Impairment Testing Methodology Of Virgin Australia Airlines Holding

Assessment of Financial Assets for Impairment

Requirement i)

At each report date, Virgin Australia has assessed financial assets for impairment and it is indicated by objective evidence that estimated future cash flow generated from assets are negatively impacted by occurrence of any loss events. Assets having finite useful lives are tested for impairment whenever there is an indication that assets might be impaired and it is done annually. The management for estimating the impairment value requires significant judgment. Virgin Australia has recognized impairment in relation to maintenance reserve deposits of amount $ 28.5 million. Impairment loss has been recognized on assets of amount 118.1 million that is associated with lease contracts (virginaustralia.com 2018).

Requirement ii)

Organization performs impairment testing on annual basis for determining if the impairment loss is generated and potential impacts through sensitivity analysis.  At each reporting date, the group does assessment whether there is any indication that assets requires impairment. Recoverable amount of assets is estimated when there is requirement of conducting annual impairment testing. Inflow us nit generated by assets when recoverable amount of assets are higher than assets. A cash-generating unit or an asset is considered impaired when their recoverable amount is less than the carrying amount and after impairment, amount is written down to its recoverable amount (virginaustralia.com 2018). Judgment is required for determination of cash generating unit, regarding the way operations is monitored by management.

Carrying value of intangible assets and goodwill is allocated to each cash-generating unit and there is no amortization of these balances and this result in impairment loss risks. Determination of Cash generating unit is based on calculations of value in use. Financial budgets form the basis of estimating future cash flow that is approved by senior management.

Requirement iii)

In the current reporting year, Virgin Australia airlines holding has recorded impairment expenses on assets that are classified as held for sales and impairment losses on other assets. Impairment assets on other assets are reported at $ 118.1 million and impairment losses on assets that are classified as held for sale is reported at $ 107.3 million. Impairment loss in relation to intangible assets is recorded at $ 4.6 million (virginaustralia.com 2018).

Requirement iv)

The calculation of impairment is done as the difference between present value of estimated future cash flows and the carrying value of assets. Future cash flow is estimated at by discounting at original effective interest rate of asset. Varying amount of assets and liabilities has the possibility of carrying significant risks in light of assumptions that are made by management and are likely to make material adjustments. Virgin Australia is required to use estimates that are based on assumptions for calculation of unearned revenue. Historical trend of financial liabilities and assets form the basis of assumptions. Any change in assumptions for determining recoverable amount of assets leads to reversal of recognized impairment loss. Projections of cash flow are based on assumptions such as expectation of management regarding revenue, market, costs, fuel price, load factors and exchange rate.  

Impairment Testing on an Annual Basis

Requirement v)

Accuracy of impairment testing by organization can be improved if there is any existence of subjectivity in determining the estimates. Management of group is required to make judgment about assets recoverable amount and in terms of inputs and parameters. Significant judgment is required for determining the estimation of impairment value. In the current year, it was recognized by the management of group that there was no requirement of conducting impairment testing and there was no triggering of impairment and recognition of goodwill (virginaustralia.com 2018). Therefore, the assumptions, framing judgment, making estimates are all accounted by exercising subjectivity and enabling management to act opportunistically.

Requirement vi)

The impairment testing methodology of virgin Australia airline holding seems to be interesting as depicted from the analysis of annual report. Management has done impairment testing by considering relevant facts and figures and determining whether impairment has triggered in any particular reporting year. Assumptions of management regarding impairment testing might reasonably change if they are identified. It has been found that other variables determining impairment have been held constant as mentioned in the sensitivity analysis. Another interesting fact that has been gained about impairment testing by analyzing the report of Airline Company that it conducts sensitivity analysis by making several assumptions and changing the assumptions for recoverable amount estimation so that it becomes equal to carrying amount (virginaustralia.com 2018).  

Requirement vii)

Analysis of financial report of virgin Australia airline holding would provide users with an interesting insight about impairment methodology. The potential impact of key risks involved in impairment testing is determined by sensitivity analysis. There is a separate area summarizing financial assets and liabilities sensitivity to changes in prices of fuel.

Requirement viii)

 The determination of fair value is done by utilizing the assumptions underlying methodology of black Scholes and valuation is undertaken in a framework that is risk neutral although variables are allowed such as dividends, volatility, withdrawal rate and risk free rate. Assumptions regarding financial liabilities and assets require judgment of management.  Measurement of financial liabilities and assets are at done fair value and they are disclosed in the financial statements by categorizing within hierarchy of fair value. Estimated discounted cash flow helps in determination of fair value of derivative financial instruments and the discounted rate is based on fuel price and forward exchange market rate at the reporting date (virginaustralia.com 2018). Due to the short-term nature, the fair value of receivables, cash and cash equivalent and payables is approximately equal to their carrying amount.

Carrying Value of Intangible Assets and Goodwill

Requirement i)

Lease is one of the most fundamental activities of organizations and mainly for airline companies. The current accounting standard for lease is not able to meet the needs to users because of employing of different accounting models that leads for different accounting for similar transactions. Recognition of liabilities and assets that arises in operating leases is done by user themselves, as there is not proper disclosure in the balance sheet of organizations. Under the existing lease standard, it is not mandatory for reporting entity to report operating lease on their statement of financial positions. This might understate the total amount of leases attributable to business as the off balance sheet leases are more than on sheet (Nash 2018). Therefore, there is no faithful representation of total lease liabilities and leases assets. Moreover, there exists lack of transparency that makes it difficult for users to evaluate the total amount of leased assets and liabilities, an organization has. In different lease transactions, different economics are involved and in the absence of their disclosures, users of financial statement are not provided with economic reality pertaining to leases.  

Requirement ii)

Under the existing lease accounting standard, organizations are required to only make disclosure of capital lease assets and liabilities. However, they are not required to disclose operating leased assets and liabilities as their disclosure is not mandatory. There exists possibility that a reporting entity might have thousands leases liabilities and assets that are not incorporated in the financial metrics. Most of the organizations have majority of leased liabilities and assets in the form of operating leases and are not disclosed in the statement of financial position leading to underestimation of actual operating lease amount (Huber et al. 2017). This would contribute in making total leases reported in the balance sheets significantly lower than off balance sheet. Although, there is no disclosure of such leasing amounts in the financial statements, organization are committed to duly meet their long-term commitments arising from such operating leases.

Many retail organizations have gone bankrupt at the time of financial crisis on part of their failure to make adjustments to reflect economic reality. Financial position of such reporting entities are perceived deceptively as their obligations to meet or repay their long-term liabilities arising from operating leases despite they are not disclosed in the financial statements in accordance with the existing or current lease standard.

Requirement iii)

Former accounting standard of leasing was criticized due to its complexity in defining and dividing line between operating and financing. This makes it difficult for investors to make comparison between the financial positions of different entities. Majority of leases of aviation companies are acquired in the form of operating leases and their disclosures are not done in the balance sheets. Hence, there exists dissimilarity between organizations who are buying most of its fleet and organizations who are leasing most of their aircraft fleets. However, in reality there exist considerable differences between financial position of such companies. It is indicative of the fact that there is no level-playing field between some of airline companies. All the leases for airline companies will be accounted in the form of assets with the adoption of this standard and it would be recorded in the form of liabilities (Edwards 2015). Therefore, the introduction of new lease standard will help in resolving the issue of level playing field between airline companies.

Requirement iv)

Impairment Losses on Assets

Views of chairman of IASB that new lease accounting standard will not be popular among everyone is because of several criticisms that are leveled against it and they are listed below:

• It is perceived that new accounting standard for lease will increase complexities and costs of reporting relating to large volume of small assets in relation to leases.
• Balance sheet profiles of lessee will change significantly that would make them looks more leveraged than they actually are (Waybright et al.2015). This would have an impact on lessees borrowing costs and making it reason for becoming unpopular among lessees.
• Some sophisticated lenders when lending to lessee already estimate the effect of leases that are off balance sheet on leverage. Hence, reporting entity is not required to bring them on balance sheets.
• One of the factors is adequacy of knowledge on part of management for implementing new lease standard. An organization is required to gather relevant facts and information and make changes accordingly so that they get adapted to new system (Mader et al.2015). However, existing financial metrics of organization will also be altered by the implementation of this new leasing standard.

Requirement v) 

The new rules that are framed for leasing as per new accounting standard will ensure that balance sheets reflect lessees correct financial state of affairs. Moreover, lenders will be able to get detailed and true information on credit risks of lessee and therefore, they will be well equipped with understanding about pricing the risk of lending. For determining how lease accounting will be affected by this new standard, it is required by reporting entity to conduct preliminary assessment. It is also required to be ensured by entities that they have adequate internal control system in place so that they are able to collect necessary information for implementation of new standard. A detailed guidance is provided to organizations for determining whether contract is service contract or lease contract (Eng et al. 2014). Organizations working heavily with operating leases will be considerably impacted by this new lease standard. There will be reasonable uncertainty by exercising leasing options relating to economic reality. Moreover, lease accounting will enable better and informed decision among investors in terms of determining contract terms, calculations and leasing practice that leads to identification of relevant leased assets relating to leasing operations. Investors under new standard are not required to perform any rough calculations for estimating the amount of leased assets and liabilities to add back them on balance sheets (Antle and Garstka 2014). It will facilitate making comparison between different companies and assist investors in leading to more balanced lease versus better buy decisions by management and making informed decisions.

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Virginaustralia.com. (2018). [online] Available at: https://www.virginaustralia.com/cs/groups/internetcontent/@wc/documents/webcontent/~edisp/2016-asx-financial-report.pdf [Accessed 15 Jan. 2018].

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