ACCT13017 KCQ’s – Getting to know Southern China Air

Getting to know Southern China Air

Established in 1989, Southern China Air began operations and became one of the “Big 3” air carriers with Air China and China Eastern. They were the first airline to purchase Boeing aircrafts in 1995 and just one year later became the first airline to fly non-stop across the Pacific. By 2000 they added destinations to Sydney and Melbourne. In 2011 five Airbus A380 super-jumbo planes significantly increased passenger capacity and also company prestige. They continued to expand routes to Auckland, Brisbane, Melbourne, Perth, Sydney, Amsterdam, Auckland, Istanbul, Tbilisi, Los Angeles and Vancouver. By 2014 they were transporting more than one million passengers annually. Their advancements continue with the introduction of the Enhanced Rapid Transfer Service for international travellers, showcased in this review and electronic ‘BAGTAG’. Currently, they are customer service orientated focusing on building their brand.

The parent company of China Southern Airlines Ltd, China Southern Air Holding Co, is a state-owned enterprise that was supervised by State-owned Assets Supervision and Administration Commission of the State Council.  They provide passenger, cargo, mail delivery and other transport services throughout the world. With 840 passenger and cargo transport aircrafts and the most developed route networks, they have successfully served 140 million passengers annually. They are ranked 1^st in Asia and 3^rd in the world according to fleet scale and passenger turnover. Currently employing more than 100 831 staff, they are considered the safest Chinese airline, receiving 2 top safety awards.  Their headquarters are located in Guangzhou with 16 branches and 8 holding aviation subsidiaries and 22 domestic business departments, including locations in Hangzhou, Qingdao, Sydney and New York.

Getting a feel for the Annual Reports

The Consolidated Income Statement

It might seem obvious that the main operation of an airline is to supply passengers with a transport service over large distances, but reading through Southern China Air’s annual report shows it’s more complicated than that. The report states, “Substantially all of the Group’s operating revenue is attributable to airlines transport operations.” I was curious to understand what ‘transport operations’ included. Transport operations comprised of passenger revenue, cargo and mail revenue, make up the RMB 138,064 million total traffic revenue. That’s about $28,892,969,156 AUD! Most of this is earned through passengers both domestic and international, 92.74%, while cargo and mail revenue only attributes 7.26%.  

They advise a change in accounting policy according to IFRS 15 involving how revenue from contracts with customers is recognised. I recall a discussion during LAWS19033 Taxation Law A, concerning when revenue is recognised from the purchase of an airfare if the customer fails to use the flight. The argument involved the principle of recognising a revenue only when the service was provided, in the income statement and where the service was not provided, a liability would be recorded in the balance sheet. My understanding of IFRS 15 is recognising the revenue when an obligation is satisfied by transferring a promised good or service to a customer, which is when the customer obtains control of that good or service. Therefore, the revenue is recognised when the customer buys a ticket and then becomes the controller of the service, regardless if that service is unfulfilled, as the airline has no control of the customers actions.

They derive other income from commission income, hotel and tour operation income, general aviation income and ground services income. I noticed that other net income, mainly from government grants is separate from the operating revenue. I am intrigued about their treatment of government grants, since they are expected to receive a $4 billion capital injection in 2019. This is the largest grant since 2017, when they received $21 million.  It is peculiar to note the disappearance of all impairment of property, plant and equipment in 2018. Nothing jumps out as to why this has occurred and will require some digging. I am wondering if it ties in with gains/losses on disposal and their commitment to safety when it comes to their aircrafts.

The other stand out is the massive amount of operating expenses. It was no surprise to find that jet fuel costs were the biggest expense, followed by flight personnel payroll, aircraft leases and catering. There was also a good chunk of change given to a Civil Aviation Development Fund, I had no idea what this was and there is nothing in the notes. A quick google search revealed it was an aviation tax imposed by the Chinese government for the development of airports. I’m beginning to understand the major impacts on the financial statements by the  involvement from the government of a state-owned company.

I am expecting a significantly low economic profit, considering the huge drop in profit from 2017 to 2018, due to rising oil prices and increased competition.

The Balance Sheet

As expected, the biggest asset was plant, property and equipment. Aircrafts are notoriously expensive, and I noticed that there was construction in progress which means there is significant outlay before the asset can be used in producing revenue. This time around I had a better understanding of derivative financial instruments and deferred tax assets, but back in 2014 I had no idea. I remember being stumped and curious. Now it makes sense to adjust the value of assets according to exchange rates or interest rates and also adjust to suit tax accounting. Considering the large amount of cash and cash equivalents, I found restricted bank deposits surprising. It might be usual in China, but it wasn’t something that made sense. It will be interesting to compare other Chinese companies to see if this a reoccurring thing. There appears to be a large amount of prepaid expenses but no corresponding notes as to what they relate, which makes me curious.

I would expect prepaid revenue, or as listed in the liabilities, ‘sales in advance of carriage’, to relate to pre-payments of flights, as people usually book and pay for flight prior to departure. I also noticed a large amount of borrowings. This coupled with government grants suggests the high amount of capital needed for operating an airline. There is also a large amount of accrued expenses, which means the company has an obligation to pay for goods or services already provided, that have not been classified as accounts payable.

I am trying to make sense of all this, but it’s a very complicated machine, being kept well-greased by the Chinese government.  

General Comments

Understanding how a state-owned company operates is very complicated. The reliance on capital is not solely focused on shareholders or the worry of rejection of finance. There is also the country’s culture within the organisational culture to consider and the impact from other countries perceptions. For example, the current USA reaction to China and president Trump’s response have impacted trade relations, the trade war still being negotiated.  China Southern Airline’s focus on branding will have AIM (Asian Integrated Media Pty) work cut out for them in the fallout.

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