Question

Background Information

Newcastle Airlines Limited has been an audit client of Sydney Accountants since 2015.

You are an audit partner in Sydney Accountants involved in the planning of the 2019 audit of Newcastle Airlines.

The following circumstances relevant to the current financial year have come to your attention:

➢ The impact of fuel prices and intense competition in the airline industry.

➢ Along with new entrants like the budget airlines in the markets and an increased passenger capacity, airline companies have been lowering their airfares to capture more customers.

➢ Airlines will end up accepting very low prices while operating with very high costs.

➢ Take Emirates for instance. Emirates operates with a young fleet, meaning more fuel efficiency, lower maintenance costs, and the ability to fit more into each plane (which lowers the marginal costs of each passenger). Being based in Dubai means there are low taxes, no unions to battle with, and an abundance of cheap labour from nearby countries. Emirates’ competitive advantage is also in their reputation for excellence in service which Emirates can charge high prices for.

You reviewed Newcastle’s significant accounting policies and found that revenue and depreciation costs are material income statement accounts. Extract of the accounting policies for Revenue and Depreciation costs, together with additional relevant information, are included below:

Item 1: Revenue recognition policy

Passenger, freight, and tours and travel sales are credited to revenue received in advance and subsequently transferred to revenue in the income statement, when passengers or freight are uplifted or when tours and travel air tickets and land contentare utilised.

Your review of the prior year’s financial statements indicates revenue from passengers represents 80% of total revenue. Newcastle’s latest financial information shows a 6% fall in revenue from passengers and an 11% decrease in revenue from passengers in advance.

Item 2: Aircraft maintenance costs policy

The standard cost of major airframe and engine maintenance checks is capitalised and depreciated over the shorter of the scheduled usage period to the next major inspection or the remaining life of the aircraft.

Newcastle’s latest financial figures show the aircraft and engines at cost (including major maintenance costs) to be at a similar level as last year while depreciation costs have decreased by 5%.

You have read articles in the financial press which suggest an increased incidence of fraud due to the competitive environment, and that the majority of these frauds are committed by company directors and senior managers. In your study of corporate governance you realised that Newcastle Airline may be facing similar problems.

Required:

a) Explain why the revenue from passenger accounts in the income statement is at significant risk of fraudulent financial reporting by management.

b) Describe a relevant and practical internal control to address the fraud risk described in (a) above. Explain how the internal control will minimise the risk of fraud.

c) With reference to Item 1 and Item 2 in the Background Information, explain why each of the two income statement accounts Revenue and Depreciation costs may represent a significant risk of material misstatement

Answer 1

Revenue from passenger accounts have a significant risk of fraudulent financial reporting because of the competitive landscape in which the company is operating. There is an implied risk of material misstatement in revenue recognition for every company. Given that other competitors are resorting to lower fares, the company would also have pressure to reduce fares and consequently the company would look to advance revenues from the previous year to meet current year profitability targets.

The internal control which can be utilized to prevent this fraud is to map all revenue recognised to the actual flight lift off to ensure that no additional revenue is recognised before the service is rendered to the customers.

With increasing fuel costs and an older fleet, there will always be pressure on the company to show reduced cost/inflated revenue to ensure that profits are maintained. data from the year shows that the revenue in advance declined by 11% whereas the actual revenue reported in the P&L shows only a 6% decline. This could indicate that the company is recording its revenue earlier than it should. The company could also defer expenditure in a similar way to commit fraud. Hence both the line items indicate a significant risk of misstatement.