easyJet's accounting policy dispute with founder Sir Stelios Haji-Ioannou

easyJet Financial Reporting

Recent History Regarding Corporate Accounting Policy

The recent corporate accounting practices of easyJet Airlines reflects financial accounting policies at the company, which were in disapproval by Sir Stelios Haji-Ioannou, founder -- easyJet (Waller, 2008) . The Board of Directors are responsible for drafting and adopting of company accounting policies. Sir Stelios' rejection of the boards annual accounts is reflective of the agency/principle problem such that the board is now potentially viewing the corporation in a different light than from the founder.

The founder proclaimed the accounting policies adopted by the board of easyJet to be inaccurate and not reflective of the "current commercial realities and the macro-economic climate" says Sir Stelios (Waller, 2008). Stelios recommends changes to the policies in place and suggests appointment of two directors of non-executive capacity to serve on the board to provide financial accounting insight into the policies established and set forth by the board.

Stelios' refusal to sign off on the accounting policies ostensibly arises from the policies inability to provide the confidence or the returns necessary for the board to vote to provide a dividend or increase the rate of growth of the company or its stock to the shareholder. According to Waller, (2008) "The figures themselves show the effect of high oil prices with underlying pre-tax profit down from £191 million to £123 million." (Waller, 2008)

According to Walsh (2008), "easyJet has yet to say if it will accede to Sir Stelio's wish to have two existing employees appointed to the board. However, legally, the company's accounts can be passed without Sir Stelios' approval." (Walsh, 2008) In fact, the accounts were passed by the rest of the board and by easyJet's auditor PwC. One must ask whether the founder is in the wrong or in the right. History shows that founders are inherently right about their organizations.

The specific argument, according to Walsh (2008), "His criticism of the board's accounting policies centres around the other directors' decision to regard the company as a "single cash generating unit" rather than as a series of businesses, as rival Ryanair does. He believes the value put on landing slots at Gatwick acquired with GB Airways a year ago is "based on optimistic assumptions about future revenues, particularly in the current economic climate. Sir Stelios also thinks the aircraft acquired with GB Airways -- seven with one more to be delivered in future -- should be written down in the accounts to their estimated market value." (Walsh, 2008)

However, Andy Harrison, the CEO of easyJet, explains Stelios disenchantment to the accounting policies in place. According to Walsh (2008), "The concerns Stelios has raised in his letter are not new news. They have been fully considered by management, the audit committee and by the auditors. The issues that Stelios has raised are non-cash items, they are non-trading items and therefore have no impact on the value or commercial strength of the company. The board's view is that it's just premature to be talking about dividends at the point in the cycle where we are now. The board had no "point of principle" against paying a dividend when the airline was sufficiently profitable." (Walsh, 2008)

The company's auditor PwC had given easyJet an unqualified report, which is synonymous with a passing accounting standards report rendering the accounting practices in line with the International Financial Reporting Standards or IFRS. According to the 2008 annual report, the audit report produced by PwC reported the following.

According to the PwC report, "the Group financial statements give a true and fair view in accordance with IFRSs as adopted by the European Union, of the state of the Group's affairs as at 30 September 2008 and of its profit and cash flows for the year then ended. The parent company financial statements give a true and fair view, in accordance with IFRSs as adopted by the European Union as applied in accordance with the provisions of the Companies Act 1985, of the state of the parent company's affairs as at 30 September 2008 and cash flows for the year then ended." (PricewaterhouseCoopers LLP, 2008)

The accounting policies were in accordance to the reporting standards in 2008. In 2010, the accounting policies included the accounting details that Sir Stelios felt were missing from the 2008 audit. According to the 2010 annual report, "Section 23: Financial risk and capital management included explanations regarding easyJet's exposure to financial risks including fluctuations in exchange rates, jet fuel prices and interest rates. Financial risk management aims to limit these market risks with selected derivative hedging instruments being used for this purpose, easyJet policy is not to trade in derivatives but to use the instruments to hedge anticipated exposure." (Annual Report, 2010)

Value of Segmental Information to Shareholders

In general, the value of segmental information as a reporting measure for shareholder benefit is to enable greater transparency and hence greater accountability to the business units within the parent corporation. EasyJet is a relatively small airline company and does not have the multiple business units generally associated with much larger companies. As mentioned by the CEO in the previous section, easyJet does not have multiple lines of business and is a rather simple cash generating airline.

Geographical segmentation however, does provide insight into potential strategy, micro and macro-economic insight, and a clear means to differentiate routes of high/low revenue/expenses that provide value and generate profit for the company. Additionally, the risks associated with various routes can be projected based on geopolitical and global economic activity.

Geographic segment is a function of the routes easyJet has secured throughout the world. Should geopolitical risk causes energy prices to rise, the shareholders can view the geographic regions where the spike in price will most hurt the airline. Getting fuel to certain airports where the airline operates will have a different expense base due to the number of flights the airline runs from each route. Certain routes will have a higher expense per passenger than other routes. Shareholders will be able to see the profitability of routes and the risks associated with each as well.

Key Ratios for easyJet

The key ratios for easyJet include the current ratio, which is the total current assets divided by the total current liabilities. Current ratio (Harrison, Horngren, Thomas, 2010) is a measure of how liquid a company is in terms of liquidating current assets to pay off current liabilities to remain in business if necessary. In 2010, the total current assets for easyJet

was 1,514.9 and the total current liabilities were (1,064.6). The current ratio is 1.42, which indicates easyJet can pay current liabilities if these expenses were demanded upon request.

The debt ratio is a measure of the amount of corporate assets that are funded by debt. A high debt ratio indicates the company is highly leveraged and has to pay interest on the financed debt and therefore needs to have a strong return to render the decision to undergo extreme debt financing as a sensible bet. The debt ratio is measured by dividing total liabilities by total assets. Total liabilities is (1,437.2) and total assets is (1514.9) The debt ratio for easyJet is 0.949.

The next key ratio is the Acid-Test Ratio, which tests for the ability to pay off current liabilities, however does not include such measures as inventory in the calculation and is hence, more stringent than the current ratio. The acid-test ratio is calculated by adding cash + short-term investments + net current receivables / total current liabilities. Cash + short-term investments + net current receivables is 1,441.7 and total current liabilities is (1,064.6). The acid-test ratio is 1.35.

The next key ratio is Earnings per Share or EPS, which tells the investor how much of a premium they are paying to own the stock. A stock with a P/E of 15 means the investor is paying 15x's earnings to own the stock. The EPS is calculated by dividing the earnings of the last quarter or the future projected earnings of the upcoming quarter by the number of shares outstanding. The EPS or easyJet is 28.4

(pence).

Significance of Audit Reports to Stakeholders

The audit report provides detailed information regarding the reliability of the internal record keeping and accountability of internal reporting of financial information. For potential investors, this form of disclosure is critical to rendering a decision regarding whether the financial reports are representing the underlying financial picture of easyJet, accurately.

Investors will not choose to buy shares of a company whom is deceptive regarding their auditing practices. PricewaterhouseCoopers has a strong reputation in the accounting industry and given the collapse of Arthur Anderson to corruption and fraudulent activity, the importance of ensuring financial transparency and integrity in reporting is heightened.

The audit reports provide a valid and trustworthy opinion delivered from a reliable and knowledgeable specialization firm that understands accounting procedures under the IFRS. Additionally, it is understood that the auditing firm can spot fraudulent activity and will detail such activity within the report. Shareholders are able to see that the company is continuing to not misrepresent earnings or expenses or create erroneous assets or inflate revenues and deflate costs, invent inventory numbers, and other accounting atrocities that can leave shareholders holding the bag.

The audit report to employees is not as important and is actually somewhat meaningless unless one is contemplating to leave the company and perhaps work elsewhere in the industry and is trying to obtain specific information. However, when compared to shareholders and investors, employees clearly do not have the requirement of reviewing the auditing report as does the aforementioned two parties.

easyJet Performance: 2010

The operating year 2010 for easyJet airlines was notably better, much improved over performance in 2009. The results according to the 2010 annual report indicate the following:

Source: http://2010annualreport.easyjet.com/2010-in-brief.asp

The management in alliance with the policies derived by the board have enabled the company to achieve strong profits before taxes and double digit growth in total revenue. Such growth at this stage in the airline industry is not an easy feat to achieve. The return on capital employed more than doubled year over year from 2009 to 2010, which is the equivalent of achieving double the output from the same set of inputs.

The return on equity is equally impressive, as 3.1ppt represents strong growth in a highly competitive market. The Pre-tax margin increased significantly in 2010. Such an increase in the operating margin allows a company to move away from operating at the margin, which is an area all too many airlines tend to operate these days. These metrics collectively indicate easyJet is a prime takeover target and the likely candidate of merger and acquisition activity from a buyer with cash or with a high enough stock price to absorb easyJet and obtain the company's routes and underlying business.

The income statement reveals that operating profit nearly tripled from 2009 to 2010 from 60.1 million to 173.6 million. EasyJet was successful at lowering their fuel costs and successful at increasing passenger revenue and ancillary revenue. Growth and savings in these areas whilst all other costs have increased. Current assets appreciated notably and current liabilities were managed well and increased only marginally. Retained earnings increased substantially in a percentage basis, increasing roughly 50% from 583.1 to 706.2.

The statement of Consolidated Cash Flows shows that Net cash generated from financing activities had decreased considerably. The decrease brought net cash generated from 440.2 to 232.8. However, the decrease was for a good business reason and is a good reflection of proper financial management in cleaning up the balance sheet. This shows responsibility as other companies might choose to not repay the loan but instead to invest the money into a project or venture that has an IRR, MIRR, NPV higher than the current market rate.

The company is operating very effectively. The founder seems unfounded in his opinion of subpar corporate governance yielding ineffective accounting policy. Board has facilitated the creation of activity that generated a strong balance sheet capable of obtaining unlimited financing at highly favourable rates. My recommendation is to look at extending routes from the Iberia and Mediterranean region to China and to India. The travel of Western Europeans to India and China may not be great now. However, travel to these regions is projected to increase over the next decade and obtaining these routes now will be less expensive now than if purchased later.

The investment to purchase easyJet is a definite recommendation and additionally, is recommended to be completed sooner than later. The value in purchasing this airline is apparent and will not be missed by merger and acquisitions strategists in the aviation industry. Strong financials as represented by the balance sheet and income statements reveal a company with very strong earnings, a tremendous pipeline of consumers and routes, and proven to be adept at reducing costs.

The following are reasons for purchasing easyJet airlines:

Strong Cash Flow

Strong Retained Earnings

Profitable service and route selection

Strong Revenues year-over-year

Management adept at keeping expenses low

Strong accounting ratios

Visionary leadership

The prospects for easyJet in the near-term are to outperform industry averages and to increase market share by obtaining consumers that normally take other airlines to now try easyJet. The airline has already accomplished this predatory market entrance into a saturated airline market however, there is additional room to grow as there are at least two main competitors at large, including Ryanair.

EasyJet appears to be very well positioned against the competition as Ryanair has other business units that complicate matter in terms of mergers and acquisition activity. Indeed, the ability for easyJet to obtain greater market share from Ryanair exists due to the constraint of knowledge and resources capable of turning $1 of resources into $1 or more in revenue for the airline business unit is not as efficient as is with easyJet.