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Industry Developments and Alerts
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1995

Airline industry developments - 1995/96; Audit

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American Institute of Certified Public Accountants. Auditing Standards Division

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 AUDIT RISK
ALERTS

Airline Industry
Developments—1995/96
Complement to AICPA Industry Audit Guide
Audits of Airlines

AICPA
American Institute of Certified Public Accountants
 NOTICE TO READERS

This Audit Risk Alert is intended to provide auditors of financial

statements of airlines with an overview of recent economic, industry,
regulatory, and professional developments that may affect the audits they
perform. This document has been prepared by the AICPA staff. It has not
been approved, disapproved, or otherwise acted on by a senior technical
committee of the AICPA.

George Dietz
Technical Manager, Audit and Accounting Guides

Gerard L. Yarnall
Director, Audit and Accounting Guides

Copyright © 1995 by
American Institute of Certified Public Accountants, Inc.,
New York, NY 10036-8775
All rights reserved. Requests for permission to make copies
of any part of this work should be mailed to Permissions
Department, AICPA, Harborside Financial Center,
201 Plaza Three, Jersey City, NJ 07311-3881.
1 2 3 4 5 6 7 8 9 0 AAG 9 9 8 7 6 5
 Table of Contents

Page

Airline Industry Developments—1995/96 ....................................... 5

Industry and Economic Developments......................................... 5

Competitive Environment........................................................... 6

Regulatory Developments................................................................. 7
Passenger Facility Charges........................................................... 7
Passenger Facility Charges — Internal Control
Examination G uid e................................................................... 10
Stage II Aircraft............................................................................... 10

Audit Issues......................................................................................... 11
Ticketless Travel............................................................................. 11
Code Sharing Agreements........................................................... 11
Restructurings................................................................................. 12
Environmental Issu es................................................................... 13

Accounting Issues and Developments........................................... 14

Stock-Based Compensation......................................................... 14
Impairment of Long-Lived A ssets............................................. 15
Risks and Uncertainties................................................................. 16
AICPA Exposure Draft: Proposed Statement of
Position on Environmental Remediation Liabilities............ 17
Frequent Travel Award Programs............................................. 18
SEC Accounting Guidance........................................................... 19

AICPA Audit and Accounting Literature..................................... 20

Industry Audit G uide................................................................... 20

Information Sources 21
 Airline Industry
Developments — 1995/96

Industry and Economic Developments

After incurring losses totaling $13 billion over the past five years, the
airline industry is expected to show a significant profit for 1995. Indus­
try-wide cost cutting measures, higher air fares, more passenger traffic
resulting from stronger than anticipated summer travel, and increases
in foreign tourism due to the weak dollar, have all contributed to mak­
ing 1995 a profitable year, thus far, for the airline industry. Moreover,
for the first time since 1988, no major carriers are operating under
bankruptcy protection. By midyear, planes had been flying at an aver­
age capacity of 72 percent while air fares had risen approximately 6
percent over 1994 levels. Airline stock prices, bolstered by expectations
of continued profitability, have appreciated by approximately 52 per­
cent so far this year.
Many airlines are attempting to solidify their positions of profitabil­
ity by continuing efforts to reduce costs. Currently the focus of these
efforts is travel agent commissions, which are typically the third larg­
est expense behind labor and fuel. Led by a major carrier, most airlines
are now cutting commissions by approximately 10 percent, capping
them at $50 for domestic round trip tickets. As a result, analysts expect
industry-wide savings of over $400 million. On the other side of the
equation, the commission cap may have an adverse effect on travel
agents. Some agencies may be unable to absorb a 10 percent decrease in
commission revenue. Accordingly, auditors should be alert to the pos­
sibility that reduced commissions may call into question the collectibil­
ity of certain accounts receivable arising from travel agency sales.
Airlines continue to seek wage and work-rule concessions from un­
ions representing transport workers, flight attendants, and pilots.
However, industry profitability along with strong demand has
strengthened the unions' resolve to resist further give-backs. In re­
sponse, some airlines have established employee stock programs in
lieu of salary increases, to compensate for salary reductions, or as pro­
ductivity incentives. See "Stock-Based Compensation" in the "Ac­
counting Issues and Developments" section of this Audit Risk Alert for
further discussion.
One of the significant factors contributing to the moderate profitabil­
ity experienced by the airline industry in 1994 was a decrease in fuel

5
costs over the prior year (approximately 13 percent lower than 1993).
However, this year the industry faces rising fuel prices (10 percent to
15 percent over 1994 prices) in addition to the impending expiration of
the gasoline tax exemption. The industry is attempting to lobby Con­
gress to extend the deadline for the exemption from the 4.3 cents per
gallon tax increase imposed by the current administration. The Budget
Reconciliation Bill before the House of Representatives is expected to
include a provision extending the exemption for two more years. How­
ever, if the exemption, which expired in October 1995, is not extended,
industry profits could be reduced by as much as $700 million. Auditors
should be alert to the impact of the tax increase on those carriers with
fleets comprised of older, less fuel-efficient aircraft. Smaller, under­
capitalized carriers, that are unable to ground these planes, will be
forced to absorb significant cost increases unless such increases can be
passed on to passengers through fare increases. As such, their ability to
continue as going concerns may be called into question (see the follow­
ing section "Competitive Environment" for discussion of this topic).

Competitive Environment
AICPA Statement on Auditing Standards (SAS) No. 22, Planning and
Supervision (AICPA, Professional Standards, vol. 1, AU sec. 311), requires
that, in planning their audits, auditors consider matters relating to the
entity's business and the industry in which it operates. One such mat­
ter for airlines is the intensely competitive environment in which the
industry operates. For example, major carriers constantly face the
threat of deep fare discounting from low cost rivals. In response, carri­
ers generally lower their own ticket prices to match the competition (a
practice that leads to what are commonly referred to as fare wars) thus
driving down air traffic revenues. These smaller carriers, some of
which are expanding operations, typically maintain lower costs by em­
ploying a non-unionized work force, offering low-fare no-frills air
travel, and by flying older aircraft which are generally less expensive
to own or lease (however, see "Stage II Aircraft" in the "Regulatory
Developments" section of this Audit Risk Alert). In contrast, many ma­
jor carriers are saddled with the higher costs associated with unionized
labor and the higher depreciation and interest expense generated by
fleets of newer, more expensive aircraft. As a result, the larger carriers
are more vulnerable to the effects of fare wars. Many airlines have
responded to such competitive pressures by implementing restructur­
ing programs (see "Restructurings" in the "Audit Issues" section of
this Audit Risk Alert) to reduce costs. Additionally, some airlines are
facing competition from unlikely sources. Carriers that rely heavily on

6
the business traveler are beginning to see that market segment shrink.
As businesses cut costs and continue to implement advanced telecom­
munications technologies there has been a corresponding reduction in
their need to incur the expense of air travel.
Despite expected industry profitability for the current year, these
competitive pressures, along with higher fuel prices and costly regula­
tory requirements (see the following section, "Regulatory Develop­
ments"), may raise going-concern issues. Auditors should be alert to
conditions and events such as those described which, when considered
in the aggregate, indicate there could be substantial doubt about the
airline's ability to continue as a going concern for a reasonable period
of time not to exceed one year from the date of the financial statements
being audited. In such circumstances, auditors should be aware of their
responsibilities pursuant to SAS No. 59, The Auditor's Consideration o f an
Entity's Ability to Continue as a Going Concern (AICPA, Professional
Standards, vol. 1, AU sec. 341). SAS No. 59 provides guidance to audi­
tors for evaluating whether there is substantial doubt about an entity's
ability to continue as a going concern for a reasonable period of time
not to exceed one year from the date of the financial statements being
audited.

Regulatory Developments

Passenger Facility Charges

The Federal Aviation Administration (FAA) has in place a passenger
facility charge (PFC) program that permits local airport authorities to
impose specified per-passenger charges at commercial service airports
in order to finance airport improvements. Airlines collecting PFCs un­
der Sections 9110 and 9111 of the Aviation Safety and Capacity Expan­
sion Act of 1990 have the responsibility for remitting such funds and,
those carriers that have at least 50,000 passengers annually, are re­
quired to have annual audits of their PFCs collected, withheld, re­
funded/exchanged, and remitted by the carrier for the year and each
quarter ended during the year. Further, implementing regulations in
Part 158 of FAA regulations outlining policies and procedures for the
PFC program require the airlines to obtain a report from their inde­
pendent auditors on "the fairness and reasonableness of the airline's
procedures for receiving, holding, and disbursing PFC revenues."
These requirements are satisfied as follows:
1. An audit in accordance with generally accepted auditing stand­
ards of a schedule of PFC charges collected, w ithheld, re-

7
 funded/exchanged, and remitted by the carrier for the year and
each quarter ended during the year
2. An internal control structure examination attestation engagement
in accordance with AICPA Statement on Standards for Attesta­
tion Engagements (SSAE) No. 2, Reporting on an Entity's Internal
Control Structure Over Financial Reporting (AICPA, Professional
Standards, vol. 1, AT sec. 400)

The AICPA has worked with the FAA and industry representatives
to develop the following illustrative reports that satisfy both existing
professional literature and the FAA's requirements.
Illustrative Report on Audit of PFC Schedules
Independent Auditor's Report
XYZ Airline Inc.:
We have audited the accompanying Schedules of Passenger Fa­
cility Charges Collected, Withheld, Refunded/Exchanged, and
Remitted by XYZ Airline, Inc. (the Company) for the year and
each quarter during the year ended December 31, 199X (the
Schedules). The Schedules are the responsibility of the Com­
pany's management. Our responsibility is to express an opinion
on the Schedules based on our audit.
We conducted our audit in accordance with generally accepted
auditing standards. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether
the Schedules are free of material misstatement. An audit in­
cludes examining, on a test basis, evidence supporting the
amounts and disclosures in the Schedules. An audit also includes
assessing the accounting principles used and significant esti­
mates made by management, as well as evaluating the overall
presentation of the Schedules. We believe that our audit provides
a reasonable basis for our opinion.
The Schedules were prepared for the purpose of complying with
the regulations issued by the Federal Aviation Administration of
the U.S. Department of Transportation to implement Section 9110
and 9111 of the Aviation Safety and Capacity Expansion Act of
1990. Those regulations define collection as the point when
agents or other intermediaries remit passenger facility charges to
the airlines. Accordingly, our audit did not encompass tests of the
underlying documentation supporting the report submitted by
such agencies and intermediaries to the Company.
In our opinion, the Schedules referred to above present fairly, in
all material respects, the passenger facility charges collected,
withheld, refunded/exchanged, and remitted by XYZ Airline,
Inc., for the year and each quarter during the year ended Decem-

8
ber 3 1 , 199X, as defined in regulations issued by the Department
of Transportation.
This report is intended solely for the information of the Board of
Directors and management of XYZ Airline, Inc., and the appro­
priate airport authorities. However, this report is a matter of pub­
lic record, and its distribution is not limited.
[Signature]
[Date]
Illustrative Report on Internal Control Structure
Used in Administering PFC's
Independent Auditor's Report
XYZ Airline, Inc.:
We have examined management's assertion included in its rep­
resentation letter, dated February 15, 19XX, that XYZ Airline,
Inc., maintained an effective internal control structure over ad­
ministering passenger facility charges collected, withheld, re-
funded/exchanged, and remitted during the year ended
December 31, 19XX, for the purpose of complying with the
regulations issued by the Federal Aviation Administration of
the Department of Transportation to implement sections 9110
and 9111 of the Aviation Safety and Capacity Expansion Act of
1990.
Our examination was made in accordance with standards estab­
lished by the American Institute of Certified Public Accountants
and, accordingly, included obtaining an understanding of the in­
ternal control structure over financial reporting, testing and
evaluating the design and operating effectiveness of the internal
control structure, and such other procedures as we considered
necessary in the circumstances. We believe that our examination
provides a reasonable basis for our opinion.
Because of inherent limitations in any internal control structure,
errors and irregularities may occur and not be detected. Also,
projections of any evaluation of the internal control structure
over financial reporting to future periods are subject to the risk
that the internal control structure may become inadequate be­
cause of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
In our opinion, management's assertion that XYZ Airline, Inc.,
maintained an effective internal control structure over admin­
istering passenger facility charges collected, withheld, re­
funded/exchanged, and remitted during the year ended De­
cember 31, 19XX, is fairly stated, in all material respects, based
upon criteria established by the Committee of Sponsoring Or­
ganizations of the Treadway Commission.

9
 This report is intended solely for the information and use of the
Board of Directors and management of XYZ Airline, Inc., and the
appropriate airport authorities. However, this report is a matter
of public record, and its distribution is not limited.
[Signature]
[Date]

Passenger Facility Charges — Internal Control Examination

Guide
The FAA has expressed interest in developing a guide for use by
independent accountants in conducting the internal control struc­
ture examination attestation engagement relative to the airline's
procedures for receiving, holding, and disbursing PFC revenues.
Practitioners should be alert for issuance of a final guide from the
FAA.

Stage II Aircraft
The FAA has issued regulations that require airlines to eliminate
certain aircraft from their passenger fleets by the end of 1999. These
aircraft, referred to as Stage II aircraft, include Boeing 727s, 737-
100s/200s, and 747-100s; McDonnell Douglas DC-9s (except 80s)
and certain DC-10s; BAC-111s; Fokker 28s; and any Boeing 707s or
DC-8s that have been retrofitted to Stage II. The regulations provide
airlines with the option to adopt one of the following compliance
schedules:
1. Reduce their base-year fleet of Stage II aircraft (determined as of
the end of 1990) by 25 percent by the end of 1994, another 25
percent by the end of 1996, another 25 percent by the end of 1998,
and the remaining 25 percent by the end of 1999.
2. Increase their percentage of Stage III airplanes to a minimum of 55
percent by the end of 1994, 65 percent by the end of 1996, 75 per­
cent by the end of 1998, and 100 percent by the end of 1999.
The FAA's regulations provide that Stage II aircraft can qualify as
Stage III if carriers fit those older model aircraft with so called hush-
kits which reduce the excess noise levels they generate. These kits
could cost up to $2 million each. Auditors should consider manage­
ment's assessment of the impact of Stage II regulations on the carrying
and residual values of existing aircraft. For a related discussion, see
"Impairment of Long-Lived Assets" in the "Accounting Issues and De­
velopments" section of this Audit Risk Alert.

10
Audit Issues

Ticketless Travel
The continuing trend toward "ticketless" travel raises an issue to be
considered by auditors. Under this system, an airline passenger can
book a flight over the telephone and be assigned a reservation number
(in a manner similar to the way hotel reservations are made) rather
than being issued a ticket. Since no ticket is issued, there is no ticket
stub available to the auditor as a source of evidential matter. Accord­
ingly, the auditor's consideration of the internal control structure relat­
ing to ticketless travel and the performance of analytical procedures on
the related revenues and receivables, will take on increased impor­
tance.

Code Sharing Agreements

Airlines are increasingly becoming involved in marketing alliances
known as code sharing agreements. These agreements may involve the
coordination of flight schedules or sharing of seats on a common air­
craft to the mutual benefit of the parties to the agreement. For exam­
ple—
• A code sharing agreement between a regional and international
carrier might require the coordination of their flight schedules so
that the regional carrier could feed air traffic to the international
carrier. The international carrier, in turn, would reciprocate by
providing frequent flier miles to customers of the regional carrier.
• A carrier seeking to withdraw from an unprofitable route without
losing a significant portion of that customer base, can continue to
provide service to that market through a code sharing agreement
with another carrier.
• A carrier may enter into a code sharing agreement to gain access to
an international market from which it was excluded due to restric­
tive bilateral agreements between the U.S. and a particular foreign
government. This can be accomplished by allocating seats on an
airplane, along with the related ticket revenue, between the two
carriers.
Such arrangements may give rise to a number of audit and account­
ing issues. In auditing the financial statements of airlines that are party
to these agreements, auditors should become familiar with the provi­
sions of code sharing agreements that may affect financial statement
amounts and consider their accounting ramifications. For example,

11
there may be a need to consider the propriety of amounts and timing of
revenue to be recognized under the agreement and whether potential
liabilities and related costs, have been properly recorded.

Restructurings
To reverse the massive losses incurred over the past few years, many
airlines implemented restructuring programs aimed at reducing costs.
By revamping route systems and the frequency of flights, redeploying
aircraft, obtaining labor concessions, grounding inefficient aircraft, or
downsizing overall operations, many airlines have made significant
progress in attaining profitability in 1995. Some carriers are likely to
continue restructuring efforts in part due to the competitive pressures
driving revenues down and regulatory requirements pushing costs up.
When airlines restructure, auditors' should consider the impact of re­
ductions in personnel on operations and on the internal control struc­
ture; the appropriateness and completeness of recorded liabilities
relating to current restructuring plans; the carrying value of aircraft
and intangibles (such as route acquisition costs); and the appropriate
period for reporting the costs associated with restructurings.
In considering restructuring liabilities and costs, auditors should be
aware of Financial Accounting Standards Board (FASB) Emerging Is­
sues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (includ­
ing Certain Costs Incurred in a Restructuring), for authoritative guidance
on the appropriate accounting for restructurings. EITF Issue No. 94-3
also provides guidance on the types of costs that should be accrued
and the timing of recognition of restructuring charges. It also pre­
scribes disclosures that should be included in the financial statements.

Internal Control Structure Implications. If, after obtaining an under­

standing of an airline's internal control structure, the auditor con­
cludes that the effects of restructuring have had a detrimental impact
on the ability of the structure to function, an increased level of control
risk may be assessed. Auditors should, therefore, adjust the scope of
their audits accordingly. Documentation of the understanding of the
airline's internal control structure is required by SAS No. 55, Considera­
tion o f the Internal Control Structure in a Financial Statement Audit
(AICPA, Professional Standards, vol. 1, AU sec. 319). If that under­
standing reveals that the internal control structure is weak, there is
increased risk that material errors and irregularities will result in mis­
statements in the financial statements, and a reportable condition, as
defined in SAS No. 60, Communication o f Internal Control Structure Re­

12
lated Matters Noted in an Audit (AICPA, Professional Standards, vol. 1, AU
sec. 325), may exist.

Publicly Held Airlines. Securities and Exchange Commission (SEC)

Staff Accounting Bulletin (SAB) No. 67 (Topic 5P), Income Statement
Presentation o f Restructuring Charges, requires that restructuring charges
be reported as a component of income from continuing operations.

Environmental Issues
Environmental remediation liability laws, written at all levels of gov­
ernment, have exposed airlines to an increased vulnerability to envi­
ronmental claims. The Resource, Conservation and Recovery Act,
Superfund, along with various clean air and water acts, may be used to
hold airlines liable for the remediation of environmental contamina­
tion. Superfund, for example, legally empowers the U.S. Environ­
mental Protection Agency to seek recovery from current and previous
owners or operators of a particular contaminated site, or anyone who
generated or transported hazardous substances to such a site. An air­
line carrier's use, storage, and disposal of significant amounts of fossil
fuels may raise issues relating to environmental contamination and,
therefore, the possibility of enforced remediation.
The accounting literature applicable to accounting for environ­
mental remediation liabilities includes FASB Statement No. 5, Account­
ing fo r Contingencies (FASB, Current Text, vol. 1, sec. C59), FASB
Interpretation No. 14, Reasonable Estimation o f the Amount o f a Loss
(FASB, Current Text, vol. 1, sec. C59), and FASB Interpretation No. 39,
Offsetting o f Amounts Related to Certain Contracts (FASB, Current Text,
vol. 1, sec. B10). In addition, guidance is included in the consensuses
reached by the EITF in Issue No. 89-13, Accounting for the Cost o f Asbes­
tos Removal, Issue No. 90-8, Capitalization o f Costs to Treat Environmental
Contamination, and Issue No. 93-5, Accounting for Environmental Liabili­
ties.
Auditors of publicly held airlines should be aware of the SEC's SAB
No. 92, Accounting and Disclosures Relating to Loss Contingencies. The
SAB provides the SEC staff's interpretation of current accounting lit­
erature related to the following:

• The inappropriateness of offsetting probable recoveries against

probable contingent liabilities.
• Recognition of liabilities for costs apportioned to other potential
responsible parties.

13
 • Uncertainties in the estimation of the extent of environmental li­
abilities.
• The appropriate discount rate for environmental liabilities, if dis­
counting is appropriate.
• Financial statement disclosures of exit costs and other items and
disclosure of certain information outside the basic financial state­
ments.
Audit Risk Alert— 1995/96 contains further discussion of issues relat­
ing to environmental remediation matters. Also, refer to the "Account­
ing Issues and Developments" section of this Audit Risk Alert for
information on AICPA Exposure Draft: Proposed Statement o f Position on
Environmental Remediation Liabilities.

Accounting Issues and Developments

Stock-Based Compensation
As part of continuing cost cutting measures, some airlines have at­
tempted to reduce payroll costs or increase productivity through the
issuance of stock to employees in lieu of cash.
In October 1995, the FASB issued Statement No. 123, Accounting for
Stock-Based Compensation. The Statement encourages companies to
adopt a new fair value based method of accounting for employee stock
compensation plans. However, it also allows companies to continue to
measure compensation cost for such plans using the intrinsic value
based method of accounting prescribed by Accounting Principles
Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees
(FASB, Current Text, vol. 1, sec. C47).
The Statement also requires certain disclosures about stock-based
employee compensation arrangements regardless of the method used
to account for them. Companies that do not adopt the new fair value
based method of accounting are required to make pro forma disclo­
sures of net income and, if presented, earnings per share, determined
as if the company had applied the new method.
The accounting requirements of FASB Statement No. 123 are effec­
tive for transactions entered into in fiscal years that begin after Decem­
ber 1 5 , 1995, though they may be adopted on issuance of the Statement.
The disclosure requirements of the Statement are effective for financial
statements for fiscal years beginning after December 1 5 , 1995, or for an
earlier fiscal year for which the Statement is initially adopted for recog­
nizing compensation cost. Pro forma disclosures required for entities
that elect to continue to measure compensation cost using APB Opin­

14
ion No. 25 must include the effects of all awards granted in fiscal years
that begin after December 1 5 , 1994. Pro forma disclosures for awards
granted in the first fiscal year beginning after December 1 5 , 1994, need
not be included in financial statements for that fiscal year but should be
presented subsequently whenever financial statements for that year
are presented for comparative purposes with financial statements for a
later fiscal year.
Auditors of airlines that issue options and warrants to their employ­
ees should consider carefully whether the accounting principles for
stock-based compensation plans have been properly applied and
whether financial statement disclosures are adequate.

Impairment of Long-Lived Assets

In March 1995, the FASB issued Statement No. 121, Accounting for the
Impairment o f Long-Lived Assets and for Long-Lived Assets to Be Disposed
O f (FASB, Current Text, vol. 1, sec. I08). FASB Statement No. 121 estab­
lishes accounting standards for the impairment of long-lived assets,
certain identifiable intangibles, and goodwill related to those assets to
be held and used, and for long-lived assets and certain identifiable
intangibles to be disposed of. The Statement requires that long-lived
assets and certain identifiable intangibles to be held and used by an
entity be reviewed for impairment whenever events or changes in cir­
cumstances indicate that the carrying amount of an asset may not be
recoverable. In performing the review for recoverability, the Statement
requires that the entity estimate the future cash flows expected to result
from the use of the asset and its eventual disposition. If the sum of the
expected future cash flows (undiscounted and w ithout interest
charges) is less than the carrying amount of the asset, an impairment
loss is recognized. Otherwise, an impairment loss is not recognized.
Measurement of an impairment loss for long-lived assets and identifi­
able intangibles that an entity expects to hold and use should be based
on the fair value of the asset. (The fair value of an asset is the amount at
which that asset could be bought or sold in a current transaction be­
tween willing parties.)
The Statement also requires that long-lived assets and certain identi­
fiable intangibles to be disposed of be reported at the lower of carrying
amount or fair value less cost to sell, except for assets covered by APB
Opinion No. 30, Reporting the Results o f Operations—Reporting the Effects
o f Disposal o f a Segment o f a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions (FASB, Current Text, vol.
1, sec. I13). Assets covered by APB Opinion No. 30 will continue to be
reported at the lower of the carrying amount or the net realizable
value.

15
 The Statement is effective for financial statements for fiscal years
beginning after December 15, 1995. Earlier application is encouraged.
Restatement of previously issued financial statements is not permitted
by the Statement. The Statement requires that impairment losses re­
sulting from its application be reported in the period in which the rec­
ognition criteria are first applied and met. The Statement requires that
initial application of its provisions to assets that are being held for
disposal at the date of adoption should be reported as the cumulative
effect of a change in accounting principle.
Aircraft carrying values, and their revenue-generating ability, may
be affected by economic, regulatory, and physical factors. Such factors
might include the price of fuel, air-worthiness directives, required air­
craft modifications, and costly maintenance procedures. For example,
the increase in fuel prices this year, along with the possible expiration
of the gasoline tax exemption, may hasten the obsolescence of less fuel-
efficient aircraft. High fuel prices and updated air-worthiness direc­
tives may cause airlines to decide that certain types of aircraft should
be temporarily grounded. Additionally, regulatory requirements such
as the elimination of Stage II aircraft in an airline's fleet may negatively
affect the carrying and residual values of flight equipment. In such
instances, the carrying amounts of recorded assets may not be recover­
able and the provisions of FASB Statement No. 121 may need to be
applied.
In considering an airline's implementation of FASB Statement No.
121, auditors should obtain an understanding of the policies and pro­
cedures used by management to determine whether all impaired assets
have been properly identified. Management's estimates of future cash
flows from asset use and impairment losses should be evaluated pur­
suant to the guidelines set forth in SAS No. 57, Auditing Accounting
Estimates (AICPA, Professional Standards, vol. 1, AU sec. 342).

Risks and Uncertainties

In December 1994, the AICPA's Accounting Standards Executive
Committee issued Statement of Position (SOP) 94-6, Disclosure o f Cer­
tain Significant Risks and Uncertainties. SOP 94-6 requires nongovern­
mental entities to include in their financial statements disclosures
about (1) the nature of their operations and (2) the use of estimates in
the preparation of financial statements. In addition, if specified criteria
are met, SOP 94-6 requires entities to include in their financial state­
ments disclosures about (1) certain significant estimates and (2) current
vulnerability due to certain concentrations.
Paragraph 18 of SOP 94-6 gives examples of items that may be based
on estimates that are particularly sensitive to change in the near term.

16
Examples of similar estimates that may be included in the financial
statements of airlines include, but are not limited to:

• Useful lives and residual values of flight equipment

• Amortization period of route acquisition costs
• Allowance for obsolescence of expendable parts inventory
• Estimates of liabilities for frequent flier programs

Examples of concentrations that may meet the criteria that require

disclosure in the financial statements of airlines in accordance with
paragraph 21 of the SOP include the following:

• Routes of regional carriers limited to a particular geographical

area
• Revenue derived from flights along a particular route
• Unionized labor subject to collective bargaining agreements
• Flights along international routes

The provisions of SOP 94-6 are effective for financial statements is­
sued for fiscal years ending after December 15, 1995, and for financial
statements for interim periods in fiscal years subsequent to the year for
which SOP 94-6 is first applied.
Auditors should be alert to the requirements of the new SOP and its
impact upon the financial statements of the entity being audited. Audi­
tors should carefully consider whether all significant estimates and
concentrations have been identified and considered for disclosure.

AICPA Exposure Draft: Proposed Statement of Position on

Environmental Remediation Liabilities
In June 1995, the AICPA issued an exposure draft of a proposed SOP,
Environmental Remediation Liabilities, which may be relevant to airlines.
The proposed SOP provides that:

• Environmental remediation liabilities should be accrued when the

criteria of FASB Statement No. 5 are met, and it includes bench­
marks to aid in determining when those criteria are met.
• Accruals for environmental remediation liabilities should include
(1) incremental direct costs of the remediation effort, as defined,
and (2) costs of compensation and benefits for employees to the
extent the employees are expected to devote time to the remedia­
tion effort.

17
 • Measurement of the liabilities should include (1) the entity's spe­
cific share of the liability for a specific site, and (2) the entity's
share of amounts related to the site that will not be paid by other
potentially responsible parties or the government.
• Measurement of the liability should be based on enacted laws and
existing regulations, policies and remediation technology.
• Measurement should be based on the reporting entity's estimates
of what it will cost to perform all elements of the remediation ef­
fort when they are expected to be performed, and may be dis­
counted to reflect the time value of money if the aggregate amount
of the obligation and the amount and timing of cash payments for
a site are fixed or reliably determinable.
The exposure draft also includes guidance on display in the financial
statements of environmental remediation liabilities and on disclosures
about environmental-cost-related accounting principles, environ­
mental remediation loss contingencies, and other loss contingency dis­
closure considerations. A separate, nonauthoritative section of the
exposure draft discusses major federal environmental pollution re­
sponsibility and clean-up laws and the need to consider various indi­
vidual state and other non-United States government requirements.
Comments on the exposure draft were due by October 3 1 , 1995.

Frequent Travel Award Programs

Since frequent travel award programs were created in the early
1980s, methods of accounting for the programs have been the subject of
considerable discussion. Currently, airlines account for frequent travel
awards by the incremental cost method, under which the airline iden­
tifies an amount based on the incremental cost associated with trans­
porting a passenger in an otherwise empty seat, and establishes an
accrual for the future obligation to provide free travel awards.
In a letter sent to publicly held airlines in 1991, the SEC staff re­
quested that the following disclosures concerning frequent travel
award programs be included in SEC filings:
• The significant terms of any frequent flyer and other free travel
award programs sponsored by the airline.
• The method of accounting for the programs, including the method
of accounting for nontravel awards redeemed under the pro­
grams.
• If the incremental cost method is used, each material category of
cost included in its measurement. In addition, a clear description

18
 of when the accrual is made and how the cost is estimated should
be provided. If the liability established for provision of future serv­
ices under the programs does not include a margin representing
contribution to overhead and profit, that fact should be disclosed.
The amount of the recorded liability or expense should be dis­
closed if it is material.
• The number of free travel awards outstanding at each balance-
sheet date (expressed in terms of mileage, equivalent revenue
value, points, trips, or any other similar measure). If the number of
awards outstanding does not include partially earned awards, the
effect of this exclusion should be quantified.
• The number of awards expected to be redeemed for purposes of
estimating the liability recorded by the airline at each balance-
sheet date. This may be expressed as a percentage of total awards
outstanding. This disclosure should be accompanied by a descrip­
tion of the factors accounting for the difference between awards
outstanding and awards expected to be redeemed, quantified to
the extent practicable. The discussion should explain any mate­
rial change in the ratio of expected redemptions to total outstand­
ing awards that has occurred or may reasonably be expected to
occur.
• The number of awards actually redeemed in the periods pre­
sented.
• The amount of free travel award usage expressed as a percentage
of passenger miles flown for each period presented.
• If the displacement of revenue customers is reasonably likely and
may materially affect liquidity or operating results, emerging
trends should be described in the Management's Discussion and
Analysis (MD&A) section of the annual report.
These disclosures may be included in the financial statements, in the
MD&A section, or in the description-of-the-business section of the air­
line's SEC filings. Material changes in frequent travel awards in in­
terim periods should be disclosed in quarterly reports on Form 10-Q.

SEC Accounting Guidance

The SEC has indicated in various public speeches and in letters of
comment to registrants during the year that publicly held airlines that
are experiencing, or are reasonably likely to experience, liquidity con­
straints should carefully analyze the adequacy of their MD&A disclo­
sures regarding liquidity. Item 303 of Regulation S-K requires that

19
publicly held companies identify in MD&A any known trends, de­
mands, commitments, events, or uncertainties that will result in, or
that are reasonably likely to result in the company's liquidity increas­
ing or decreasing in any material way. Further, if a material deficiency
is identified, such companies should indicate the course of action that
they have taken or plan to take to remedy the deficiency. Auditors
should consider the consistency of the MD&A discussion of liquidity
and financial condition with the company's financial statement disclo­
sures and the auditor's report on the company's financial statements.
In regard to the required MD&A discussion of liquidity, in 1994 the
SEC issued an Accounting and Auditing Enforcement Release (No.
562) relative to the alleged MD&A deficiencies of an airline. According
to the release, the MD&A in certain of the airline's periodic reports
failed to describe uncertainties surrounding the company's efforts to
obtain additional financing and its ability to meet its existing capital
commitments that were conditioned on such financing. In addition, the
release states that the MD&A failed to objectively evaluate how the
known uncertainties could impact the financial viability of the air­
line.
In considering MD&A, auditors should be aware of their responsi­
bilities pursuant to SAS No. 8, Other Information in Documents Contain­
ing Audited Financial Statements (AICPA, Professional Standards, vol. 1,
AU sec. 550). The auditor's responsibility with respect to information
in a document does not extend beyond the financial information iden­
tified in the auditor's report, and the auditor has no obligation to
perform any procedures to corroborate other information contained
in a document, such as that presented in MD&A. However, the auditor
should read the other information and consider whether such informa­
tion, or the manner of its presentation, is materially inconsistent with
information, or the manner of its presentation, appearing in the finan­
cial statements. Auditors should refer to SAS No. 8 for further specific
guidance.

AICPA Audit and Accounting Literature

Industry Audit Guide

The AICPA Industry Audit Guide Audits o f Airlines is available
through the AICPA loose-leaf subscription service. In the loose-leaf
service, conforming changes (those necessitated by the issuance of
new authoritative pronouncements) and other minor changes that
do not require due process are incorporated periodically. Paperback
editions of the Guides as they appear in the service are printed an­
nually.

20
Information Sources
Further information on matters addressed in this risk alert is avail­
able through various publications and services listed in the table at the
end of this document. Many non-government and some government
publications and services involve a charge or membership require­
ment.
Fax services allow users to follow voice cues and request that se­
lected documents be sent by fax machine. Some fax services require the
user to call from the handset of the fax machine, others allow users to
call from any phone. Most fax services offer an index document, which
lists titles and other information describing available documents.
Electronic bulletin board services allow users to read, copy, and ex­
change information electronically. Most are available using a modem
and standard communications software. Some bulletin board services
are also available using one or more Internet protocols.
Recorded announcements allow users to listen to announcements
about a variety of recent or scheduled actions or meetings.
All phone numbers listed are voice lines, unless otherwise desig­
nated as fax (f) or data (d) lines. Required modem speeds, expressed in
bauds per second (bps), are listed data lines.

****

This Audit Risk Alert supersedes Airline Industry Developments—

1992.

****

Practitioners should also be aware of the economic, industry, regula­

tory, and professional developments described in Audit Risk Alert—
1995/96 and Compilation and Review Alert— 1995/96, w hich may be
obtained by calling the AICPA Order Department at the number below
and asking for product no. 022180 (audit) or 060669 (compilation and
review).

21
22
Information Sources
Organization General Information Fax Services Electronic Bulletin Board Services Recorded Announcements
American Institute of Order Department 24 Hour Fax Hotline Accountants Forum
Certified Public Harborside Financial Center (201) 938-3787 This information service is available
Accountants 201 Plaza Three on CompuServe. Some information is
Jersey City, N J 07311-3881 available only to AICPA members.
(800) TO-AICPA To set up a CompuServe account call
or (800) 862-4272 (800) 524-3388 and ask for the AICPA
package or rep. 748.
Information about AICPA
continuing professional
education programs is
available through the AICPA
CPE Division (ext. 3) and the
AICPA Meetings and Travel
Division: (201) 938-3232.
Financial Accounting Order Department Action Alert Telephone Line
Standards Board P.O. Box 5116 (203) 847-0700 (ext. 444)
Norwalk, CT 06856-5116
(203) 847-0700, ext. 10_________
U.S. Securities and Publications Unit Information Line Information Line
Exchange Commission 450 Fifth Street, NW (202) 942-8088, ext.3 (202) 942-8088
Washington, DC 20549-0001 (202) 942-7114 (tty) (202) 942-7114 (tty)
(202) 942-4046
SEC Public Reference Room
(202) 942-8079________________
Federal Aviation 800 Independence Ave., SW General Information
Administration Washington, DC (202) 366-4000________
National Business 1200 18th Street, NW General Information
Aircraft Association Suite 400 (202) 783-9000
Washington, DC 20036
National Air 4226 King Street General Information
Transportation Alexandria, VA 22302 (800) 808-NATA
Association
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