airline accounting guideline no. 1

In association with

AIRLINE ACCOUNTING GUIDELINE No. 1Accounting 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 factsor 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 particularorganisation. 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 nowarranty of accuracy or reliability is given.

Accordingly, neither the IATA Accounting policy task force or KPMG undertakes responsibility arising in any way whatsoever to anypersons in respect of this airline accounting guidance, for any error or omissions herein, arising through negligence or otherwisehowever caused.

1 Background

2 Objectives

3 Current accounting standards framework

4 Hedge accounting

4.1 Introduction

4.2 Types of hedge addressed by this guideline

4.3 Hedge effectiveness

4.4 Hedge documentation

5 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

6 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

Contents

Airline Accounting Guideline 1: Accounting for foreign currencytranslation and hedging

1 BackgroundFor most international airlines, the management of foreign currency position is of criticalimportance. Their operations will generally involve multi-currency inflows and outflows,although a significant proportion of an airline's expenditure is typically denominated in USdollars, whatever the local currency. In addition airlines frequently borrow or enter intolease obligations in foreign currencies for a number of differing reasons. These mightinclude the availability of surplus funds generated in those particular currencies from theiroperations, which can then be used to meet repayments; the attraction of the cost of capitalin foreign markets; or perhaps simply because they are unable to access funds for significantasset acquisitions from their local capital markets.

It follows that the accounting treatment of exchange difference arising from the variousforeign currency transactions has a potentially important bearing on airlines' reportedresults. Airlines have developed a number of strategies for dealing with the commercialimpact of currency and commodity price fluctuations and these strategies are reflected in thevarious accounting treatments adopted.

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IATA accounting pol icy task force

Recent developments in International and US accounting standards in the area of foreignexchange accounting and the financial instruments frameworks have lead to substantialchanges in the treatments available to airlines in accounting for their foreign currencyexposures and related derivative hedging activities. This Airline Accounting Guideline isdesigned 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 aspecific hedging technique that has been used in some jurisdictions and addresses the relatedissue of determining the functional currency of an airline or a part of it.

2 Object ives

In preparing this Airline Accounting Guideline the Accounting Policy Task Force hasconsidered in particular International standards IAS 21 on foreign currency translation andthe financial instrument standards, IAS 32 and IAS 39 together with the US standard onderivatives and related hedging instruments, FAS 133. At the time of writing, a number ofrevisions to the relevant International standards have been finalised and these are reflectedin the accounting discussion in this guideline. The guideline has not sought to address theissues raised by the Joint Working Group's paper Financial Instruments and Similar Items(issued in 2000) which proposed prohibiting hedge accounting. [Although the issue remainson the International Accounting Standards Board's agenda, no further developments areexpected in the short term.]

The conceptual framework underpinning the approach to financial instruments and hedgingis broadly similar in both FAS 133 and IAS 39 although there are a few importantdifferences in detail, pertinent to the subject matter of this guideline, which are highlightedwhere appropriate in the narrative below.

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3 Current accounting standards framework

4.1 IntroductionHedge accounting is designed to overcome the accounting mismatch that can occur whenone side of a transaction is accounted for at fair value and the other side at historic cost (ornot at all, in the case of committed - i.e. contractual - future transactions) and where forecasttransactions are being hedged. The resulting accounting usually results in the recognition ofthe 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 arereleased to profit at the same time as the underlying transaction. The aim of hedgeaccounting is to remove volatility from an entity's financial statements that can occurthrough 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 exceptionto the general rules for accounting for financial assets and liabilities. As such, any hedgingrelationship must meet certain criteria and be explicitly identified and documented in advanceof the underlying transactions being entered into. Unless these conditions are met hedgeaccounting is not permitted. Two criteria that must be met for adoption of hedge accountingconcern documentation of the hedge relationship at inception of the hedge and the requirementto quantitatively measure its effectiveness. These requirements are discussed below.

Even though hedge relationship is considered to be economically effective, it does notfollow that it automatically qualifies as a hedge for accounting purposes under either IAS39 or FAS 133. A number of established hedging practices exist amongst airlines whicheven if commercially sound, may not now meet accounting requirements and hedgingstrategies will have to be reviewed as a consequence of this.

4 Hedge accounting

4.2 Types of hedge addressed by this guidelineThis Airline Accounting Guideline considers four types of hedge: natural, fair value, cashflow and net investment, focusing on the basic accounting and the requirements for hedgeaccounting to apply. However, the main focus of this guideline is their practicalimplementation.

Natural hedgesWhere possible, most airlines and other entities seek to minimise their exposure to fluctuationsin exchange or interest rates and commodity prices through matching the pricing of theirservices to inputs and related assets, liabilities and cash flows. The simplest example dealswith foreign exchange risk; an airline generally incurs local currency costs at the same timeas it earns local currency revenues. To the extent that the two offset, gains and losses on oneare matched by gains or losses on the other. This is termed a natural hedge. No specifichedge accounting is required to achieve this result. The issue for airlines is that very seldomdo currency inflows exactly match the outflows. It is this imbalance that airlines hedgethrough the use of derivatives and other financial instruments.

Fair value hedgeFair value hedges hedge changes in the fair value of recognised assets and liabilities andunrecognised but firmly committed future transactions. A typical example of the latter wouldbe the use of forward contacts to hedge the foreign currency translation risk associated withthe purchase price of an aircraft between contract and delivery dates. Non-derivativeinstruments may also be used to hedge foreign exchange risk. As referred to in the examplesin section 6 below, where a committed but unrecognised transaction is hedged for foreignexchange risk (for example in relation to an aircraft purchase), it may alternatively be treatedas a cash flow hedge.

Financial assets/liabilities may be hedged for any constituent risk (i.e. benchmark interestrate, credit and foreign currency) as it is assumed that fair values of the individual risks arereadily ascertainable. This is not assumed to be the case for non-financial items such as theprocurement of jet fuel and, consequently, they may be hedged either for at the commodityrisk in its entirety, the commodity risk measured in the reporting currency or for foreignexchange risk only.

The accounting for fair value hedges is straightforward - both the hedging instrument andthe hedged item (in respect of the components hedged) are marked to market and gains andlosses taken through the P&L. To the extent that the hedge is effective, the gain or loss onthe hedged instrument should be offset by the loss/ gain on the hedging instrument.

Cash flow hedgesCash flow hedges hedge changes in future cash flows of recognised assets or liabilities,unrecognised but committed transactions (in respect of foreign exchange risk, otherwisesuch 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 foreignexchange risk. However, an important difference between the two is that FAS 133 is morerestrictive in that it does not permit non-derivative instruments to be used as a hedge ofuncommitted or forecast transactions, whereas IAS 39 does. Thus a commonly used practice

amongst international carriers of hedging future (foreign currency) route revenues withforeign 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 ordetermining a present value of cash flows using valuation techniques) and the change invalue for the effective portion taken to equity initially. Any ineffective portion of thehedge caused by the hedging instrument is immediately recognised in the profit and lossstatement. This will occur where the position is over-hedged or there is significant basisrisk in the hedging relationship (i.e. the change in fair value of the hedging instrument isgreater than the change in value of the hedged item), and when the transaction takes placeif it is under-hedged.

• The amount held in equity is recycled to the profit and loss statement as the futuretransactions affect the profit and loss account and where the hedged item is a financialasset 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 beadjusted by the amount held in equity - this is termed a basis adjustment. Basisadjustments are not permitted under US GAAP; instead, the amount held in equity isrecycled to profit over the life of the hedged item (for example for a fixed asset, in apattern consistent with the depreciation charge.)

Net investment hedgeA net investment hedge is a derivative or non-derivative hedge of currency risk of a netinvestment in a foreign entity. Historically, a number of airlines have used the netinvestment hedge under local GAAP to limit exchange differences on the carrying values ofaircraft and related borrowings. The continued applicability of this approach is discussed inparagraph 5 below.

The accounting for net investment hedges is as follows:

• The hedge instrument is measured at fair value and the currency element or spottranslation 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 thechange in its time value, as this does not form part of the hedge. This means that thederivative used to net investment hedge requires split accounting, and an effect on P&L iscertain. Under International GAAP, for non-derivative hedging instruments, theineffective 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 effectivenessIn order to qualify for hedge accounting, any hedge relationship must be shown to beeffective on both a prospective and retrospective basis. At inception the hedge transactionmust be expected to be highly effective in achieving offsetting changes in the fair value orcash flows attributable to the hedged item. A hedge is normally regarded as highly effectiveif, at inception and throughout the life of the hedge relationship, the enterprise can expectchanges in the fair value or cash flows of the hedging instrument to significantly offset

changes in the fair value or cash flows of the hedged item. Typically 'highly effective' isinterpreted as in the range of 80% to 125%, as for the retrospective test. Actual results for ahedge relationship must be within the range of 80% to 125% to allow for unexpectedineffectiveness.

Hedge effectiveness is of particular practical importance where proxy instruments are usedas hedging instruments. For example, many airlines use crude oil derivatives to hedge theirfuel price risk as part of longer term hedging strategies. Typically these strategies requirethe hedging instrument to be swapped into a more highly correlated product such as gasoiland eventually jet fuel as the hedge horizon approaches spot. Although spot and forwardcrude oil and jet fuel prices have historically been closely correlated over the medium tolong term, short term correlations of particularly spot prices have each exhibited greaterdivergence and may fall outside the 80% to125% range. Under either IAS 39 or FAS 133this would result in the whole of the hedge being deemed ineffective for that period, givingrise to accounting induced volatility in reporting of earnings. The prospective assessmenttest for hedge effectiveness together with the need for frequent measurement of actualeffectiveness means that poor correlations may preclude hedge accounting notwithstandingthe economics of the hedge strategy.

4.4 Hedge documentationAll hedge relationships must be documented at their inception. The documentation mustinclude:

• 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 hedginginstrument; and

• how hedge effectiveness will be measured and assessed on an ongoing basis. The methodand procedures to be consistently applied for the particular hedge should be described insufficient detail to establish a firm basis for measurement at subsequent dates.

In practice, some standardisation of the documentation may be possible, incorporating byreference, for example, details of the airline's risk management objective and the hedgeeffectiveness measurement process.

5.1 IntroductionAs noted above, some airlines have been able under their local GAAP to use net investmenthedges in relation to aircraft ownership entities typically designed to match exchange ratechanges arising from dollar denominated financing and assets. This has been achieved bytranslating 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/ othercomprehensive income. The mechanism to achieve this accounting treatment varies betweenairlines for their particular circumstances and the GAAP that they report under, but allessentially treat the aircraft, borrowings and related revenues and expenses as an entityseparate 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 netinvestment 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 operationIn certain circumstances, an airline might seek to argue that a part of its business operateswith a functional currency other than that of the core airline (usually the currency of thecountry 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 sustainthe argument, the activities of the foreign operation must be based or conducted in a countryor currency other than those of the reporting entity. The operation should be managedseparately 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 questionof fact rather than management choice. The key factors involved in that determinationrevolve around the currency in which revenues are received and costs denominated andsettled, currency in which funds from financing activities are generated and the economicenvironment in which the business operates.

The level of US dollar costs and revenues of non-US international airlines can besignificant. Typical costs include fuel, aircraft leases and aspects of maintenance and pilottraining. US dollar revenues for passenger and cargo businesses can also be significant.

5 Net investment hedges under IAS 21

In the airline industry, with its significant international operations in market segments suchas the North Atlantic, which for non US airlines potentially receive significant US dollarrevenues and US dollar costs the above considerations require an analysis of the substanceof the operation.

Two practical considerations in two particular situations are considered below: a specialpurpose vehicle to hold aircraft and a foreign currency branch.

5.3 A foreign entity used for the acquisition of aircraftScenario

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

GuidanceIf the structure simply involved the acquired aircraft being leased internally to the group'sairline business, its business would be viewed as an extension of the airline and the SPVwould accordingly have the same functional currency as the parent.

If the foreign entity also has significant third party leasing revenue, then the conclusionmight be different. In such cases, judgement would be required. Key factors in thedetermination 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 SPVrevenues; and

• the degree of autonomy of the subsidiary's management.

5.4 Foreign currency branches

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

GuidanceThe main practical consideration in relation to this particular accounting treatment iswhether an aircraft and its associated financing and revenue generation capability aresufficiently separable from the rest of the business to enable a clearly defined foreign branchto exist. For many airlines, the answer has hinged on the interpretation of local accountingstandards. As an example, the UK accounting standard, SSAP20 allowed a relatively wideinterpretation, permitting a branch to consist of a “...group of assets and liabilities which areaccounted for in a foreign currency”. For this reason, accounting standards aligned to UKstandards previously have allowed some flexibility in this area.

It is considered that International Accounting Standards set a higher threshold. If a branchwas appropriately established, the foreign operation accounting would follow; however thebranch structure would have to faithfully represent the economic substance of the underlyingposition.

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 someinter airline alliance structures;

- separate 'governance board' which reviews management's strategy, performance andremuneration. There would need to be a level of autonomy from the airline's 'mainboard'; and

- decision making ability around key airline activities such as fleet procurement, productoffering 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 swappedinto the foreign currency, would need to be significant (probably the greaterproportion) of overall branch revenues; and

- the settlement of labour costs, including senior management. Labour costs are oftenthe largest component of an airlines cost base and the denomination of settlement oftenreflects 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 ofthe operation; and

- currency revenue must be proportionate to the assets and liabilities denominated in thecurrency.

We believe that passing these thresholds would be very challenging (if not impossible) formost airlines to meet and therefore would not expect many airlines to have embeddedforeign currency branches accounted for under the net investment method.

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

6.1 Hedges of committed transactionsIssue - Airlines may use forward contacts or other derivatives to hedge their currencyexposure 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 approachto hedge accounting to be used to hedge committed transactions provided that foreign currencyrisk is being hedged, otherwise cash flow hedging is required. In a fair value hedge of afirm commitment, changes in the fair value of the (unrecognised) asset being purchasedrelating to the risk being hedged, and changes in value of the hedging instrument, areincluded on the balance sheet and in the profit and loss account (meaning that to the extentthat the hedging instrument is fully effective, there will be no net profit effect). In a cashflow hedge, changes in fair value of the hedging instrument are taken initially to equity andsubsequently recycled to either the balance sheet on recognition of the asset or progressivelyto the profit and loss statement when depreciation associated with the asset is recognised asis required under US GAAP. . We would expect most airlines to follow the cash flow hedgeaccounting approach, particularly as this allows a single cash flow hedge to be used where atransaction starts as uncommitted but highly probable and then, as the transaction dateapproaches, becomes committed. On recognition of the asset, we would also expect hedgegains and losses to be offset against the carrying value of the asset as a basis adjustment tostreamline the accounting process and reconciliation of the hedge reserve in equity.

6.2 Foreign currency loans as cash flow hedgesIssue - Certain airlines borrow in currencies in which they have surplus net cash inflowsafter operating expenses (whether from route revenues or other specific transactions) takingadvantage of a natural hedge to mitigate translation risk on cash flows. Cash flow hedgeaccounting 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 theprofit and loss statement.

Cash flow hedging is permitted under IAS (for foreign exchange risk only) but not under USGAAP (only derivatives may be used to hedge forecast transactions).

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6 Pract ical examples of hedging for a ir l ines

Guidance

Use of route revenues to hedge borrowings

The APTF expects the use of cash flow hedging to manage the currency exposures willincrease 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 thustaking advantage of a natural hedge of their cash flows. The accounting requirement for acash flow hedge ensures that the reporting of the hedge relationship in the profit and lossstatement 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 probableforecast transactions may be hedged and therefore airlines must be able to demonstratethat they are able to forecast demand accurately and that they can point to a history ofstable revenue generation in that currency. The greater the proportion of revenue to behedged, the more important the ability to forecast accurately as hedge ineffectiveness ismore likely to occur (through revenue falling short of that expected). Equally, whererevenues are forecast a number of years out, it will become harder to demonstrate thehigh degree of probability of those transaction occurring that is required without aconsistent 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 theperiod into the future increased;

• Care needs to be taken in defining the hedge to ensure that it is effective and will remainso throughout the hedge. Significant changes in passenger demand may lead to hedgeineffectiveness (attributed to variability in the component of the forecast load designatedas part of the hedge relationship) which would be taken directly to profit and lossstatement and in more extreme cases where effectiveness fell outside the 80-125%corridor would require hedge accounting to be discontinued. The hedge must be definedin terms of a gross cash flow which is determinable. For example a hedge of the first $20million of revenue would be acceptable whereas none of a hedge of 20% of revenue, ofthe last $20 million of revenue or of $15 million of net income would qualify as a hedgerelationship under IAS39.

• Testing prospective and retrospective effectiveness of hedge relationship. Formaleffectiveness testing, both prospectively and retrospectively, must be performed at eachreporting date, as a minimum six monthly for listed entities, or on a more frequent basisdepending on the nature of the hedge relationship and requirements of the reporting entitysuch as quarterly or monthly to coincide with management reporting processes;

• Determining the timing of the cash flows hedged. For example, the degree of accuracypossible in matching revenue receipts to loan repayments will affect the effectiveness ofthe hedge. If the matching is not sufficiently close, the hedge effectiveness may falloutside the 80%-125% corridor which would inhibit hedge accounting for that period.

• Documentation and periodic re-designation of hedges as additional loans are taken orexisting loans repaid;

• Gain or loss on revaluation of the loan is held in equity and recycled to the profit and lossstatement offsetting the impact of any change in exchange rates on the measurement ofthe 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 ratemovements to profit will affect both the revenue and interest paid lines with a consequentimpact on gross and operating margins.

Use of the proceeds of disposal of an aircraft to hedge its initial carryingvalueCertain airlines have sought to use the anticipated proceeds from the disposal of a financedaircraft to hedge the associated loan. Thus, for example, an airline with a policy of holdingnew aircraft for only seven years before disposal would argue that the disposal proceeds actsas a hedge against a portion of the initial loan, reducing the airline's exposure to foreignexchange fluctuations against the US dollar. Such an arrangement could meet the requirementsof IAS 39 (but not, at least initially, FAS 133 as it uses a non-derivative to hedge a non-committed transaction) provided that transaction and its timing was considered to be highlyprobable. Determining whether there is sufficient probability is a question of judgment, butthere may be a number of indicators that support the argument. These include loan termspermitting (or requiring) early repayment of the loan on a sale of the aircraft, the airline'sbusiness plan, firm orders for replacement aircraft, evidence of the airline's ability to enterinto such a transaction and a prior track record of making such disposals.

Even if an initial assessment indicated that the transaction was not considered sufficientlyprobable and therefore hedge accounting was not available, it would be appropriate toreassess the hedge position as the anticipated sale date becomes closer (and hence presumablymore likely) to the point where a sale becomes committed. The question of when it wouldbe possible to recognise a hedge that meets the hedge accounting criteria in this caseremains one of judgment.

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

6.3 Fuel hedge accounting, including component hedgingIntroduction - Many airlines hedge the price of jet fuel but do so in a variety of ways andwith a number of instruments including forward purchases, swaps, options etc. Airlineswith 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 aproxy (eg. crude oil). This section deals with examples of common jet fuel derivatives firstand 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 thefuel hedged. It is essentially a purchased option. Typically a premium is paid to the issuerof the instrument. Both the instrument and the premium are required to be accounted forunder US and International GAAP.

The value of a cap is split into two components; the intrinsic value (essentially the amountby 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 ofthe option on expiry are often deferred and brought to account in the profit and lossstatement 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 islikely to be recognised to the profit and loss statement over the life of the cap based onchanges in the fair value component of the option (unless hedge effectiveness is assessed onthe total change in value of the hedging derivative). Changes in the intrinsic value of theoption can be taken to equity in the case of a cash flow hedge until the expiry of theinstrument and recycled to the profit and loss statement when the underlying hedged item isrecognised.

It is the requirement for the changes in the time value to be taken to the current period'sprofit and loss statement which brings profit and loss volatility into accounting for caps forthe first time.

Zero cost collar

A zero cost collar comprising a bought cap and sold (written) floor is a popular instrumentas 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 exercisedand no additional accounting entries are required in the absence of a cash flow impact.

Written options are not normally permitted as hedging instruments. However, incombination with a purchased option, provided that the end result is a zero cost collar or netpurchased 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.

Guidance - proxy hedges

Neither US nor International GAAP permits components of non-financial assets to beindividually hedged (other than currency risk) - thus one could not hedge only the crude oilcomponent of jet fuel. However, it is permissible to use a combination of derivatives (forexample, crude oil and jet fuel differential forward contracts to hedge the jet fuel price. Theinstruments will need to have the same maturity date as otherwise it is unlikely that thecombination will meet the prospective and retrospective effectiveness tests;

Given that components of the jet fuel price may not be hedged, airlines will be faced withusing a suitable proxy when jet fuel derivatives are unavailable (for example, when lookingmore 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 thetest for prospective effectiveness because although crude oil and jet fuel prices havehistorically been highly correlated over a longer time frame, the correlation is much lowerover short periods. Where the hedging strategy specifically contemplates swapping fromcrude to jet fuel derivative products over the duration of the strategy, consideration wouldneed 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 naturerisk management strategy.

IAS 39 The requirement for prospective hedge effectiveness is similar to FAS 133 andinterpreted (although this is not expressly stated) as permitting such hedge instrumentsproviding they fall within the 80%-125% effectiveness corridor.

Even if the prospective test is met (whether under IAS or US GAAP), such hedges may failwhen looking at correlation retrospectively as it may be found that the price correlation hasnot always been within the 80%-125% corridor on either a period by period or cumulativeperiod basis of assessment.

Jet fuel hedge using component derivatives is designed to overcome the lack of liquidity forlonger 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 anairline uses a crude oil forward to cover fuel purchases up to five years out, supplementingthat with a separate forward to cover the heating oil differential as these become available upto a year or so out. Finally a third forward representing a jet fuel differential is added over ashorter period.

IAS 39 specifically permits such a composite approach to building an effective hedge. Itrequires that hedges be designated for the remaining life of the derivative used and thus thederivatives 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 ahedging instrument comprising the 'old' hedge plus the new component. The new hedge willneed to be separately documented. Importantly, the amounts deferred in equity under theoriginal hedge remain deferred until the hedged transaction occurs.

Determining effectiveness

Neither IAS 39 nor FAS 133 mandates an approach to determining hedge effectivenesseither prospectively or retrospectively allowing a variety of methodologies to be used.However, the documentation of the hedge must detail how hedge effectiveness is to bemeasured and the approach should be consistent with that used in similar hedges unlessthere is good reason to change.

The prospective test is measured over an appropriate timeframe. Typically the length of theperiod for accumulating data used would be similar to that of the hedge, although, wherethat 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 theeffectiveness of the hedging relationship will cover a much longer time period sufficient togenerate a suitable number of data points replicating the hedge period.

Retrospective effectiveness normally is determined using the dollar offset. The offsetmethod expresses the degree of offset between changes in the fair value of the hedginginstrument 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 the80%-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 allcases, any ineffectiveness in the hedge must be taken to profit together with any change inthe time value of the derivative. This may still give rise to significant volatility in anairline's results.

The requirement to use actual results limits the application of statistical techniques. UnlikeUS GAAP, IAS 39 does not explicitly approve as a concession the use of rolling data setswhich incorporate observations prior to inception of the hedge relationship.

IAS 39 does permit the effectiveness of a hedge relationship to be improved by choosing ahedge ratio other than one-to-one so long as this designation is specified in documentationof the hedge relationship.

6.4 Embedded derivativesIssue - In certain circumstances contracts may be considered to contain embeddedderivatives as well as the underlying host contract. Both International and US GAAPrequire that these embedded derivatives be separated. For example, a contract denominatedin a currency other than that of the parties to it might be considered to have an embeddedforeign exchange derivative which would then have to be accounted for separately.

Guidance - The question of whether an embedded derivative should be separated from itshost contract depends on how closely related the derivative is to the host contract. Otherthan financing or leasing contracts, the most likely area where embedded derivatives mightoccur is with contracts denominated in a currency other than that of the airline. Generally ifthe contract currency is that of a party to the contract then the contract need not beseparated. This is also the case where the contract currency is one in which the relevantgood or service is routinely denominated or the currency commonly used in contracts in theeconomic environment in which the transaction takes place. The APTF would not expectmany industry standard contracts to be require separation.

• Embedded derivatives may also occur in leasing and financing arrangement Primarilythese would occur when lease or interest rates are leveraged or indexed to prices of itemsnot 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 dollarseven where the dollar is not the functional currency of any of the contracting parties.Common examples of such contracts include:

•❥ Fuel purchases;

• Aircraft and aircraft spares purchases;

• Aircraft leases;

• Inter airline settlements; and

• Airframe and engine maintenance.

6.5 Intra group hedgingGuidance - IAS 39 is more flexible than US GAAP on dealing with hedge accounting withingroups. US GAAP permits hedge accounting only where the entity with the risk is party tothe hedging transaction - thus a central treasury dealing with risk across the group will needto write back-to-back contracts with the relevant subsidiary. International GAAP does notrequire the entity with the risk to be party to the hedging transaction.

6.6 Macro or net exposure hedgingIssue - Both US and International GAAP prohibit macro hedging of risks. Specialconcessions apply in the case of hedging interest rate risk under IAS 39. Macro hedging isthe hedging of a net position without designating specific transactions for the hedge. Anairline looking at its net US dollar position will take into account a number of flowsincluding revenues, operating and financing costs and fleet sales and purchases. To qualifyfor 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 anddoes not qualify for hedge accounting.

Guidance - In practical terms, airlines can avoid the macro hedging issue through carefuldesignation of their hedges of the net exposure. In effect they rely on a natural hedge of theoffsetting elements and a specific hedge of an underlying gross position (a key requirementis to identify the hedged item, meaning that a net position does not qualify). The hedgedocumentation will need to be clear as to the precise flows being hedged.

Notes:

© 2005 KPMG, an Australian partnership, is part of the KPMG International network. KPMGInternational is a Swiss cooperative. All rightsreserved. Printed in Australia. The KPMG logoand name are trademarks of KPMG. May2005. VIC9259IM.

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airline accounting guideline no. 1

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