In association with

AIRLINE ACCOUNTING GUIDELINE No. 1

Accounting for foreign currency translation and hedging

Effective I June 2005

International Air Transport Association

DISCLAIMER The application of this airline accounting guidance to a particular organisation may not be appropriate as it does not deal with the facts or circumstances of that organisation or the manner in which the accounting guidance will be applied. This airline accounting guidance does not address the accounting treatment and the statement implications of any particular organisation. Therefore, the airline accounting guidance should be read with this in mind. The ultimate responsibility for the accounting treatment of any organisation must rest with the directors of that organisation. IATA accounting policy Task Force and KPMG believe the statements made in this Airline Accounting Guidance are accurate, but no warranty of accuracy or reliability is given. Accordingly, neither the IATA Accounting policy task force or KPMG undertakes responsibility arising in any way whatsoever to any persons in respect of this airline accounting guidance, for any error or omissions herein, arising through negligence or otherwise however caused.

Contents

1 2 3 4

Background Objectives Current accounting standards framework Hedge accounting 4.1 Introduction 4.2 Types of hedge addressed by this guideline 4.3 Hedge effectiveness 4.4 Hedge documentation

Net investment hedges (branch accounting) under IAS 21 5.1 Introduction 5.2 Identification of foreign operation 5.3 A foreign entity used for the acquisition of aircraft 5.4 Foreign currency branches

Airline specific examples of hedge accounting 6.1 Hedges of committed transactions 6.2 Foreign currency loans as cash flow hedges 6.3 Fuel hedge accounting, including component hedging 6.4 Embedded derivatives 6.5 Intra group hedging 6.6 Macro or net exposure hedging

I ATA a c c o u n t i n g p o l i c y t a s k f o r c e

Airline Accounting Guideline 1: Accounting for foreign currency translation and hedging 1 Background

For most international airlines, the management of foreign currency position is of critical importance. Their operations will generally involve multi-currency inflows and outflows, although a significant proportion of an airline's expenditure is typically denominated in US dollars, whatever the local currency. In addition airlines frequently borrow or enter into lease obligations in foreign currencies for a number of differing reasons. These might include the availability of surplus funds generated in those particular currencies from their operations, which can then be used to meet repayments; the attraction of the cost of capital in foreign markets; or perhaps simply because they are unable to access funds for significant asset acquisitions from their local capital markets. It follows that the accounting treatment of exchange difference arising from the various foreign currency transactions has a potentially important bearing on airlines' reported results. Airlines have developed a number of strategies for dealing with the commercial impact of currency and commodity price fluctuations and these strategies are reflected in the various accounting treatments adopted.

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2 Objectives

Recent developments in International and US accounting standards in the area of foreign exchange accounting and the financial instruments frameworks have lead to substantial changes in the treatments available to airlines in accounting for their foreign currency exposures and related derivative hedging activities. This Airline Accounting Guideline is designed to summarise the accounting requirements for a variety of hedging strategies and, more importantly, to provide examples of their use and to discuss implementation issues. This Airline Accounting Guideline also deals with the net investment hedge which is a specific hedging technique that has been used in some jurisdictions and addresses the related issue of determining the functional currency of an airline or a part of it.

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3 C u rr e n t a c c o u n t i n g s t a n d a r d s f r a m e w o r k

In preparing this Airline Accounting Guideline the Accounting Policy Task Force has considered in particular International standards IAS 21 on foreign currency translation and the financial instrument standards, IAS 32 and IAS 39 together with the US standard on derivatives and related hedging instruments, FAS 133. At the time of writing, a number of revisions to the relevant International standards have been finalised and these are reflected in the accounting discussion in this guideline. The guideline has not sought to address the issues raised by the Joint Working Group's paper Financial Instruments and Similar Items (issued in 2000) which proposed prohibiting hedge accounting. [Although the issue remains on the International Accounting Standards Board's agenda, no further developments are expected in the short term.] The conceptual framework underpinning the approach to financial instruments and hedging is broadly similar in both FAS 133 and IAS 39 although there are a few important differences in detail, pertinent to the subject matter of this guideline, which are highlighted where appropriate in the narrative below.

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4 Hedge accounting

4.1

Introduction

Hedge accounting is designed to overcome the accounting mismatch that can occur when one side of a transaction is accounted for at fair value and the other side at historic cost (or not at all, in the case of committed - i.e. contractual - future transactions) and where forecast transactions are being hedged. The resulting accounting usually results in the recognition of the hedging instrument and the hedged item (or changes in its value for committed transactions) on balance sheet at fair value, or deferral in equity of fair value gains or losses that are released to profit at the same time as the underlying transaction. The aim of hedge accounting is to remove volatility from an entity's financial statements that can occur through short term fluctuations in exchange or interest rates or commodity prices. Both International and US GAAP approach hedging from the principle that it is an exception to the general rules for accounting for financial assets and liabilities. As such, any hedging relationship must meet certain criteria and be explicitly identified and documented in advance of the underlying transactions being entered into. Unless these conditions are met hedge accounting is not permitted. Two criteria that must be met for adoption of hedge accounting concern documentation of the hedge relationship at inception of the hedge and the requirement to quantitatively measure its effectiveness. These requirements are discussed below. Even though hedge relationship is considered to be economically effective, it does not follow that it automatically qualifies as a hedge for accounting purposes under either IAS 39 or FAS 133. A number of established hedging practices exist amongst airlines which even if commercially sound, may not now meet accounting requirements and hedging strategies will have to be reviewed as a consequence of this.

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4.2

Types of hedge addressed by this guideline

This Airline Accounting Guideline considers four types of hedge: natural, fair value, cash flow and net investment, focusing on the basic accounting and the requirements for hedge accounting to apply. However, the main focus of this guideline is their practical implementation.

Natural hedges
Where possible, most airlines and other entities seek to minimise their exposure to fluctuations in exchange or interest rates and commodity prices through matching the pricing of their services to inputs and related assets, liabilities and cash flows. The simplest example deals with foreign exchange risk; an airline generally incurs local currency costs at the same time as it earns local currency revenues. To the extent that the two offset, gains and losses on one are matched by gains or losses on the other. This is termed a natural hedge. No specific hedge accounting is required to achieve this result. The issue for airlines is that very seldom do currency inflows exactly match the outflows. It is this imbalance that airlines hedge through the use of derivatives and other financial instruments.

Fair value hedge

Fair value hedges hedge changes in the fair value of recognised assets and liabilities and unrecognised but firmly committed future transactions. A typical example of the latter would be the use of forward contacts to hedge the foreign currency translation risk associated with the purchase price of an aircraft between contract and delivery dates. Non-derivative instruments may also be used to hedge foreign exchange risk. As referred to in the examples in section 6 below, where a committed but unrecognised transaction is hedged for foreign exchange risk (for example in relation to an aircraft purchase), it may alternatively be treated as a cash flow hedge. Financial assets/liabilities may be hedged for any constituent risk (i.e. benchmark interest rate, credit and foreign currency) as it is assumed that fair values of the individual risks are readily ascertainable. This is not assumed to be the case for non-financial items such as the procurement of jet fuel and, consequently, they may be hedged either for at the commodity risk in its entirety, the commodity risk measured in the reporting currency or for foreign exchange risk only. The accounting for fair value hedges is straightforward - both the hedging instrument and the hedged item (in respect of the components hedged) are marked to market and gains and losses taken through the P&L. To the extent that the hedge is effective, the gain or loss on the hedged instrument should be offset by the loss/ gain on the hedging instrument.

Cash flow hedges

Cash flow hedges hedge changes in future cash flows of recognised assets or liabilities, unrecognised but committed transactions (in respect of foreign exchange risk, otherwise such hedges are fair value hedges) or uncommitted but highly probable transactions. Both US and International GAAP permit non derivatives to be used only to hedge foreign exchange risk. However, an important difference between the two is that FAS 133 is more restrictive in that it does not permit non-derivative instruments to be used as a hedge of uncommitted or forecast transactions, whereas IAS 39 does. Thus a commonly used practice

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amongst international carriers of hedging future (foreign currency) route revenues with foreign currency borrowings does not qualify as a hedge under US GAAP.

Under both GAAPs, derivatives may be used to hedge any component of risk.
The accounting for cash flow hedges is as follows: The hedging instrument is measured at its fair value (analogous to marked-to-market or determining a present value of cash flows using valuation techniques) and the change in value for the effective portion taken to equity initially. Any ineffective portion of the hedge caused by the hedging instrument is immediately recognised in the profit and loss statement. This will occur where the position is over-hedged or there is significant basis risk in the hedging relationship (i.e. the change in fair value of the hedging instrument is greater than the change in value of the hedged item), and when the transaction takes place if it is under-hedged. The amount held in equity is recycled to the profit and loss statement as the future transactions affect the profit and loss account and where the hedged item is a financial asset or liability. Under International GAAP, where the hedged asset is non-financial, either the treatment can mirror that of financial assets, or its initial carrying value may be adjusted by the amount held in equity - this is termed a basis adjustment. Basis adjustments are not permitted under US GAAP; instead, the amount held in equity is recycled to profit over the life of the hedged item (for example for a fixed asset, in a pattern consistent with the depreciation charge.)

Net investment hedge

A net investment hedge is a derivative or non-derivative hedge of currency risk of a net investment in a foreign entity. Historically, a number of airlines have used the net investment hedge under local GAAP to limit exchange differences on the carrying values of aircraft and related borrowings. The continued applicability of this approach is discussed in paragraph 5 below. The accounting for net investment hedges is as follows: The hedge instrument is measured at fair value and the currency element or spot translation component of the change in value for the effective portion is taken to equity. For a derivative hedging instrument, any ineffective portion is taken to profit as is the change in its time value, as this does not form part of the hedge. This means that the derivative used to net investment hedge requires split accounting, and an effect on P&L is certain. Under International GAAP, for non-derivative hedging instruments, the ineffective portion is also taken to equity; under US GAAP this is taken to profit. Amounts taken to equity are recycled to profit on the sale of the foreign entity.

4.3

Hedge effectiveness

In order to qualify for hedge accounting, any hedge relationship must be shown to be effective on both a prospective and retrospective basis. At inception the hedge transaction must be expected to be highly effective in achieving offsetting changes in the fair value or cash flows attributable to the hedged item. A hedge is normally regarded as highly effective if, at inception and throughout the life of the hedge relationship, the enterprise can expect changes in the fair value or cash flows of the hedging instrument to significantly offset

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changes in the fair value or cash flows of the hedged item. Typically 'highly effective' is interpreted as in the range of 80% to 125%, as for the retrospective test. Actual results for a hedge relationship must be within the range of 80% to 125% to allow for unexpected ineffectiveness. Hedge effectiveness is of particular practical importance where proxy instruments are used as hedging instruments. For example, many airlines use crude oil derivatives to hedge their fuel price risk as part of longer term hedging strategies. Typically these strategies require the hedging instrument to be swapped into a more highly correlated product such as gasoil and eventually jet fuel as the hedge horizon approaches spot. Although spot and forward crude oil and jet fuel prices have historically been closely correlated over the medium to long term, short term correlations of particularly spot prices have each exhibited greater divergence and may fall outside the 80% to125% range. Under either IAS 39 or FAS 133 this would result in the whole of the hedge being deemed ineffective for that period, giving rise to accounting induced volatility in reporting of earnings. The prospective assessment test for hedge effectiveness together with the need for frequent measurement of actual effectiveness means that poor correlations may preclude hedge accounting notwithstanding the economics of the hedge strategy.

4.4

Hedge documentation

All hedge relationships must be documented at their inception. The documentation must include: the airline's risk management objective and strategy for undertaking the hedge; the nature of the risk being hedged; identification of the hedged item (asset, liability or cash flows) and the hedging instrument; and how hedge effectiveness will be measured and assessed on an ongoing basis. The method and procedures to be consistently applied for the particular hedge should be described in sufficient detail to establish a firm basis for measurement at subsequent dates. In practice, some standardisation of the documentation may be possible, incorporating by reference, for example, details of the airline's risk management objective and the hedge effectiveness measurement process.

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5 N e t i nv e s t m e n t h e d g e s u n d e r I AS 2 1

5.1

Introduction

As noted above, some airlines have been able under their local GAAP to use net investment hedges in relation to aircraft ownership entities typically designed to match exchange rate changes arising from dollar denominated financing and assets. This has been achieved by translating both the carrying amount of the aircraft and the related debt at the closing rate, offsetting exchange gains and losses through the statement of realised gains and losses/ other comprehensive income. The mechanism to achieve this accounting treatment varies between airlines for their particular circumstances and the GAAP that they report under, but all essentially treat the aircraft, borrowings and related revenues and expenses as an entity separate from the rest of the business (for convenience termed a 'foreign operation'). There are a number of issues that need to be considered in deciding whether a net investment hedge is justifiable under current IAS or US GAAP. These include: the assets, liabilities, revenues and costs that form the foreign operation; the degree of autonomy and substance of the foreign operation; and determination of its functional currency. All three are interdependent and are discussed together below.

5.2

Identification of a foreign operation

In certain circumstances, an airline might seek to argue that a part of its business operates with a functional currency other than that of the core airline (usually the currency of the country in which the airline is headquartered). Such a separate part may be a subsidiary, associate, joint venture or branch of the airline; the legal form is not important. To sustain the argument, the activities of the foreign operation must be based or conducted in a country or currency other than those of the reporting entity. The operation should be managed separately from the remainder of the airline rather than simply being an extension of it. IAS 21 ensures as far as possible that the selection of the functional currency is a question of fact rather than management choice. The key factors involved in that determination revolve around the currency in which revenues are received and costs denominated and settled, currency in which funds from financing activities are generated and the economic environment in which the business operates. The level of US dollar costs and revenues of non-US international airlines can be significant. Typical costs include fuel, aircraft leases and aspects of maintenance and pilot training. US dollar revenues for passenger and cargo businesses can also be significant.

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In the airline industry, with its significant international operations in market segments such as the North Atlantic, which for non US airlines potentially receive significant US dollar revenues and US dollar costs the above considerations require an analysis of the substance of the operation. Two practical considerations in two particular situations are considered below: a special purpose vehicle to hold aircraft and a foreign currency branch.

5.3

A foreign entity used for the acquisition of aircraft Scenario

An airline establishes a separate legal entity ('Special Purpose Vehicle' or 'SPV') to hold aircraft and related (US dollar denominated) borrowings. The question to be addressed is in what circumstances is it justified for the SPV to have a functional currency different from that of its parent airline?

Guidance
If the structure simply involved the acquired aircraft being leased internally to the group's airline business, its business would be viewed as an extension of the airline and the SPV would accordingly have the same functional currency as the parent. If the foreign entity also has significant third party leasing revenue, then the conclusion might be different. In such cases, judgement would be required. Key factors in the determination would include: the nature and duration of the leasing contracts - i.e. short term leasing of excess capacity (indicates extension of airline) versus longer term leases; a demonstration that third party lease rentals are not just incidental to the total SPV revenues; and the degree of autonomy of the subsidiary's management.

5.4

Foreign currency branches

Scenario
An airline holds a number of aircraft and related US dollar denominated borrowings and generates US dollar revenues and costs. In what circumstances (if any) can the airline treat these foreign currency assets, liabilities and flows as an embedded 'foreign currency branch'?

Guidance
The main practical consideration in relation to this particular accounting treatment is whether an aircraft and its associated financing and revenue generation capability are sufficiently separable from the rest of the business to enable a clearly defined foreign branch to exist. For many airlines, the answer has hinged on the interpretation of local accounting standards. As an example, the UK accounting standard, SSAP20 allowed a relatively wide interpretation, permitting a branch to consist of a ...group of assets and liabilities which are accounted for in a foreign currency. For this reason, accounting standards aligned to UK standards previously have allowed some flexibility in this area.

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It is considered that International Accounting Standards set a higher threshold. If a branch was appropriately established, the foreign operation accounting would follow; however the branch structure would have to faithfully represent the economic substance of the underlying position. The thresholds to be overcome are in relation to: the separation and autonomy of management - indicators would need to include: - management reporting in the functional currency, for example this may exist in some inter airline alliance structures; - separate 'governance board' which reviews management's strategy, performance and remuneration. There would need to be a level of autonomy from the airline's 'main board'; and - decision making ability around key airline activities such as fleet procurement, product offering and fare pricing. the extent of foreign currency sales and costs - indicators would include: - passenger and cargo revenue in the foreign currency, including any revenues swapped into the foreign currency, would need to be significant (probably the greater proportion) of overall branch revenues; and - the settlement of labour costs, including senior management. Labour costs are often the largest component of an airlines cost base and the denomination of settlement often reflects the location of the management decision making level of financing - indicators would include: - the currency of borrowings indicated must be the same as the functional currency of the operation; and - currency revenue must be proportionate to the assets and liabilities denominated in the currency. We believe that passing these thresholds would be very challenging (if not impossible) for most airlines to meet and therefore would not expect many airlines to have embedded foreign currency branches accounted for under the net investment method.

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6 Pr a c t i c a l e x a m p l e s o f h e d g i n g f o r a i r l i n e s

The following section sets out typical instances of hedge arrangements common in the industry.

6.1

Hedges of committed transactions

Issue - Airlines may use forward contacts or other derivatives to hedge their currency exposure when committing to future purchases, particularly of capital items such as aircraft. Guidance - Both US and International GAAP permit either a fair value or cash flow approach to hedge accounting to be used to hedge committed transactions provided that foreign currency risk is being hedged, otherwise cash flow hedging is required. In a fair value hedge of a firm commitment, changes in the fair value of the (unrecognised) asset being purchased relating to the risk being hedged, and changes in value of the hedging instrument, are included on the balance sheet and in the profit and loss account (meaning that to the extent that the hedging instrument is fully effective, there will be no net profit effect). In a cash flow hedge, changes in fair value of the hedging instrument are taken initially to equity and subsequently recycled to either the balance sheet on recognition of the asset or progressively to the profit and loss statement when depreciation associated with the asset is recognised as is required under US GAAP. . We would expect most airlines to follow the cash flow hedge accounting approach, particularly as this allows a single cash flow hedge to be used where a transaction starts as uncommitted but highly probable and then, as the transaction date approaches, becomes committed. On recognition of the asset, we would also expect hedge gains and losses to be offset against the carrying value of the asset as a basis adjustment to streamline the accounting process and reconciliation of the hedge reserve in equity.

6.2

Foreign currency loans as cash flow hedges

Issue - Certain airlines borrow in currencies in which they have surplus net cash inflows after operating expenses (whether from route revenues or other specific transactions) taking advantage of a natural hedge to mitigate translation risk on cash flows. Cash flow hedge accounting is used to ensure that the accounting reflects the substance of the transaction, particularly that the revaluation at balance sheet date of the loan does not go through the profit and loss statement. Cash flow hedging is permitted under IAS (for foreign exchange risk only) but not under US GAAP (only derivatives may be used to hedge forecast transactions).

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Guidance Use of route revenues to hedge borrowings

The APTF expects the use of cash flow hedging to manage the currency exposures will increase as it becomes more difficult to demonstrate a net investment hedge relationship. Airlines arrange their borrowings in currencies in which they have net cash inflows thus taking advantage of a natural hedge of their cash flows. The accounting requirement for a cash flow hedge ensures that the reporting of the hedge relationship in the profit and loss statement follows the substance of the transaction. Although straightforward on concept, there are a number of implementation issues to deal with. These include: An ability to forecast route revenues with a degree of accuracy. Only highly probable forecast transactions may be hedged and therefore airlines must be able to demonstrate that they are able to forecast demand accurately and that they can point to a history of stable revenue generation in that currency. The greater the proportion of revenue to be hedged, the more important the ability to forecast accurately as hedge ineffectiveness is more likely to occur (through revenue falling short of that expected). Equally, where revenues are forecast a number of years out, it will become harder to demonstrate the high degree of probability of those transaction occurring that is required without a consistent track record of revenue generation and ability to accurately forecast demand. As a rule, the APTF would expect that the percentage of revenue hedged would fall as the period into the future increased; Care needs to be taken in defining the hedge to ensure that it is effective and will remain so throughout the hedge. Significant changes in passenger demand may lead to hedge ineffectiveness (attributed to variability in the component of the forecast load designated as part of the hedge relationship) which would be taken directly to profit and loss statement and in more extreme cases where effectiveness fell outside the 80-125% corridor would require hedge accounting to be discontinued. The hedge must be defined in terms of a gross cash flow which is determinable. For example a hedge of the first $20 million of revenue would be acceptable whereas none of a hedge of 20% of revenue, of the last $20 million of revenue or of $15 million of net income would qualify as a hedge relationship under IAS39. Testing prospective and retrospective effectiveness of hedge relationship. Formal effectiveness testing, both prospectively and retrospectively, must be performed at each reporting date, as a minimum six monthly for listed entities, or on a more frequent basis depending on the nature of the hedge relationship and requirements of the reporting entity such as quarterly or monthly to coincide with management reporting processes; Determining the timing of the cash flows hedged. For example, the degree of accuracy possible in matching revenue receipts to loan repayments will affect the effectiveness of the hedge. If the matching is not sufficiently close, the hedge effectiveness may fall outside the 80%-125% corridor which would inhibit hedge accounting for that period. Documentation and periodic re-designation of hedges as additional loans are taken or existing loans repaid;

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 Gain or loss on revaluation of the loan is held in equity and recycled to the profit and loss statement offsetting the impact of any change in exchange rates on the measurement of the hedged revenues. Calculation of amounts to be recycled can be complex in practice; and Profit and loss account presentation. The recycling of the deferred exchange rate movements to profit will affect both the revenue and interest paid lines with a consequent impact on gross and operating margins.

Use of the proceeds of disposal of an aircraft to hedge its initial carrying value
Certain airlines have sought to use the anticipated proceeds from the disposal of a financed aircraft to hedge the associated loan. Thus, for example, an airline with a policy of holding new aircraft for only seven years before disposal would argue that the disposal proceeds acts as a hedge against a portion of the initial loan, reducing the airline's exposure to foreign exchange fluctuations against the US dollar. Such an arrangement could meet the requirements of IAS 39 (but not, at least initially, FAS 133 as it uses a non-derivative to hedge a noncommitted transaction) provided that transaction and its timing was considered to be highly probable. Determining whether there is sufficient probability is a question of judgment, but there may be a number of indicators that support the argument. These include loan terms permitting (or requiring) early repayment of the loan on a sale of the aircraft, the airline's business plan, firm orders for replacement aircraft, evidence of the airline's ability to enter into such a transaction and a prior track record of making such disposals. Even if an initial assessment indicated that the transaction was not considered sufficiently probable and therefore hedge accounting was not available, it would be appropriate to reassess the hedge position as the anticipated sale date becomes closer (and hence presumably more likely) to the point where a sale becomes committed. The question of when it would be possible to recognise a hedge that meets the hedge accounting criteria in this case remains one of judgment.

Contractual guaranteed minimum residual value

The position is more straight forward in the case where an aircraft is acquired and financed by US dollar borrowings with a contractual guaranteed minimum residual value (expressed in dollars) from the manufacturer. In the APTF's view, the airline is not exposed to currency risk on the portion of the debt covered by the guaranteed residual and should not therefore recognise translation gains and losses on it through the profit and loss account.

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6.3

Fuel hedge accounting, including component hedging

Introduction - Many airlines hedge the price of jet fuel but do so in a variety of ways and with a number of instruments including forward purchases, swaps, options etc. Airlines with more sophisticated treasury functions may hedge the components of jet fuel directly, others will hedge jet fuel itself, or, if such hedging instruments are not available, will use a proxy (eg. crude oil). This section deals with examples of common jet fuel derivatives first and then considers the use of proxy hedging instruments including crude oil derivatives.

Guidance - jet fuel derivatives Jet Fuel Cap

A fuel cap essentially fixes the highest price that an airline will pay for the quantity of the fuel hedged. It is essentially a purchased option. Typically a premium is paid to the issuer of the instrument. Both the instrument and the premium are required to be accounted for under US and International GAAP. The value of a cap is split into two components; the intrinsic value (essentially the amount by which the option is in the money) and the time value (the remainder of the fair value). Typically, the premium paid for purchasing a cap represents the time value of the option. Under local GAAP, premiums paid and settled cash flows representing the intrinsic value of the option on expiry are often deferred and brought to account in the profit and loss statement over the hedge period or the measurement of the hedged item. There is a subtle difference in accounting for options under IAS 39. The premium paid is likely to be recognised to the profit and loss statement over the life of the cap based on changes in the fair value component of the option (unless hedge effectiveness is assessed on the total change in value of the hedging derivative). Changes in the intrinsic value of the option can be taken to equity in the case of a cash flow hedge until the expiry of the instrument and recycled to the profit and loss statement when the underlying hedged item is recognised. It is the requirement for the changes in the time value to be taken to the current period's profit and loss statement which brings profit and loss volatility into accounting for caps for the first time.

Zero cost collar

A zero cost collar comprising a bought cap and sold (written) floor is a popular instrument as it effectively limits the fuel cost to a range for typically no or limited net premium paid. Where the spot price of the fuel remains within the collar range, neither option is exercised and no additional accounting entries are required in the absence of a cash flow impact. Written options are not normally permitted as hedging instruments. However, in combination with a purchased option, provided that the end result is a zero cost collar or net purchased cap, hedge accounting may be used. Within the range, changes to intrinsic value offset requiring no additional accounting entries. Any net premium paid upfront would be accounted for in a manner similar to purchased cap.

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Guidance - proxy hedges

Neither US nor International GAAP permits components of non-financial assets to be individually hedged (other than currency risk) - thus one could not hedge only the crude oil component of jet fuel. However, it is permissible to use a combination of derivatives (for example, crude oil and jet fuel differential forward contracts to hedge the jet fuel price. The instruments will need to have the same maturity date as otherwise it is unlikely that the combination will meet the prospective and retrospective effectiveness tests; Given that components of the jet fuel price may not be hedged, airlines will be faced with using a suitable proxy when jet fuel derivatives are unavailable (for example, when looking more than 12-18 months out). The usual proxy is a derivative based on crude or heating oil. Such arrangements may not qualify for hedge accounting under IAS 39 as they may fail the test for prospective effectiveness because although crude oil and jet fuel prices have historically been highly correlated over a longer time frame, the correlation is much lower over short periods. Where the hedging strategy specifically contemplates swapping from crude to jet fuel derivative products over the duration of the strategy, consideration would need to be given to assessing effectiveness using forward as distinct from spot prices. Importantly, the requirements of the measurement process will be influenced by the nature risk management strategy. IAS 39 The requirement for prospective hedge effectiveness is similar to FAS 133 and interpreted (although this is not expressly stated) as permitting such hedge instruments providing they fall within the 80%-125% effectiveness corridor. Even if the prospective test is met (whether under IAS or US GAAP), such hedges may fail when looking at correlation retrospectively as it may be found that the price correlation has not always been within the 80%-125% corridor on either a period by period or cumulative period basis of assessment. Jet fuel hedge using component derivatives is designed to overcome the lack of liquidity for longer term jet fuel forward contracts that is common in European and Asian markets. There are a number of approaches used but all are similar in execution. Essentially an airline uses a crude oil forward to cover fuel purchases up to five years out, supplementing that with a separate forward to cover the heating oil differential as these become available up to a year or so out. Finally a third forward representing a jet fuel differential is added over a shorter period. IAS 39 specifically permits such a composite approach to building an effective hedge. It requires that hedges be designated for the remaining life of the derivative used and thus the derivatives should be coterminous (though they will, of course, have different start dates). As the additional 'layers' are added, the previous hedge is de-designated to be replaced by a hedging instrument comprising the 'old' hedge plus the new component. The new hedge will need to be separately documented. Importantly, the amounts deferred in equity under the original hedge remain deferred until the hedged transaction occurs.

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Determining effectiveness
Neither IAS 39 nor FAS 133 mandates an approach to determining hedge effectiveness either prospectively or retrospectively allowing a variety of methodologies to be used. However, the documentation of the hedge must detail how hedge effectiveness is to be measured and the approach should be consistent with that used in similar hedges unless there is good reason to change. The prospective test is measured over an appropriate timeframe. Typically the length of the period for accumulating data used would be similar to that of the hedge, although, where that period contained a 'one-off' event, it would be appropriate to take a longer period. Where statistical techniques are contemplated, the data set to simulate measurement of the effectiveness of the hedging relationship will cover a much longer time period sufficient to generate a suitable number of data points replicating the hedge period. Retrospective effectiveness normally is determined using the dollar offset. The offset method expresses the degree of offset between changes in the fair value of the hedging instrument and changes in the fair value or cash flows of the hedged item as a percentage. The retrospective test should be measured on a cumulative or period-by -period basis. Normally it is advantageous to measure effectiveness on a cumulative basis. In early periods there is a higher chance that the hedge effectiveness will fall outside the 80%-125% range as the correlation has historically been lower over shorter time frames. The risk of falling outside the range in later periods will fall as the 'history' grows. In all cases, any ineffectiveness in the hedge must be taken to profit together with any change in the time value of the derivative. This may still give rise to significant volatility in an airline's results. The requirement to use actual results limits the application of statistical techniques. Unlike US GAAP, IAS 39 does not explicitly approve as a concession the use of rolling data sets which incorporate observations prior to inception of the hedge relationship. IAS 39 does permit the effectiveness of a hedge relationship to be improved by choosing a hedge ratio other than one-to-one so long as this designation is specified in documentation of the hedge relationship.

6.4

Embedded derivatives

Issue - In certain circumstances contracts may be considered to contain embedded derivatives as well as the underlying host contract. Both International and US GAAP require that these embedded derivatives be separated. For example, a contract denominated in a currency other than that of the parties to it might be considered to have an embedded foreign exchange derivative which would then have to be accounted for separately. Guidance - The question of whether an embedded derivative should be separated from its host contract depends on how closely related the derivative is to the host contract. Other than financing or leasing contracts, the most likely area where embedded derivatives might occur is with contracts denominated in a currency other than that of the airline. Generally if the contract currency is that of a party to the contract then the contract need not be separated. This is also the case where the contract currency is one in which the relevant good or service is routinely denominated or the currency commonly used in contracts in the economic environment in which the transaction takes place. The APTF would not expect many industry standard contracts to be require separation.

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 Embedded derivatives may also occur in leasing and financing arrangement Primarily these would occur when lease or interest rates are leveraged or indexed to prices of items not closely related to the contract (eg. aircraft lease rates indexed to the price of gold). Again, the APTF would not expect such contracts to be commonplace in the industry. In the aviation industry, it is commonplace for contracts to be denominated in US dollars even where the dollar is not the functional currency of any of the contracting parties. Common examples of such contracts include: j Fuel purchases; Aircraft and aircraft spares purchases; Aircraft leases; Inter airline settlements; and Airframe and engine maintenance.

6.5

Intra group hedging

Guidance - IAS 39 is more flexible than US GAAP on dealing with hedge accounting within groups. US GAAP permits hedge accounting only where the entity with the risk is party to the hedging transaction - thus a central treasury dealing with risk across the group will need to write back-to-back contracts with the relevant subsidiary. International GAAP does not require the entity with the risk to be party to the hedging transaction.

6.6

Macro or net exposure hedging

Issue - Both US and International GAAP prohibit macro hedging of risks. Special concessions apply in the case of hedging interest rate risk under IAS 39. Macro hedging is the hedging of a net position without designating specific transactions for the hedge. An airline looking at its net US dollar position will take into account a number of flows including revenues, operating and financing costs and fleet sales and purchases. To qualify for hedge accounting, the hedge of the net position must be designated against specific flows (eg. the first $X million of fuel purchases). A hedge not so designated is a macro-hedge and does not qualify for hedge accounting. Guidance - In practical terms, airlines can avoid the macro hedging issue through careful designation of their hedges of the net exposure. In effect they rely on a natural hedge of the offsetting elements and a specific hedge of an underlying gross position (a key requirement is to identify the hedged item, meaning that a net position does not qualify). The hedge documentation will need to be clear as to the precise flows being hedged.

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