Delta's Financial and Corporate Governance Analysis

Delta Airlines CFO Project

Delta is an established leader in the aviation industry due to its strong brand image that is complemented by numerous prestigious awards. The airline’s commitment to innovation has played a critical role in its success since emerging from bankruptcy in 2007 (Anderson, 2014). Over the past few decades, Delta has adopted an innovative business model and corporate culture that include an employee profit-sharing program and global expansion. In 2019, Delta Air Lines served nearly 200 million customers and was ranked the largest airline across the globe by total revenues. Additionally, the airline was the most profitable with five consecutive years of $5 billion or more in pre-tax income (Delta Air Lines, 2020). This report provides forensic financial analysis and corporate governance assessment of Delta Air Lines, Inc. at a time when the airline is experiencing tremendous growth and profitability.

Business Background and Operations

Delta Air Lines is currently the most profitable airline given its pre-tax profits of at least $5 billion for the last five years. As an exceptional and trusted customer brand, Delta has an expansive global network through which it connects more than 200 million customers to over 300 destinations in over 50 countries (Delta Air Lines, 2020). The growth and profitability of the airline in recent years is attributable to its global standard in customer experience, service, and reliability. The airline was named one of Fortune’s most admired companies in 2020 due to its consistent delivery of industry-leading results with unrivaled empathy and commitment to innovation. Delta has capitalized on its strong brand image to maintain strong financial performance and position over the last five years.

As evident in the company’s 2020 10-K Financial Statement, Delta has two major business/operating segments named Airlines and Refinery. The airline segment focuses on passenger and cargo services offered by the airline domestically and internationally. Additionally, this business/operational segment covers the maintenance and repair of third-party aircraft by the company (Bush, 2016). On the other hand, the Refinery segment covers refining and production of jet fuel. It is operated by Delta’s subsidiary, Monroe Energy LLC and MIPC, LLC and basically produces jet fuel, diesel, and gasoline. This operational segment also covers the provision of jet fuel to Delta’s aircraft for a cheaper amount in comparison to outsourcing the service. The main objective of the Refinery segment is to resource for the Airline segment as a means of increasing the airline’s overall profitability and success. The table below shows the financial information by segment for the airline for the year ending 2020.

Table 1: Segmented Data for Delta Air Lines for year ended December 31, 2020

(in millions)

Airline

Refinery

Intersegment Sales/Other

Consolidated

Operating revenue:

Sales to airline segment

Exchanged products

Sales of refined products

Operating loss (4)

Interest expense, net

Depreciation and amortization

Restructuring charges

Total assets, end of period

Capital expenditures

Source: https://www.annualreports.com/HostedData/AnnualReports/PDF/NYSE_DAL_2020.pdf

Delta Air Lines has transformed its business strategy and approach over the last decade. During this period, the company has established a customer-focused operation with industry-leading products, service, reliability, and a strong financial position. However, there are factors in the firm’s financial statements and risk management policies that show vulnerability to SEC action (fraud or otherwise). Similarly, there are factors in corporate governance that are potential weaknesses requiring mitigation through stronger governance policy.

Forensic Financial Analysis

As shown in the 2020 10-K Financial Statement, Delta Air Lines has a strong financial position in the market. The airline’s strong financial position is evident in its consistent pre-tax income of $5 billion or more over the past five years. However, the advent of the COVID-19 pandemic has had significant impacts on the aviation industry. Following the onset of the pandemic, the airline made significant adjustments to its network and operations. These changes were fueled by travel restrictions and the decline in demand. The measures were initiated to help the firm safeguard its customers and financial position. As the firm continues to make significant operational adjustments due to the pandemic and other market factors, it is important to ensure that its financial reporting standards and practices are not vulnerable to Securities and Exchange Commission (SEC) action (fraud or otherwise).

DiPiazza & Eccles (2002) notes that businesses face the need to develop an effective business-reporting model in order to build public trust. Financial reporting should embrace the spirit of transparency and performance auditing. This forensic financial analysis examines factors in the financial statements provided by Delta Air Lines and potential vulnerability to SEC action. The assessment primarily focuses on identifying issues that could be buried in the airline’s statements and associated notes as well as information disclosed to the public. This information is provided as a preemptive risk mitigation action and includes recommendations.

As shown in the consolidated balance sheets for the year ending December 31, 2020, Delta Air Lines has assets totaling $71,996 million, which was a $7,464 million increase from the previous financial year (Delta Air Lines, 2020). These assets can be divided into three major categories i.e. Current Assets, Plant, Property and Equipment (PPE), and Other Assets. Similar to its main competitors, Delta’s PPE accounts for a significant portion of its total assets followed by other assets and current assets. According to Bush (2016), current assets are usually low for airlines because of significant investments in PPE, which is an essential function of an airline. Additionally, PPE accounts for the highest asset group for airlines because the required planes and airport gates to provide this service are classified under this asset category.

Computing Delta Air Lines financing requires making an adjustment when comparing total liabilities with total equity. Bush (2016) notes that Total Stockholder Equity would not be suitable for use in this scenario because of the firm’s deficit in Retained Earnings. While Delta Air Lines had no deficit in Retained Earnings in the year ending December 31, 2019, the deficit in the year ending December 31, 2020 implies that the company had no income from stock in this fiscal year. Therefore, Paid in Capital was compared with total liabilities to determine whether total liabilities or total equity handles the airline’s financing. Despite its strong financial performance and position, Delta Air Lines faces some financial risks that could have significant negative impacts on financial reporting. Some of these risks include:

A Higher Debt-to-Equity Ratio

As shown in financial statements for the year ending December 31, 2020, Delta Air Lines had higher amounts of liabilities compared to stock income. This trend is evident in the firm’s financial performance for the past five years. Despite being in a strong financial position compared to industry rivals, the higher amounts of liabilities than stock income implies that Delta heavily relies on debt and loans to fund expenditures. This is a major risk for Delta Air Lines as it can put the company in debt and have negative impacts on its solvency ratios. Generally, business organizations with a higher debt-to-equity ratio are at higher risks of increased loans and poor solvency ratios.

The company’s vulnerability to negative solvency ratios due to heavy reliance on debt and loans to finance expenditures could be a source of fraudulent financial reporting activities. Delta Air Lines face the need to ensure that its financial reports reflect the heavy reliance on debt and loans to finance expenditures. Failure to highlight this in the financial statements would imply that the firm has engaged in a material misstatement. Murphy (2020) states that companies need to acknowledge what they don’t know and seek help to understand and mitigate fraud risks in financial reporting. For Delta Air Lines, recognition of the heavy reliance on loans and debts to finance expenditures is critical towards providing an accurate picture of its financial position and strength in the industry. By acknowledging the reliance on debt and loans, Delta Air Lines would accurately demonstrate its vulnerability to negative solvency ratios, which would be a major business risk. Such a move is essential for the company to demonstrate what it does not know and its potential impacts on the business. The current financial statements for the year ending December 31, 2020, do not provide an accurate picture of solvency ratios in relation to the firm’s higher debt-to-equity ratio.

Asset Fraud

The second risk in relation to Delta Air Lines’ asset composition and company financing is assets. According to Bush (2016), audit risks that are likely to occur in financial reporting and auditing are linked to three areas of the fraud triangle i.e. pressure, opportunity, and realization. For Delta, assets is a major audit risk because it meets all the three areas or requirements of the fraud triangle. Delta’s management may face the pressure to increase the amounts of assets in order to increase financial analysis data and essentially increase shareholder value. The pressure to increase the amounts of assets is attributable to the company’s current asset composition and its heavy reliance on debts and loans to finance expenditures. As previously indicated, PPE accounts for a significant portion of the company’s total assets. As compared to the previous fiscal year, PPE values for the year ending December 31, 2020, has decreased whereas the Current Assets have increased. The management could face pressure to increase the amounts of Current Assets, which include cash, short-term investments, cash equivalents, account receivable, and deferred income assets. Such a move is likely to occur due to the pressure to enhance the company’s Delta’s solvency ratios. Similarly, PPE is vulnerable to audit risks or asset fraud because of its size and estimations used for computation.

Additionally, the pressure to increase asset amounts could be fueled by the realization that assets can be easily manipulated. This realization implies that the company would commit fraud in attempt to paint a picture of a strong financial position in the market. Manipulation of assets to higher values could be attributable to the fact that Delta Air Lines currently value assets with predicted amounts instead of pre-determined values such as liabilities due (Bush, 2016). Therefore, the airline does not utilize absolute valuation methods to value its assets but relies on relative valuation and comparable transactions. This contributes to the realization of the possibility to manipulate the values of assets to higher amounts, which could, in turn, contribute to fraudulent activity warranting a SEC action.

Assets also present an opportunity for fraud for Delta’s management since they are easily accessible. Assets are easily accessible and could be used to commit a SEC fraud as they are the right of the firm. As a result, they can be easily misinterpreted because the company has no obligation to offer a service or pay another entity. The lack of involvement of other entities implies that Delta can act alone in asset fraud.

While there is no evidence of asset fraud in Delta’s financial statements for the year ending December 31, 2020, assets are still vulnerable to fraud or audit risks. Delta’s assets are vulnerable to audit risks or asset fraud because of the lack of clarity in inventory controls. The airline manages inventory on an origin and destination basis (Delta Air Lines, 2016). In order to prevent fraud, the company has established a policy that focuses on preventing any measures to circumvent inventory management controls. To achieve this, the company has established disciplinary actions for agents engaging in circumvention of its inventory controls. However, there is no clarity in inventory controls relating to assets. Current inventory controls lack clarity on measures to prevent asset fraud or audit risks. Therefore, the firm’s risk management policies do not adequately address asset fraud or audit risks in relation to existing inventory controls. Even though the firm has established the Inventory Circumvention Policy, the lack of clarity in inventory controls allows for audit risks, particularly asset fraud.

Valuation of PPE

The third potential risk in Delta Air Lines’ financial statements is the valuation of PPE, which accounts for over 40% of its total assets. Financial values presented under this may not reflect what actually exists. There is no information in the financial statements and other reports issued by Delta Air Lines regarding the physical count of its aircraft and the fair market value of each aircraft. The determination of the fair market value of each aircraft should be made using current average sales prices. The lack of information regarding Delta’s number of aircraft and their fair market value implies that the financial values presented under PPE may not accurately reflect what exists. In addition to using the current average sales prices, PPE estimation at Delta Air Lines entails the calculation of depreciation expense. The airline utilizes a straight-line depreciation, which implies that the depreciation expense for each asset each year should be equal (Bush, 2016). It is not clear the extent to which Delta Air Lines examines the historical useful life of all its assets, particularly under this asset group.

Therefore, the likelihood of reporting figures that may not represent the accurate financial valuations for PPE increases Delta’s likelihood to engage in improper revenue recognition. Murphy (2020) states that improper revenue recognition has been identified as one of the most common fraud areas in financial reporting. In most of the studies conducted on fraud in financial reporting, improper revenue recognition is the most common. This fraud is attributable to fictitious revenues, poor valuation, timing, and the use of the percentage of completion method. For Delta Air Line, vulnerability to improper revenue recognition is due to valuation issues in relation to financial valuations of PPE. The firm faces the need to ensure that financial valuations in this category reflect what actually exists and are based on accurate valuation measures.

Recommendations to Ensure Compliance

In light of the risks identified in the forensic financial analysis of Delta Air Lines, there are several recommendations that could help improve compliance with the Sarbanes-Oxley Act of 2002 and new regulations published by the regulatory bodies. Some recommendations to address the identified loopholes in the forensic financial analysis are as follows:

Review of Internal Controls

One of the risks identified in the financial analysis is asset fraud, which is an audit risk attributable to various factors. Delta Air Lines can address this risk through review and improvement of current internal controls. The review and improvement should be conducted in line with the provisions of SOX and other new regulations. To help decrease asset fraud or audit risk, the airline should review its internal controls to include limited access to assets and independent verification and segregation of duties. In this regard, Delta Air Lines should limit who can change the value of its various asset categories, particularly Current Assets and PPE. By limiting access to assets, the airline will essentially prevent or close gaps relating to asset fraud. The individuals responsible for assets would ensure that valuations are done accurately and reflect what actually exists.

Apart from limiting access to assets like PPE, the review of internal controls should also entail creating measures for independent verification and segregation of duties. In relation to segregation of duties, the company should not only assign responsibilities for access to assets but also make it harder for any internal stakeholder to get kickbacks from the sale of any assets. Company internal control policies should incorporate safeguards or checks and balances that prevent any individual from getting an extra commission or kickbacks from the purchase or sale of PPE assets. With regards to independent verification, Delta Air Lines should have auditors who ensure all valuations are calculated accurately. Independent verification of financial valuations is essential to lessen potential errors in financial records. This will in turn enhance the possibility of generating accurate financial records/reports and avoid improper revenue recognition or financial misstatements.

Independent verification of financial records or valuations should be adopted as part of internal control over financial reporting. According to the Public Company Accounting Oversight Board (n.d.), effective control over financial reporting helps to avoid SEC action by providing reasonable assurance about the reliability of financial reporting. In this regard, Delta’s financial records should be scrutinized by internal auditors prior to publication. The objective of the auditor when scrutinizing the company’s financial reports before they are published is to express an opinion regarding their effectiveness. This would help avoid financial misstatements and ensure that financial reports reflect an accurate picture of the firm’s financial position and strength in the market. As suggested by the Public Company Accounting Oversight Board (n.d.), the auditor should obtain suitable evidence for reasonable assurance regarding the probable existence of material weaknesses as of the date specified in the assessment by the management.

For Delta Air Lines, independent verification of financial records includes obtaining evidence to determine whether financial valuations are based on the fair market value of assets. As stipulated by the Securities and Exchange Commission (2020), companies should adopt valuation practices that demonstrate a fair value of their investments. Based on this rule, fair value determination of investments is an act of good faith on the part of a company. The airline would avoid the risk of improper valuations and revenue recognition through ensuring that the asset valuations, especially PPE, are based on fair value. To promote fair value determination, independent auditors would help Delta to adopt suitable valuation methodologies and evaluate prices based on fair market prices. This would help ensure that financial valuations of assets are based on accurate market prices in order to avoid misstatements and incorrect valuations.

Audit Trails

The second recommendation to help address potential risks in Delta’s financial records and reports is the use of audit trails. Audit trails provide a premise for the airline to examine the historical useful life of assets and ensure their correct valuations in financial assessments and records. An audit trail is part of a well-established and managed accounting system for a company for all its transactions. It is an important tool to avoid financial misstatement as it helps to track line items in financial statements or records.

Audit trails would help Delta Air Lines avoid the negative impacts of higher debt-to-equity ratios in financial statements as well as asset fraud. These tools will provide supportive evidence for each line item in the financial statements. The use of audit trails will ensure that each line item in financial records is an accurate representation of the airline’s operations and financial position. Audit trails will help ensure that the cost of PPE and depreciation are in line with the reported adjusted basis of the asset (Bush, 2016).

Corporate Governance Assessment

Sound corporate governance practices remain core aspects of Delta’s operations and success in the market. The firm’s growth and development to become the most profitable airline for five consecutive years is partly attributable to its adoption of sound corporate governance practices. The airline’s Board of Directors believes that these practices provide a suitable framework to assist in the fulfillment of the Board’s responsibilities (Delta Air Lines, 2016). As part of sound corporate governance practices, Delta’s business is handled and managed under the oversight and direction of the Board whose composition/selection is determined by stockholders via elections. As a result, the Board represents the stockholders’ interests with regards to optimizing long-term financial returns. In addition, the Board considers the interests of the other stakeholders and interested parties like employees, suppliers, customers, the public, and government officials.

Integrity and Rigor of Delta’s Corporate Governance

As previously indicated, a sound corporate governance framework and practices are critical to the successful operations of Delta Air Lines in an increasingly competitive industry. Therefore, Delta has established a corporate governance structure headed by the Board of Directors responsible for managing its business. The company has a comprehensive corporate governance structure with appropriate checks and balances for each management position. The top-hierarchical corporate governance structure acts as a foundation for the effective management of Delta’s operations. The establishment of an effective corporate governance framework and structure remains critical since inadequacies in management have contributed to the downfall of several companies over the last two decades (Ramachandran, 2015).

According to Sage Advisory (2021), sound corporate governance framework and practices are determined based on five key factors i.e. compensation, composition, competency, clarity, and consistency. These key factors will be utilized to determine the integrity and rigor of Delta’s corporate governance with a view of identifying any potential weaknesses and providing recommendations for improvement. As discussed by Sage Advisory (2021), composition refers to the structure of the Board of Directors and management whereas compensation refers to proper incentivization of organizational leadership. On the other hand, competency refers to the leadership’s credentials in running or managing the company while clarity refers to the transparency of policies and disclosure of financially material issues. Consistency implies the consideration of all stakeholders during policy creation and steady policy execution.

As shown in its recent Notice of Annual Meeting and Proxy Statement, Delta has sought to foster the integrity and rigor of its corporate governance by electing an independent non-executive Chairman of the Board separate from the Chief Executive Officer (Delta Air Lines, 2021). The airline believes that such a leader plays a vital role in improving its long-term shareholder value. This recent move was geared towards strengthening the airline’s composition of the Board of Directors and the overall corporate governance structure. Additionally, the Board established Corporate Governance, Audit, Finance, Safety & Security, and Personnel & Compensation committees to help in discharging responsibilities (Delta Air Lines, 2020).

A review of the company’s recent reports and 10-K Financial Statement for the year ending December 31, 2020, shows that it has a suitable corporate governance structure. The suitability of the Board’s composition and corporate governance structure is evident in its creation of different committees to take care of different responsibilities. This has created a suitable foundation for the Board to discharge its responsibilities in an effective and efficient manner for the airline’s benefit. Despite establishing a suitable corporate governance structure and framework, there are some inherent weaknesses in Delta’s corporate governance practices. These weaknesses are evident following a review of its corporate governance framework and practices in terms of the Board, Audit Committee, and policies as follows:

Quality of Audits

One of the key aspects of Delta’s corporate governance structure is the establishment of various committees to help the Board of Directors to discharge its responsibilities. The audit committee is one of these committees and is mandated with the task of carrying out audits as part of internal controls. As stated in Form 10-K for the year ending December 31, 2020, Delta’s management communicates critical audit matters to the audit committee (Delta Air Lines, 2020). These matters relate to accounts or disclosures that are critical in financial statements and incorporate subjective, challenging, or complex judgments. Through communication to the audit committee, the airline’s management provides separate opinions on critical audit matters for the relevant accounts or disclosures.

While communication to the audit committee is part of enhancing the quality of audits at Delta, there are some inherent weaknesses in this process. As noted by Ramachandran (2016), the audit committee basically provides comments or views on the company’s financial statements. This implies that the quality of audits provided by the committee is average since its work is to primarily offer comments/views. This points to an ineffective or average internal control over financial reporting. Therefore, the audit committee does not provide recommendations but simply offers its opinion on financial records and reports. By simply providing comments, the audit committee does not seemingly carry out comprehensive review and assessment of financial records and reports. The audit committee seemingly relies on directors’ information and uses it as the premise for making judgments and giving its opinion.

By mostly relying on directors’ information as the premise for comments and opinions on audits, the audit committee is seemingly not well-prepared and established as part of the corporate governance structure. A good corporate governance structure would be one in which the audit committee has the mandate to thoroughly review financial reports or records and make recommendations without solely relying on directors’ information. The audit committee’s heavy reliance on directors’ information is evident in the fact that the management’s communication of critical audit matters does not alter opinions on the consolidated financial statements (Delta Air Lines, 2020). Therefore, the reliance on directors’ information and average quality of audits is an inherent weakness in Delta’s corporate governance framework.

Whistleblowing Policy

As previously stated, the clarity of policies is one of the most important factors for a sound corporate governance structure and framework. As part of its corporate governance framework, the company mentions its whistleblowing policy, which is governed by SOX 2002 (Ramachandran, 2016). Delta established a whistleblowing policy as part of the management’s effort to ensure good corporate governance practices and to avoid corporate mismanagement. The whistleblowing policy is an important part of Delta’s management objective though rewards or compensation for whistleblowers remain confidential. Delta’s whistleblowing policy is essentially based on a set of Business Ethics and Conduct. As a result, the policy provides channels through which the firm’s employees can provide information regarding any corporate malpractices with a view of fostering a culture of accountability and honesty.

However, Delta’s whistleblowing policy is only mentioned and not specified as an important part of its corporate governance framework and structure. The company has essentially relied on a set of Business Ethics and Conduct as the premise for its whistleblowing policy without providing comprehensive details on what it entails. While the policy is disclosed, it lacks more details on the channels whistleblowers can utilize to communicate. By adopting a seemingly general whistleblowing policy, whistleblowing practices at the organization are seemingly weak or average. One of the major components missing in the firm’s whistleblowing policy is whistleblower protection programs. Patrick (2011) notes that airline employees are not reporting malpractices in their organizations because of inadequate whistleblower protections. Even though many airlines like Delta have a whistleblowing policy, lack of adequate protection implies that the policies are essentially weak. A strong whistleblower protection program will enhance the effectiveness of the policy and contribute to effective corporate governance practices at Delta Air Lines.

Lack of Risk Management Program

Risk management is recognized as a core function in promoting the effective and efficient operations of Delta in a highly competitive industry/market. The company has incorporated risk management into its corporate governance framework. Delta’s risk management framework involves different committees that help the Board of Governors in discharging its responsibilities. Unlike other airlines, Delta does not have a specific risk management committee. For this company, risk management is an integral part of each of the committees of the Board of Directors. This implies that the firm’s risk management practices are handled by each of the committees of the Board.