or locally. But one of the main obstacles in judging the performance of the airline can be with measuring the exact total or the exact number of different types of costs associated with the industry. For example, the concept of marginal cost may at times tend to be a very elusive concept in the airline industry. As a more contemporary approach to marginal cost may be that it is just the additional cost to produce or manufacture one additional unit of output. However, this normalized definition of marginal cost may not apply on the airline industry. It may however be considered at the seat level or at the aircraft level and that too in the most basic of flight route situation of a flight that is traveling form one place to another without having any stops in between (Fojt, 2006). Furthermore, airlines may also increase the level of their capacity through different means in order to meet the challenges of competition that exists now or for the future new entrants. Since the basic elements in terms of input to an airline are aircraft, labor and fuel, combined increase in the capacity of an airline to increase these inputs would very likely increase their output as well (Datamonitor.com, 2007). In this case, the marginal cost of operating an airline must not be dealt at the set level but at the aircraft level. Measuring the marginal cost at the aircraft level would mean to include the costs of making that aircraft and crew available for that flight. In these proportions, the marginal cost must be incorporate din such a way that it should reflect the opportunity cost of making use of the aircraft specifically for the city-pair market that is being considered rather than evaluating it or comparing it to any other city-pair marlet. Following the same principals, the marginal cost should also take into account the cost of any new aircraft that is added to the existing operating fleet of the airline and so must the average variable cost account for these same cost factors (Fojt, 2006). Another factor that complicates the evaluation of average variable cost and or marginal variable cost is the commission that is paid to the travel agents who reserve tickets for airlines on their behalf. This practice may be overridden for an effort in relation to capturing market and retaining traffic that are exposed to new entry. Since the contracts of these activities and the in-depth information is not available at hand for the public, so apart from a good guess a more precise figure is not available. This leads to a variable amount in the calculation or estimation of the marginal or average variable cost. But still, in some cases, many practices have come to form that the at least some of these payments and contracts are structures which result in all the additional payments made to the travel agents are in proportionate and made relevant to the market share and strebgth of an airline for the segmented market (Thompson, 2005). These relationships between the travel agent commission and the marginal costs may be based more on a nonlinear relationship between the market share of the airline and the concept of the override commission that is paid to the agents. However, this may not be precisely correlated to any increase in the marginal cost of serving a passenger. The airlines, among many other challenges in auditing their performance, face the dilemma that there has not been an easier passage to compete against these overrides and often the extent of the size and importance of the affects of these relationships cannot be completely understood. Judging the variance in calculating these relationships, airlines find it difficult to maintain one price level that reflects the marginal or variable cost and end up setting up different prices for the seats on a single flight (Pulvino, 1998). Moreover, the differences in prices may also be influenced by the variety of different services. These services include the segments in which seats are divided on an airline in relevance of price and are the first class, the business class and the coach class. The fares of these seats vary from high to low from first to the coach class. Another factor in services includes the availability of discount fares and a vide variety of restrictions such as not serving meals on board or charging for the meals. An example of a very common restriction in the airline industry is that often in long hauls, they require an advance payment for any hotel stops the passengers may require. For many reasons and the major chunk of this part, all of these restrictions and barriers set by the airlines are there to structure a price discrimination to make use of the flight outbound optimally and generate the maximum profits wherever possible. Airlines try to divide the passengers or their customers in relation to their elasticity of demand and develop their fare systems in such a way that the customers with more inelastic demand will be charged with higher fares as compared to those with more elastic demand (Pulvino, 1998). The airline industry faces several strategic financial risks that are further spread over its operations and risks involving hazards. For the investors, financial risks forecast a lot of uncertainty due to changes in economic systems and fluctuations in revenues, operating expenditure and financing costs. The rate of interest and the risk involved in the hike in prices of fuel are the major source of the inherent risks that are a thereat to the airline industry. Since airlines are faced with many growing international markets, volatility and a huge array of trends may not be forecasted and still may be seen in interest rates, currency values and the price of fuel. However, if these inherent risks are managed properly, any airline may be able to gain a competitive edge over the other and the industry as a whole can grow at a much larger pace, while providing better services to the customers (Smith, 1995). In addition to these key factors, the airline industry may also be subjected to unexpected volatility in market variables and operating environment. The key financial risks that are invoved for the industry are linked to the the cyclical demand, strong price competition, high capital investment, high gearing levels and higher fixed costs. All of these influences in the operations of the airlines are of high impact and reduce the ability of airlines to internally hedge or to take up any other offsetting action (NCESCAI, 1993). Works Cited AICPA (American Institute of Certified Public Accountants). 2007, Exposure Draft: Proposed Audit and Accounting Guide for Airlines. American Institute of Certified Public Accountants. Datamonitor. 2007, Airlines in the United States, www.datamonitor.com. Fojt, M. 2006. The Airline Industry. Emerald Group Publishing. NCESCAI (The National Commission to Ensure a Strong Competitive Airline Industry). 1993. Change, Challenge and Competition: A Report to the President and Congress. Washington, D.C.: U.S. Government Printing Office. Pulvino, T.C. 1998, ‘Do asset fire sales exist? An empirical investigation of commercial aircraft transactions’, The Journal of Finance, vol. 53, pp. 939–78 Smith, T. 1995. Why Air Travel Doesnt Work, Fortune, 3 April: p43. Taneja, N. 1987. The International Airline Industry: Trends, Issues, and Challenges, # Lexington Books. Thompson, Arthur A., Jr., et al. 2005. Crafting and Executing Strategy: The Quest for Competitive Advantage – Concepts and Cases. McGraw-Hill Irwin. Word Count: 1,736 Read More