Anyone reading a company’s financial reports should be aware of the assumptions and estimates used by the preparer of the report because it can lead to a distorted picture of a company’s performance
In this article, Multi-Act experts analyze the financial reports of a major airline company and uncover key assumptions in calculating yearly pension cost. In this case, higher assumption of expected return can lead to lower pension expenses and higher earnings. Assumption relaxation in revenue recognition was observed by another major airliner thus boosting revenues and earnings in their reporting period.
Investors need to pay close attention to assumptions and estimates that may be used by the preparer of any report. The examples of these airline companies give a clear picture of how assumptions can be used to project companies in better light.
“Figures often beguile me…particularly when I have the arranging of them myself; in which case the remark attributed to Disraeli would often apply with justice and force: ‘There are three kinds of lies: lies, damned lies, and statistics.” – Mark Twain
Had Mark Twain seen the financial statements of various companies, he would have exclaimed- “Lies, damned lies, statistics and accounting”.
It is common knowledge that graphs and figures can be used to distort reality, so that differences seem larger than they are. The reader is influenced by the statistician or accountant to see a supposed reality.
Key assumptions used whilst preparing a report are amongst the most important aspects to consider whilst reading a financial report. It is also imperative that the assumptions used are based on as sound a footing as possible to avoid overly optimistic forecasts.
We have noticed a few major changes in assumptions by some major US airlines, to make the best of the feel good factor which in turn, is largely caused by the latest cyclical upturn in profitability.
Key assumptions used whilst preparing a report are amongst the most important aspects to consider whilst reading a financial report. It is also imperative that the assumptions used are based on as sound a footing as possible to avoid overly optimistic forecasts. A few examples are:
The first case in our review is a major airliner with obligations of around USD 24bn payable as pension benefits.. Pension is of course an important area to watch out for since airliners often have a labor intensive business model and pensioners are major unsecured claim holders as such.
Expected return on plan assets is among the key assumptions in calculating the yearly pension cost to be expensed. And this airline company not only exhibits way higher assumptions of expected return versus peers, but also when stacked against its own historical performance. This lofty assumption leads to an addition of anywhere between 5% to 11% range to its pre-tax earnings (PBT) for 2015. There were losses in 2008-() making calculation meaningless. To be fair, we have also given a somewhat optimistic number for expected return of at 7%, though achieving it will be difficult given the valuation levels and macro policies. In terms of sales, the firm has added near 50 bps to 200 bps to the profit margins, which is a high number considering historical profit margin range. While the pension deficit is high, historically it cannot be meaningfully compared given the negative net worth.
Source: Company 10Ks. Numbers USD mn.
This though is not all, there is more to it. The company’s pension plan assets are nearly 51% ($5.1 bn) under Level 3 classification. Here the valuation relates to illiquid assets and thus again depends on assumptions. These have nearly doubled since 2013.
Revenues are another area ripe for assumptions. The chart below is of growth for 2015, reported by another major airline.
Source- Company 10K
The point you will notice is a near 50% jump in the “Other” heading under revenues, which shows growth at 50% year on year versus a staid 3%-5% growth rate for passenger freight.
Frequent Flyer Programs = Frequent Assumption Programs
Frequent flyer points and related cost booking at various periods and their valuation involves assumptions and estimates. To complicate an already complex situation, the company sells the reward points to Chase Bank. In an earlier period, the company used to defer portion of amounts received on such sale of points and recognize them as passenger revenue when the awards were actually flown.
However under a new agreement with Chase in July 2015, the company amended its co-branded credit card agreement. This resulted in a new accounting treatment, which in simple terms resulted in a lower deferral of revenues. The company now allocates revenue over the term of agreement and in addition also estimates the value of various deliverable elements involved, like the main elements of travel points, advertising and use of brand etc.
What does this lead to?
Whilst the accounting gibberish is fine, what is the ultimate impact? It added 2% to sales and 10% to bottom line 2015. This is real food for thought.
Source- Company 10K
On the top of it, the company with the flyer program case also adopted a predictive statistical model for behavior of flyers to estimate spoilage or breakage of points sold. This relates to the points which expire unused with an increased expectation of spoilage rate. This changed assumption in Oct 2014 leads to the following impact:
Source- Company 10K
Of course, very conveniently, this bonanza from assumption change is not fully deducted while calculating the Non-GAAP earnings.
All said, to close let me repeat the same thing: Key assumptions used by the preparer of a report, are very important aspects to pay detailed attention to when reading any financial report.