Financial Accounting 101 Report

Case 12: Property, Plant and Equipment in the Aviation Industry

(Singapore Airlines, Cathay Pacific, British Airways, Malaysia Airlines)

INSTRUCTOR: Chung Sung Gon

By: Ashutosh Khetan, Sneha Sultania, Amelia Aw, Joshua Lau, Claire Lee, Wee Yang Lin (Section: G5)

Table of Contents
1. Introduction 2. PPE as a percentage 2.1 Ownership of Aircrafts 3. Comparison of the companies using ratios 3.1 Fixed Asset Turnover 3.2 Return on assets 4. Reasons for Low PPE ratio of Malaysia Airlines 5. Addition and disposal of PPE of Singapore Airlines 5.1 Addition of fixed assets 5.2 Disposal of fixed assets 6. Conclusion 2 4 4 5 5 5 6 9 9 10 10

7. Annexure 1 Annexure 2 Annexure 3 References

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1. Introduction
Fixed assets refer to a long-term tangible piece of property that a firm owns and uses in the production of its income and is not expected to be consumed or converted into cash any sooner than at least one years time. They are typically in the form of Plant, property and Equipment. (PPE) In this report, we will be looking into the airline sector and examining the PPE ratios of four different airline companies: Cathay Pacific, British Airways, Singapore Airlines and Malaysia Airlines. It should be noted that the PPE of an airline primarily and mostly

comprises of its fleet of aircrafts, land and other PPE like flight stimulator and training aircrafts. The four companies, listed above are extremely well known and popular among the travellers in the particular regions and even across the globe. In order to analyze better, we would first look at the four companies at a glance: Cathay Pacific Airways is an international airline registered and based in Hong Kong, offering scheduled cargo and passenger service to over 105 destinations around the world. Their corporate headquarters is at Hong Kong International Airport. British Airways is UKs largest international scheduled airline, flying to over 550 destinations at convenient times, to the best-located airports. Whether customers are in air or ground British Airways takes pride in providing a full service experience. Singapore Airlines has evolved as one of the most respected travel brands around the world. It has one the worlds youngest fleet in the air, a network spanning five continents, and the Singapore Girl as their symbol of quality customer service and care. Malaysia Airlines is the national carrier of Malaysia and is recognized as Asias largest, flying more than 14 million passengers to over 100 destinations across 6 continents. Recently, Penton Medias Air Transport World Magazine, one of the leading aviation magazines, awarded the Phoenix Award to Malaysia Airlines. The focus of our report will be on the PPE and PPE ratio of the above companies. In the first section, we will highlight the PPE as a percentage of the total assets and draw comparisons across companies. We will also assess if owning aircrafts is critical to the operations of an airline. The following section will calculate the fixed assets turnover and the return on assets ratios compare them. In the next section, we would go deeper into the reasons why Malaysia Airlines has a relatively low PPE ratio when compared to the other three airlines. Here, we will look extensively into the accounting policies outlined in the annual reports. In the last section we will be concentrating on Singapore Airlines and compute the net additions made to the fixed assets during the period of

2007-2008. We will also look at the resulting gain or loss from the disposal of fixed assets in the same period.

2. PPE as a percentage
In Table 1 (Annexure 1), the four airline companies have been listed down. The fixed assets and the total assets of all the companies are used to compute the PPE percentage, i.e. percentage of fixed assets to the total assets. British Airways has the highest PPE percentage of 64.6 with Singapore Airlines closely following up at 62.8%. Cathay Pacific rounds up to 53% but surprisingly, its seen that this percentage of Malaysia Airlines dips to 20.5%, lowest of the four.

2.1 Ownership of Aircrafts

Ownership of aircrafts proves to be beneficial for the big companies. PPE ratios for a big airline companies, like the four above, depend heavily upon the ownership of aircrafts and hence is critical in their operations. There are a few main reasons why a big airline company should own their aircrafts. The cost of purchasing an aircraft is definitely cheaper than leasing in the long run. Moreover, big airlines have the capital to afford the purchase. The airlines are able to configure the aircraft when they own them, which is essential as they could plan and decide the seating arrangements and segregate the different price tiers. This counts as one of the competition factors for the big airlines companies. Therefore, the ability to configure their aircrafts helps them to compete more effectively. Purchasing an aircraft gives the companies a newer and more reliable fleet. Reliability on the airline is one of the differentiating factors for the big airlines, which directly affects their reputation in the airline industry. In terms of costs, leasing aircrafts debits very high rent expenses on the income statement every year as compared to the high initial expense of purchasing the aircraft for just that year. This leads to a lower Gross profit each year.

However, for smaller companies ownership of aircrafts isnt critical. Given their purchasing capacity, smaller airlines tend to lease their aircrafts, which is rational. Purchasing an aircraft for smaller airlines could only be done through financing with debt, since they have insufficient capital. The interest expense and the depreciation expense could exceed the rent expense, which wouldnt make any economic sense. When market conditions are bad, leasing aircrafts allows them to reduce their costs by terminating the short term leasing contracts. They are able to cut down on unprofitable trips, instead of letting the aircraft idle.

3. Comparison of the companies using ratios

Two ratios would be used to compare the four companies: Fixed Asset Turnover Return on Assets

3.1 Fixed Asset Turnover

Fixed asset turnover is a measure of the companys ability to generate revenue from its plant, property and equipment (PPE). It is calculated as a ratio of net sales generated to net PPE. Among the four airlines, Malaysian Airlines has the highest fixed asset turnover of 7.13 while Singapore Airlines, Cathay, and British Airways have fixed asset turnover of 1.12, 1.21, and 1.15 respectively. (Table 2, Annexure 1). A higher ratio is better, because it indicates that the company has less money tied up in fixed assets for each unit of currency of sales revenue. A declining ratio may indicate that the business is overinvested in plant, equipment, or other fixed assets.

3.2 Return on assets

Return on assets measures how much profit a company generates for every dollar in total assets. It is calculated as a ratio of net income to total assets. Malaysian Airlines has the highest return on assets among all four airlines, at 0.087. Return on assets for Singapore Airlines, Cathay, and British Airways are 0.051, 0.066 and 0.053 respectively. (Table 3, Annexure 1)

A high ROA indicates strong financial health of the company and that it has been able to earn on a smaller investment. Higher the ROA, the more profitable is the company. Low ROA indicates that the company has not been able to earn a high net income given its total assets, which is not a good sign for the company.

4. Reasons for Low PPE ratio of Malaysia Airlines

As mentioned in section 2, the PPE ratio of Malaysia Airlines is relatively low and the principal reason we have recognized is the way Malaysia Airlines recognizes its leases assets on its balance sheet. In order to understand the reasons behind this low PPE in greater details, it is first important to understand the meaning of a few terms. A lease is a rental agreement in which the tenant (lessee) agrees to make rent payments to the property owner (lessor) in exchange for the use of the asset. There are two categories of leases: Capital/financial lease: Accounting doe a financial lease is much like accounting for the purchase; the lessee enters the asset into the lessees long-term asset accounts and records a long-term lease liability at the beginning of the lease term. Thus the lessee capitalizes the asset even though the lessee may never take legal title to the asset. Operating lease: These are basically rental agreements between the lessor and the lessee. To account for operating leases the lessee debits Rent Expense and credits Cash. The properties or equipment via operating lease are not reported on the balance sheet of the lessee. In the aviation industry, the companies on an average recognize their leases as capital leases and recognize the asset and the liability on their balance sheet. However the accounting policies of Malaysia Airlines is different, which results in its low PPE ratio. 1. Firstly, leasehold property can be broadly divided into leasehold land and other types of property. Malaysia Airlines recognizes only the cost of acquiring the land till date

less accumulated depreciation. Leasehold land were stated at cost less accumulated depreciation and impairment losses. Malaysia Airlines Annual Report 2007 This means that no portion of the lease payments payable is recognized on the balance sheet. British Airways, Cathay Pacific Airways and Singapore Airlines have different accounting policies and do not recognize it at cost less depreciation, implying that they recognize the lease payments payable on their balance sheet. Thus, the portion of leasehold land recognized on Malaysia Airlines balance sheet will be less than that of other airlines even if the leasehold lands and deals are identical. 2. Another reason why Malaysia airlines PPE ratio is lower than that of the other airlines mentioned is the accounting policy of Malaysia Airlines regarding the treatment of prepaid-rent on leasehold land. Malaysia Airlines recognizes prepaid rent on leasehold land a completely separate class of assets and doesnt recognize it under PPE. However, other airlines recognize it under PPE. This divides the PPE of Malaysia Airlines into smaller segments and decreases the PPE value on the balance sheet without decreasing the value of the total assets. This again, results in a lower PPE ratio. This information can be obtained from the annual report of Malaysia Airlines. The report mentions that previously, Malaysia Airlines used to include prepaid rent of leasehold lands under PPE but due to a recent change in policy, it has been included as a separate asset on the balance sheet. This creates a decrease in total PPE value without changing the total asset value on the books. The image (Annexure 2 a) shows the details regarding the changes: 3. The third and perhaps the largest contributor to Malaysia Airlines low PPE ratio is nature of ownership of its aircraft fleet and its recognition policies regarding financial and operating lease agreements. Firstly, Malaysia Airlines recognizes that majority of its aircrafts and other flight related assets are on lease agreements. The Company leased a majority of its aircraft as well as certain engines (Malaysia Airlines Annual Report 2007-2008, page 147). This implies that it has a large

obligation every year in terms of lease expenses. The only other airline that has a similar situation is Cathay Pacific. Table 4 (Annexure 1) shows that Cathay Pacific, Malaysia Airlines and British Airways have a significantly higher leased asset value to total PPE value ratio. This implies that a large portion of PPE used by Cathay Pacific, Malaysia Airlines and British Airways are leased. Looking at the table, the ratio of lease payment to total expense ratio is significantly higher for Malaysia Airlines and Cathay Pacific. This implies that Singapore Airlines and British Airways do not pay much for their leased assets when placed in comparison. Thus, Malaysia Airlines and Cathay Pacific have a large proportion of assets leased and pay large expenses as lease charges. Singapore Airways clearly doesnt lease many of its assets and thus, can be expected to have a high PPE ratio. British Airways is a peculiar case and there might be several reasons for the case. Firstly, the lease asset ratio includes several asset classes and not just PPE. Cathay Pacific and Malaysia Airlines provide a breakdown of their PPE into leased and owned, which British Airways doesnt. For example, British Airways leases a large portion of its simulator and other operating software, which has agreements of up to 150 years. This might imply a large value and a small annual payment obligation unlike aircrafts. British airways might also be leasing out several of its assets retaining the title and value on their balance sheet. What can be said for certain, is that British Airways doesnt pay high annual rates of leased assets and thus, it is unlikely that a large proportion of their fleet is leased. Cathay Pacific and Malaysia Airlines are two companies that lease a large proportion of their aircraft fleet, typically the largest component of PPE in airline companies. The reason why Malaysia Airlines has a low PPE ratio and Cathay Pacific has a high PPE ratio is that Malaysia Airlines doesnt believe that it retains the titles in operating leases and records them at cost less depreciation. For financial leases, they record the present value of all future payments due under PPE. Cathay Pacific treats the aircrafts as they were purchased outright which means it records the market value of the leased assets on the books and depreciates it accordingly. The market value of the asset is likely to be

significantly greater than the current value of all future payments and thus, for similar assets, Cathay Pacific will recognize a greater value of PPE on its balance sheet. Thus, Malaysia Airlines PPE ratio will be lower than that of Cathay and other airlines, which lease its fleet. Another fact that supports this reason is that a large proportion of Malaysia Airlines leases are operating leases. Malaysia Airlines has determined that it does not retain all the significant risks and rewards of ownership of these assets and hence, the aircraft and freighters do not form part of the aircraft, property, plant and equipment of the Group. (Malaysia Airlines Annual Report 2007-2008, Page 146) The ratio of operating lease payables to financial lease payable for Malaysia Airlines is 18:1. Which shows that a large amount of its assets are under operating leases. Since Malaysia Airlines doesnt recognize operating leases in PPE, its PPE amount is expected to be lower than competing airlines. The same ratio for Cathay Pacific is at almost 1:2. The difference is staggering and is one of the principal reasons why Malaysia Airlines PPE ratio is so low.

5. Addition and disposal of PPE of Singapore Airlines

5.1 Addition of fixed assets
In 2007, Singapore Airlines made additions to its fixed assets. Additions of fixed assets can be derived from the T-account of PPE. (Annexure 3 c)The beginning balance is derived from the total PPE of year 2007. The ending balance is derived from the Total PPE of 2008. The PPE is already stated at cost less accumulated depreciation and accumulated impairment losses; hence no further deduction is required. The addition for the year is 1651.2, which is calculated as follows: Additions to PPE = Ending Balance of PPE Beginning Balance of PPE + Depreciation

The journal entry for this addition has been annexed. (Annexure 3a) The annual report of Singapore Airlines (2007-2008) reports this addition on its balance sheet under PPE. (Annexure 2)

5.2 Disposal of fixed assets

In 2008, Singapore Airlines sold fixed assets worth SGD 539.5 million. This resulted in a net gain of SGD 89.3 million. The journal entry for this has been annexed. (Annexure 3 b)

6. Conclusion
It is clear from the analysis that different companies even in the same sector have different accounting policies with regard to PPE in this case. Each of the four companies, in this case, have their own set of policies and accounting norms, and it is important to understand the policies of each one of them before concluding anything about the financial position of a particular industry as a whole. The companys financial policies impact the balance sheet and a smart investor needs to understand the impact of these policies. PPE in the airline industry is critical and we saw how its nature can change across airlines with different business strategies.

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7. Annexure 1
Table 1

Table 2 Singapore Airlines

In SGD millions

Cathay Pacific
In HKD millions

British Airways
In GBP millions

Malaysian Airlines
In RM millions

Net Sales Net PPE Fixed Asset Turnover

14,494.4 12,994.3 1.12

75358 62,388 1.21

8492 7,357 1.15

14,686 2,061 7.13

Table 3 Singapore Airlines

In SGD millions

Cathay Pacific
In HKD millions

British Airways
In GBP millions

Malaysian Airlines
In RM millions

Net Income Total Assets Return on assets

1,314.4 25,992 0.051

7,739 117,650 0.066

602 11,384 0.053

875 10.054 0.087

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Table 4 Malaysia Airlines

PPE percentage of Total Assets

Cathay Airways

Singapore Airlines

British Airways

20.5

53.0

62.8

65.3

Lease Expense as percentage of total expense

14.7

12.9

2.9

2.1

Lease assets to PPE ratio

60.9

47.3

6.5

45.1

Table 5 Calculation for Table 4:

Lease Expense Malaysia Airlines Cathay Pacific Singapore Airlines British Airways 2119412 7091 379.9 169 Lease PPE value Malaysia Airlines Cathay Pacific Singapore Airlines British Airways 8775558 29491 1073.9 3277 PPE value Malaysia Airlines Cathay Pacific Singapore Airlines British Airways 2061 62388 16474.1 7263 Total Expense 14413413 55106 13180 7878 Total PPE Value 14413413 62388 16474.1 7263 Total Assets 10054 117650 26515.2 11123 Ratio 14.7 12.9 2.9 2.1 Percentag e 60.9 47.3 6.5 45.1 Percentag e 20.5 53.0 62.1 65.3

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MALAYSIA AIRLINES Operating Lease Payables Finance Lease Payables 7767584 430081 18.0607467

CATHAY PACIFIC Operating Lease Payables Finance Lease Payables 14138 28146 0.502309387

Annexure 2
2 a.

2 b.

(Source: Singapore Airlines Annual Report 2007-2008)

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Annexure 3
3 a. Journal Date 2008 Amount PPE, net Cash Debit 1651.2 1651.2 Credit

3 b. Journal Date 2008 Amount Cash Accumulated Depreciation PPE: Total Gain on Disposal Debit 539.5 829.5 1279.7 89.3 Credit

3 c.

BB 16311.7 Addition 1651.2

Depreciation 1488.8

EB 16474.1

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References
Themin Suwardy. Understanding Financial Statements: A Case-Based Approach. Pearson

Harrison Jr; Horgren; Thomas; Suwardy. Financial Accounting: International Financial Reporting Standards. Pearson, Eighth Edition

Annual Reports: Singapore Airlines (2007-2008); Cathay Pacific (2006-2007); Malaysia Airlines (2006-2007); British Airways (2007-2008)

The Big Buy: Aircraft buying and leasing for Low cost Airlines (2011). Retrieved from: http://blogs.terrapinn.com/bluesky/2011/01/19/big-buy-aircraft-buying-leasing-costairlines/

Aircraft Leasing: Buy or Rent? (January 21, 2012); Print Edition. Retrieved from: http://www.economist.com/node/21543195

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