22747 Financial Reporting Analysis

1. Qantas Background and Strategy

Qantas (ASX: QAN) founded in 1920, nickname flying Kangaroo - is widely regarded as the world's leading long distance airline and one of the strongest brands in Australia. Qantas group operates in four core segments: Qantas and Jetstar as passenger flying businesses, Qantas Freight as a courier service and Qantas Frequent Flyer. Its broad portfolio also includes other airlines, and businesses in specialist markets such as Qantas Holidays and Q Catering. In terms of operation scale, Qantas accounts for 65% of domestic aviation capacity, 20% international capacity and 80% of airfreight delivery services, directly employs 33,000 Australians and in-bound tourists Qantas carried contribute $24 billion to the Australian economy per annum1. Qantas main rival in Australia is Virgin Australia Airlines (VAH). Qantas vs. Virgin Mkt Cap. QAN VAH
2,435 854

During the financial year 2011/12, Qantas group faced a number of significant challenges including natural disasters, huge unfavorable movement in fuel price and an unprecedented industrial dispute. These factors resulted in the groups reporting statutory loss after tax of $245 million despite the solid $3 billion in cash.

ROE

NPM

EPS

(4.1%) 8.40%

1.36% 2.23%

(10.8) 1.60

In short term, Qantas groups core strategy is to profitably grow its two flying brands, Qantas and low-cost Jetstar. Qantas will seek to strengthen its leading positions in premium markets while Jetstar will expand locally and into international leisure markets. In longer-term strategy, the group aims to restructure its international business in an attempt to eliminate mounting losses. The so-called 5-year international turnaround plan aims to reduce the capital intensity of the business by forging partnerships with carriers in certain sectors that are uneconomical. Cost controlling is also among the groups top priorities, leading example of which is the large-scale job cutting of 1000 announced in 2011.

2. Accounting policies - Alignment to the groups strategy - Level of Flexibility:

As per Qantass annual report 2011/12, Qantas group has applied wide range of notable accounting policies, all of which are prepared in accordance to AASB standards. Within the scope of this report, we will be analyzing 5 major policies relevant to the group operation.

22747 Financial Reporting Analysis

Accounting Policy/ Standard Applied AASB118 - Revenue Recognition AASB 121 - Foreign Currency Transaction AASB 116 - Property, Plant and Equipment AASB 137 - Provisions, Contingent Liabilities and Contingent Assets AASB 119 - Employee Benefits

Overall Level of Flexibility Medium Low ???? (I guess Low) Medium Moderate

2.1. AASB118 - Revenue Recognition: Qantas group arranges their operating revenue into 3 categories namely Passenger Revenue, Freight Revenue and Other Revenue; involving a number of accounting policies in which revenue are recognized differently (See Analysis in Appendix) Under Statement of Significant Accounting Policies, the group reported on how revenue is recognized. All these recognition processes are complied with the standard set out in AASB118. Judging from the recognition criteria of the group, the level of Flexibility is rated as table above. Passenger Revenue: recognized when passengers or freight are uplifted or when tours and travel air tickets and land content are utilized. Passenger recoveries including fuel surcharge on passenger tickets) are included in net passenger revenue. Notably, the group recognizes unused tickets as revenue using estimates based on the terms and conditions of the ticket which is set out by the group themselves; this effectively indicates that Qantas management board has the direct influence and a significant level of manipulation on the portion of income they want to recognize. Freight revenue: included the Freight fuel surcharge. This amount despite being compared to other airlines, is clearly within the power of control of the management. Other income: including results from claims for liquidated damages is recognized when all performance obligations are met, including when a contractual entitlement exists, when it can be reliably measured and probable that the economic benefits will accrue to the Qantas Group. Non-operating income such as income from assets disposals, dividend revenue also explained within the statement. This category of revenue demonstrates low flexibility level. 2.2. AASB 121 - Foreign Currency Transaction: Qantass flying network comprises of 182 destinations in 44 countries which means they have to deal with foreign currencies on an extremely regular basis thus accounting for this matter is important. In addition, under AASB 121, Qantas in preparing financial statements must translate other foreign currencies into Australian dollars. Qantas assets, liabilities, and income statements of foreign operation are 2

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translated to the Australian dollars at prevailing exchange rates at either the dates of the transactions or balance date except where hedge accounting is applied. Exchange differences arising on translation are recognized in other comprehensive income (for Transactions) and are presented within equity in the Foreign currency translation reserve (for foreign operations). When a foreign operation is disposed, the difference is reclassified to the Consolidated Income Statement as part of the gain or loss on disposal. With respect to Foreign Currency Transaction, Qantas management board has little control over because the currency rates are externally established; the only time where they do have some impact is when non-monetary assets liabilities denominated in foreign currencies are accounted for. Management can pick the date where exchange rates are in their favor. 2.3. AASB 116 - Property, Plant and Equipment: Majority of Qantass assets is items of Property, Plant, and Equipment (66.8 per cent of total assets), which are measured at initial cost or estimated cost less accumulated depreciation and impairment losses. As of June 2012, Qantas possessed $ 14,139 million dollars worth of Property, Plant and Equipment, an increase of 3.57% when comparing with the previous financial year ($13,652m). This increased amount indicates that Qantas has made a sound business improvement. Depreciation of these owned assets except for freehold land are provided on a straight-line basis over their estimated useful lives from the date of acquisition. For this key accounting policy, Qantas has complied with AASB 116 Property, Plant, and Equipment. Therefore, the valuation of these assets plays a critical part in Qantass performance and they would be subjected to an impairment test in accordance with AASB 136 Impairment of Assets. During the year, in International Transformation Plan, Qantas recognises an impairment loss of property, plant, and equipment is $147,000 which is made where the carrying amount of an asset or cash generating unit exceeds its recoverable amount. On another hand, Qantas has experienced a reduction of 2.8% in having cash and cash equivalents that suggests Qantas has less liquidity than their previous financial year. The accounting policy states that cash and cash equivalents consist of cash at bank and on hand, cash at call and short-term money market securities and term deposits that are readily convertible. 2.4. AASB 137 - Provisions, Contingent Liabilities and Contingent Assets: With a total of $1,307 billion of Provisions (current and non-current, represents 8.5 percent of total liabilities), it is absolutely critical that Qantas accounts for it properly. In accordance to AASB137, the group accounts for provisions for dividends, employee benefits, onerous contracts and insurance and legal. It is calculated using pre-tax rates that reflect current market assessment of the time value of money and the risks specific to the liabilities and have maturity dates approximating the 3

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terms of Qantas obligations. Among the Provisions, the Redundancies, restructuring and other employee benefits increased to $168 million from $58 million in 2010/11 (189%). This increment is anticipated due to announcement of a 1000 job-cutting plan; however, there were no further explanations on what estimates the group used thus there exists some moderate flexibility for the particular provision. 2.5. AASB 119 - Employee Benefits: Qantas directly employs 33,584 full-time equivalents as at 30 June 2012 across 200 separate job categories. According to 2011/12 annual report, the Manpower and staff related expenses were increased to $3,774 million from $3,695 million in 2011, accounts for 23.7% of its total expense. AASB119 requires employee benefit provisions to be discounted to their present value using a discount rate determined by reference to market yields at the end of the reporting period. Complying with AASB 119, Qantas now uses the State Government Bond yields rather than Federal Government Bond yields previously used. The changes in discount rates resulted in a decrease in the Workers Compensation provision of $15 million and an increase in the long service leave provision of $45. The net effect of these changes was a $30 million increase in provisions at 2012. Accounting for the groups Employee Benefits is detailed, reflecting the changes introduce by AASB while offering some room for management flexibility as in the end, it is still a provision which essentially based on expectations and estimates.

3. Evaluate Accounting Strategy - Management incentives

Under normal circumstances, where certain degree of flexibility is available when preparing the reports, the board of management is prone to take advantage to hide the unfavourable figures thus create a gap between the actual performance and the reported. This can mislead the stakeholders in assessing the group overall. Given the level of flexibility that Qantas employed during the process of preparing the annual report, there is a good chance that some figures are at manipulated. Reporting a Statutory Loss after Tax of $244 million, it is sensible to assume that Qantas board tried to minimize this figure. This can be done via fixing some of the revenue recognition criteria, particularly the terms and conditions to effectively recognize a larger portion unused tickets as revenue. Change in terms and condition is not to be abused frequently but is possible. One of the common incentives for CEO to cook the report is to boost up the remuneration packages being granted. Analysing the remuneration for the groups Key Management Personnel, the findings indicate that this is not the case. Non-statutory remuneration disclosure 4

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reflects the actual pay the KMP actually get for financial year 2011/12. There is a significant decrease ($1.7 million or 14.6%) in total pay comparing to previous year where Qantas made a $249 million Profit after Tax. CEO Alan Joyce also declined his $792,000 award under Short term rewarding scheme. Therefore, there is weak evidence that Qantas board has abused the flexibility in accounting standards to get paid more.

4. Evaluate Quality of the Disclosure

Overall, Qantass annual report was well presented and complied with the mandatory disclosure requirements set out by relevant accounting standards. They clearly delivered financial statements in Directors Report and Review of Operations (performance of 4 segments include Qantas, Jetstar, Qantas Frequent Flyer and Qantas Freight) which helps readers understand the report. In addition, Qantas provide extra materials such as data book, investors fact file. However, there are shortfalls in statutory accounts, only accounting numbers and brief explanations of changes their financial performances are delivered which constrains investors who are not familiar with complex accounting figures from understanding managements approach. Throughout the report, estimates are used in certain sections such as Discount rates for Provisions, Fair Value of Qantas Frequent Flyer and Intangible Assets. Despite of possible great impacts of estimates on other accounts, limited sensitivity information is provided regarding the method used to compute these items. One of Qantass major issues during the period is the prolonged Industrial Dispute, this is reported to cost the group a huge amount of $194 million; however, components and calculation process is not explained under the scope of the report. In response to bad news about losses in international routes, Qantas reports its changes by using international transformation during the year and subsequent period. In addition, Qantas provides no further explanation for an impairment loss of property, plant, and equipment even it states the information will be explained in details. The Qantas Group is subject to foreign currency, interest rate, and fuel price and credit risks. Derivative financial instruments and hedging is a complicated task. The report is in accordance with disclosure requirements however explanation remains way complicated for majority of report users. In short, under the groups perspective, although it is not required to provide detailed information on each item/matter to the public as long as the report provides true and fair

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condition of the firm, any single figure can mislead the report users thus create inefficiency and lose investment opportunities.

5. Potential questionable Accounting Number

In analyzing the 2011/12 Annual Report of Qantas, we have identified the following questionable accounting numbers.

6. Undo Distortion Possibility 7. Media Reviews

During the financial year 2011/12, the media and press have been continuously reporting on Qantas major issues arise. On the industrial dispute debate, Clayton Utz released an article in March 2012 regarding the lock out that Qantas management took in response to the strikes from ALAEA and TWU. After the urgent FWA hearing, Qantas was able to bring an end to the protracted negotiations and trigger arbitration of the agreements. Since then, Qantas and the unions were able to reach agreement but writer opined that Qantas dispute demonstrates the need for legislative change to make it easier for an affected party to apply for suspension or cooling-off of protected action. Media discussion on Qantas also focused on several aspects of its accounts. The article Qantas posts $244m loss, cancels order for new jets analyzed Qantass first reported net loss since it went private in 1995. The article also quoted a survey by financial news service Bloomberg which result demonstrated the level of disappointment of the public. However, investors were pleased by the decision to cancel orders for 35 new Boeing 787s, which will save Qantas approximately $AUD8.1 billion.

22747 Financial Reporting Analysis

1- http://www.mondaq.com/australia/x/234664/employee+rights+labour+relations/The+Qantas +dispute+employers+lockout+ministerial+intervention+and+Fair+Work+Australias+decision

22747 Financial Reporting Analysis

22747 Financial Reporting Analysis

Appendices

INCOME STATEMENT ANALYSIS REVENUE Passenger Freight Other EXPENSE

Manpower/ staff related Fuel Other

2012 ($000) 12,494 $784 2,446 3,774 4,220 2,828

2011 ($000) 12,042 842 2,010 3,695 3,627 2,455

2012 %
79.5% 32.1% 15.6% 23.7% 26.5% 17.8%

% Change
3.75% -6.9% 21.69% 2.1% 16.4% 15.2%

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BALANCE SHEET ANALYSIS

2012 ($000)

2011 ($000)

2012 %

% Change

Assets

Cash Receivables PPE

3,398 1,111 14,139 1,876 3,172 1,119 1,136 5,430 737

3,496 1,027 13,652 1,738 3,067 577 1,111 5,454 647

16.0% 5.2% 66.8% 12.3% 20.7% 7.3% 7.4% 35.5% 4.8%

(2.8%) 8.2% 3.6% 7.9% 3.4% 93.9% 2.3% (0.4%) 13.9%

Current Liabilities Non-Current Liabilities

Payables Revenue received in advance Interest bearing liabilities Revenue received in advance Interest bearing liabilities Provisions

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