BFA303 Auditing

Preliminary Inherent Risk Assessment of Qantas Airways Ltd

Prepared by Reza Riantono Sukarno (139526) 14th May 2012 Words count: 1,967

Executive Summary Qantas group is the largest aviation servicer in Australia. Its main business is passenger air travel, which is serviced under two brands: Qantas and Jetstar. It has some other subsidiaries as well, such as freight and frequent flyer. This report analyze the inherent risk present in Qantas as required by ASA 315 by assessing the riskof material misstatement by understanding environment and entity. Qantas used the be ranked as the world safest airlines, however the reputation was stripped off due to various accident Qantas has in the recent years. Qantas is also having financial challenges due to increasing competition from overseas carriers that have cost advantage and lighter regulations. However, Jetstar have been performing impressively due to the increasing demand for budget carrier. Significant risk area in the entity and environment are: loss of market share due to increased competition, workers unions and industrial action, fuel price and carbon pricing, aging fleet and capitalization of maintenance and overhaul cost and credit rating downgrade. Whereas decreasing risk area are: penetration to budget market in Asia Pacific. Analysis of financial accounts that may be significantly affected by the risks mentioned above are: property, plant and equipment, legal cost and provision for legal cost, unearned revenue and operational expense.

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Table of Contents Executive Summary............................................................................................................................... i Introduction ........................................................................................................................................... 1 Business Structure and Objectives....................................................................................................... 2 Inherent Risk ......................................................................................................................................... 4 Risk Increasing ............................................................................................................................ 4 Risk decreasing............................................................................................................................ 5 Risky Accounts ..................................................................................................................................... 7 Property, plant and equipment .................................................................................................... 7 Legal cost and provision for legal cost ...................................................................................... 7 Unearned revenue........................................................................................................................ 7 Operational Expense ................................................................................................................... 8 Appendix ............................................................................................................................................... 9 Q1-1 (Sources of information) .................................................................................................. 9 Q2-1 (Business objective) ........................................................................................................ 10 Q3-1 (Preliminary inherent risk assessment) .......................................................................... 11 Q4-1 (Indentification of signifcant risk) ................................................................................. 12 Q5-1 (Highly risk affected account) ....................................................................................... 13 References ........................................................................................................................................... 14

Introduction Qantas Airways Ltd. is Australia largest airline company that was setup in 1920. Qantas main business is passenger air travel that is serviced under two brands, Qantas and Jetstar. Qantas also has other subsidiaries, such as: freight and catering (Qantas, 2011c). This report analyzes the risk structure that presents in Qantas group. The assessment is done for the whole Qantas as a group; however it focuses on main businesses and subsidiaries. This report follows AASB ASA 315 standard, thus only inherent risks and those that posses risk of material misstatement are included in the assessment. Sources used are publicly available information issued by both Qantas and third parties. There are a few limitations found in writing this report. First, the lack of information regarding internal procedure and operation of the business makes it difficult to analyze the application of internal control in the business. Second the lack of information from independent third-party sources.

Business Structure and Objectives Qantas Airways Ltd is a group of four businesses that domiciles in Australia and operates in airways industry (Qantas, 2011). There are four business groups in Qantas: Qantas Qantas is a premium passenger service airline subsidiary of the group. Qantas focuses in business and higher-end leisure passengers. Jetstar Jetstar is a subsidiary that focuses in providing low fares flights. Jetstar was initiated in 2004 to response the increasing demand and competition for budget flights. Jetstar performance has been impressive due to the increasing demand for budget flight. Qantas Frequent Flyer Qantas Frequent Flyer (QFF) is a subsidiary that manages the frequent flyer sectors of Qantas. QFF enables loyalty members to earn and spend points in Qantas flights or partners. Qantas Freight Qantas Freight works mainly with business customers in providing freight services. There are other subsidiaries such as catering and aviation network; however those are the main four subsidiaries. The enterprise wide business objective of Qantas as presented on its Strategy Day in 2011 is as follow (Qantas, 2011a): Maintain safety as first priority Achieve 65% market share in domestic airways market (achieved) Enhance Frequent Flyer Programs (increase members and partners) Growth its business portfolio Exploit international market (especially Asia Pacific growing market)

Qantas had the reputation as one the worlds best and safest airlines (Skytrax, 2011). However, since 2008 the reputation has been dropping and it was ranked eighth safest in 2011 (Skytrax, 2011). There were various reasons for this, such as: A380 Singapore-Sydney engine incident, numerous mechanical and landing failures, industrial action, etc.

Qantas financial performance faces challenges too. Penetrating international market is difficult for Qantas. In Asia and Europe, competition is high and demand for premium airlines services is lower. Furthermore, Qantas has cost disadvantage compared to Asia and Middle Eastern carriers. On the other hand, Jetstar has gained in ranking over the last few years and was listed as the worlds second best low cost airlines in 2011 (Skytrax, 2011). Jetsar has also grown financially because of its product offering that suits the growing market of low cost airlines in Asia Pacific.

Inherent Risk Inherent risk is assessed by studying publicly available information, both published by Qantas and news media. In this report, inherent risk is broken down into two parts: risk increasing and risk decreasing. Risk increasing are inherent factors that adds to the riskiness of the company, vice versa. The analysis is as follow: Risk Increasing Loss of market share Qantas is losing its international premium passenger market share. Qantas used to have 35% of the traffic in 2003 and it fell down to just 18% in 2011 (Creedy, 2011; Newsport, 2011). One of the causes of this problem is the increasingly popular Singapore and Middle Eastern carriers such as Emirates for premium Australian international flights (Creedy, 2011). They have cost advantage compared to Qantas. Increasing customers preference towards budget airlines is also hurting Qantas market share. Qantas tried to jointly start with Malaysian Airlines a new premium carrier based in Asia (Creddy, 2012). Being Asian based, this carrier will have cost advantage compared to Qantas which has to do most of its administration and maintenance in Australia. However Malaysian Airlines walked out from the negotiations. Qantas started talks with Singapore on establishing a premium carrier there but it is still at an early stage (AFP, 2012). Workers unions and industrial action In November 2011, Qantas had an industrial action against its workers unions that led to lock-out and grounding of aircraft that affected around 68,000 passengers worldwide. Unions demanded pay rise which Qantas refused to fulfill. The industrial caused Qantas a bad image and affected Qantass profitability this financial year. Workers unions in Qantas have a relatively strong negotiation power. Qantas management claims that workers unions have limited Qantass ability to make financially advantageous decision, such as outsourcing and cutting redundant jobs (Creedy & Hannan 2012). The discussion between the unions and Qantas is still undergoing with Fair Work Australia assistance. The parliament is also considering strengthening Qantas Sale Act. If it is successful, it will further limit Qantas ability to outsource job (such as maintenance, lease aircraft). Thus, even further lead to Qantas cost disadvantage. Fuel price and carbon pricing Carbon pricing implementation and fuel price rise affect Qantas operation expenditure. Fuel cost to Qantas in Q1 2012 is expected to increase by AU$ 0.45 billion (26%) from a year earlier. Carbon pricing implementation has affected European flights from 1 January 2012 and will affect domestic (Australian) flights from 1 July 2012. Qantas will increase their ticket price with a maximum of $ 6.30 in response to this (Qantas, 2012a).

Aging fleet Qantas fleets (including Jetstar and Freight) average age is 9.2 years old, whereas it was aged at around 8.5 years in 2008. Qantas has been forced to renew its fleet with more modern and fuel saving planes, however they are delaying that in order to reduce expenditure. Initially, planned capital expenditure for 2012 was $2.3 billion however was reduced to $1.9 billion (Joyce, 2012). In 2010-2011 financial year, Qantas changed its accounting policy regarding expenditure of major maintenance and overhaul for older fleets. The change in the accounting policy caused in the capitalization of $50 million of maintenance costs which would have been expensed.

Macroeconomic risks Macroeconomic risks have a big part in Qantas. Qantas operates internationally and has international financial interest (such as exchange rate). The economic expectation for areas where Qantas has significant business operations (Australia and Asia) is positive. The economy is expected to be showing signs of growth as it is recovering from 2009 financial crisis (Deloitte, 2012)

Credit rating downgrade In January 2012, Moodys downgraded Qantas credit rating to Baa3 (Moodys, 2012). The reasons behind this action are: Higher fuel prices Strong competition and difficult working environment Outcome of unions negotiation Requirement for fleet reinvestment in the coming years

Other risks There are other risks present due to the nature of the business, such as the limited ability to change or remove non-profitable routes and operations in short notice. However, better data is needed to assess such risks.

Risk decreasing Penetration to low-cost market Jetstar market share and performance is improving, despite Qantas decline. Jetstar market share for domestic passenger in 2011 is 20% compared 12% in 2006. Jetstar market share for international passenger in 2011 is 8% compared to 2% in 2006 (Qantas, 2011). Jetstar also responded to growing demand for low-cost carrier (LCC) in Asia by opening new branches in Singapore and Vietnam.

Jetstar has successfully reach out to low-cost market so far. Jetstar is one of the fastest growing and biggest revenue LCC in Asia (Saurine, 2012). Jetstar is also continually monitoring for expansion opportunities in other areas in Asia. Jetstar Japan and Jetstar Hong Kong Jetstar is to start flying on 5 Japan domestic routes. They will become the first low-cost carrier to operate in Japan (Qantas, 2011a). Jetstar will also co-operate with China Eastern Airlines to start new subsidiary based in Hong Kong. The new subsidiary will operate flights from Hong Kong to China and other countries (Qantas, 2012c). Although expansion is risky, these expansions are categorized as risk decreasing. Jetstar has previously succeeded to set up Jetstar Singapore and Jetstar Vietnam (Broadbridge, 2012). The market for low-cost carriers (LCC) is growing tremendously in Asia and yet the market is still underdeveloped (Airline Leader, 2011). Jetstar also partners with JAL and Mitsubishi in Japan and China Eastern Airlines in Hong Kong reduces risk by sharing.

Risky Accounts Potentially risky accounts as derived from the preliminary risk assessment: Property, plant and equipment In 2011, Qantas changed its accounting method that led to the capitalization of $50 million of fleets major maintenance and overhaul. Moodys credit rating downgrade in early 2012, may become an incentive to overstate fixed assets to increase liquidity ratio and leverage. Method to check for the assertions: Assertion about account balances (completeness and valuation) This will check if the method and procedure used is appropriate. Compare Qantas practices with other company in the industry will be the first step. Then, check if there is an appropriate procedure (such as consulting to experts) placed to measure the value of the fleets. Assertion about transaction and events (accuracy and occurrence) This is done by sampling if fleet has appropriate value as stated on the balance sheet. Invite experts to analyze the market value of the planes. Legal cost and provision for legal cost Legal cost and provision might arise from unions or customers legal action against Qantas. Recently, there are many possible legal actions due to demand from the unions, industrial action and strengthening of Qantas Sale Act. Method to check for the assertions: Presentation and disclosure (occurrence, right and obligations) Test if method used to allocate the provision is correct and follow the accounting standard. Check if provision and legal cost has been correctly included in the financial statement. Account balances (valuation and allocation) Check if method used to calculate the provision for legal cost is appropriate (e.g. probability of legal course outcome x cost). Unearned revenue Due to the nature of the business, Qantas unearned revenue is crucial to test. Qantas unearned revenue (liability) makes up 20% of total revenue (Qantas, 2011c). However, there are possibilities of unearned revenue being not received, such as flight cancellation (due to industrial action or natural disaster) or macroeconomic factors (such as financial crisis).

Method to check for the assertions: Account balances (valuation and allocation) Analyze the items that are contained under unearned revenue accounts and test if appropriate according to the accounting standard. Compare the data with previous years regarding the recovery of unearned revenue and check if they are apportioned accordingly. Transaction and events (classification) Test by sampling if each item under unearned revenue accounts is appropriate. This does not need to be done if account balances check above indicates low level of risk. Operational Expense Qantas business nature is quite limited in its flexibility. For example: the ability to outsource jobs to cheaper market and the ability to change unprofitable routes. The limitations come from: obligation to perform service, unions lobby or legislation. Thus, prudency is required so that company can mantain good cash flow, liquidity and profit. Method to check these assertions: Presentation and disclosure (occurrence, rights and obligations) Analyze if the company disclose its financial prospect appropriately by comparing it to auditors expectation that has been systematically derived from the macroeconomics, industry and companys economy condition. Account balances (valuation and allocation) Test if expenses are appropriately allocated to the correct accounts. Also, compare the balances to last year and across industry data to check for any material inconsistency.

W/P ref: Q1-1 Prepared by : RRS Date : 13 May 2012 Qantas Airways Ltd Period ending 30 June 2012 Sources of information Qantas Airways Ltd o Annual report o Annual shareholder presentation o Media releases ASX o Company news News media o The Australian o The Age o Herald Sun Company analyst o Qantas business case study (http://www.businesscasestudy.com.au) Moodys Deloitte o Global Economy Outlook 2012

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W/P ref: Q2-1 Prepared by : RRS Date : 13 May 2012 Qantas Airways Ltd Period ending 30 June 2012 Business objectives Qantas business objectives as outlined in the presentation on Strategy Day 2011 (Qantas, 2011a): Maintain safety as first priority Achieve 65% market share in domestic airways market (achieved) Enhance Frequent Flyer Programs (increase members and partners) Growth business portfolio Exploit international market (especially Asia Pacific growing market)

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W/P ref: Q3-1 Prepared by : RRS Date : 13 May 2012 Qantas Airways Ltd Period ending 30 June 2012 Preliminary inherent risk assessment

Risk Increasing: Loss of market share o Increased competition by carrier from Middle East and Singapore o Bad cost advantage Workers unions and industrial actions o Demand for pay rise o Prevented outsourcing job to cheaper sources Fuel price and carbon pricing o Increased cost o Further cost disadvantage Aging fleet o Reduced budget for renewal o Capitalization of major maintenance and overhaul cost Macroeconomic risk o Exchange rate risk o International economic downturn

Risk decreasing: Penetration to low-cost market o Jetstar performance has been increasing Jetstar Japan and Jetstar Hong Kong o New market with probability of high demand o Joint venture

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W/P ref: Q4-1 Prepared by : RRS Date : 13 May 2012 Qantas Airways Ltd Period ending 30 June 2012 Identification of significant risk Accounts affected Revenue, Profit, Expenses

Potential risk Overstating revenue and profit as performance is under pressure Capitalization of fleets maintenance cost Limited outsourcing ability

Assertion

Account balances (completeness, valuation)

Level of risk identified Low

Property, plant and equipment, Depreciation expense Operational expense

Account balances (valuation and allocation); Transaction and events (accuracy, occurrence) Presentation and disclosure (occurrence, rights and obligations); Account balances (valuation and allocation) Account balances (valuation and allocation) Transaction and events (occurrence and completeness), Presentation and disclosure (occurrence, rights and obligations) Transaction and events (classification), Account balances (valuation and allocation) Presentation and disclosure (Accuracy and valuation)

High

ModerateHigh Moderate-Low Moderate-Low

Inflated fuel cost and carbon pricing Unexpected legal cost

Fuel expenditure Legal provision

Penalty and customer reimbursement Fleet reinvestment and flexibility

Unearned revenue Revenue, Property, plant and equipment

Moderate-Low Moderate

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W/P ref: Q5-1 Prepared by : RRS Date : 13 May 2012 Qantas Airways Ltd Period ending 30 June 2012 Highly risk affected accounts

Account Property, plant and equipment Legal cost and provision for legal cost Unearned revenue Operational expense

Assertions Account balances (completeness and valuation) Transaction and events (accuracy and occurrence) Presentation and disclosure (occurrence, right and obligations) Account balances (valuation and allocation) Account balances (valuation and allocation) Transaction and events (classification) Presentation and disclosure (occurrence, rights and obligations) Account balances (valuation and allocation)

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References AFP 2012, Qantas eyes Singapore for premium airline in attempt to refocus on Asian region Joyce, Borneo Post, 24th April, viewed on 2nd May 2012, http://www.theborneopost.com/2012/04/24/qantas-eyes-singapore-for-premium-airlinein-attempt-to-refocus-on-asian-region-joyce/ . Airline Leader, 2011, Low-cost airline growth in Asia, Airline Leader, viewed 2nd May 2012, http://www.airlineleader.com/this-months-highlights/low-cost-airline-growth-in-asia. Broadbridge, D 2012, Latest Qantas News March 2012, Get Smart Education, viewed 2nd May 2012, http://www.businesscasestudy.com.au/news.html. Creedy, S & Hannan, E 2012, Union urges Qantas to keep Avalon maintenance operation open, The Australian, 2nd May, viewed 2nd May 2012 http://www.theaustralian.com.au/business/aviation/union-urges-qantas-to-keep-avalonmaintenance-operation-open/story-e6frg95x-1226344130671. Creedy, S 2011, Low-cost airlies bite into Qantas market share, The Australian, 18th January, viewed 2nd May 2012, http://www.theaustralian.com.au/business/low-cost-airlinesbite-into-qantas-market-share/story-e6frg8zx-1225989847536. Creedy, S 2012, Qantass premium Asia plan fails to lift off, The Australian, 10th March, viewed 2nd May 2012, http://www.theaustralian.com.au/business/aviation/qantasspremium-asia-plan-fails-to-lift-off/story-e6frg95x-1226295442812. Creedy, S, 2011, Qantas international share falls to new low, The Australian, 2nd March, viewed 30th April 2012, http://www.theaustralian.com.au/business/qantasinternational-share-falls-to-new-low/story-e6frg8zx-1226014384949. Deloitte 2012, Global Economic Outlook 2 nd Quarter 2012, Deloitte Research Publication, Los Angeles, CA, USA. Forsyth, A. & Howe, J 2011, Fair Work at Work, The Age, 31 October, viewed 11 May 2012, http://www.theage.com.au/opinion/politics/fair-work-at-work-201110301mqdj.html. Joyce, A 2012, The Qantas group A strong sustainable future, Macquarie Australia Conference, viewed 12 May 2012, http://www.asx.com.au/asxpdf/20120504/pdf/42625yqh51dy4s.pdf Moodys, 2012, Moody's lowers Qantas' rating to Baa3 from Baa2; Outlook stable, Sydney, viewed 21st April 2012, http://www.moodys.com/research/Moodys-lowers-Qantasrating-to-Baa3-from-Baa2-Outlook-stable--PR_236397. Newsport, 2012, Qantas now less than 20% market share, viewed 30th April 2012, http://www.tourismportdouglas.com.au/Qantas-now-less-than-20-marketshare.3641.0.html. Qantas Airways Ltd, 2012c, China Eastern Airlines and Qantas announce Jetstar Hong Kong,

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media release, viewed 2nd May 2012, http://www.asx.com.au/asxpdf/20120326/pdf/4257gblzv2ryz8.pdf. Qantas Airways Ltd. 2011, Qantas Data Book [Online],viewed 20 April 2012, http://www.qantas.com.au/infodetail/about/investors/qantasDataBook2011.pdf. Qantas Airways Ltd. 2011a, Qantas Strategy Day [Slides], viewed 12 May 2012, http://www.qantas.com.au/infodetail/about/investors/qantas-strategy-day-presentation2011.pdf. Qantas Airways Ltd. 2011c, Annual Report 2011, Qantas Airways, Sydney, NSW Qantas Airways Ltd. 2012a, Qantas group policy on higher fuel prices and carbon pricing, media release, Sydney, 2 February, viewed 21st April 2012, http://www.asx.com.au/asxpdf/20120202/pdf/4244cc5vj8v185.pdf. Qantas Airways Ltd. 2012b, Qantas profit update, media release, Sydney, 28 November, viewed 21st April 2012, http://www.asx.com.au/asxpdf/20111128/pdf/422vt5shj7fng3.pdf. Qantas Airways Ltd. 2012c, Our company, Qantas, viewed 13 May 2012, http://www.qantas.com.au/travel/airlines/company/global/en. Saurine, A 2012, Jetstar reaping big dividends for its parents, Herald Sun, 21 April, viewed 12 May 2012, http://www.heraldsun.com.au/business/jetstar-reaping-big-dividends-forits-parent/story-fn7j19iv-1226334818444. Skytrax 2011, Qatar Airways wins the worlds Best Airline award [Online], viewed 20 April 2012, http://www.worldairlineawards.com/Awards_2011/Airline2011.htm. Transport Worker Union of Australia 2011, Qantas: not just another airline, viewed 13 May 2012, http://www.twu.com.au/CMSPages/GetFile.aspx?nodeguid=9296801d-3a494a65-856b-162846f94ef7.