Homework – Group Assignment

2215 – Auditing (TXA)

Audit Report on Air France KLM

Submitted on March 4th, 2024 by:

Séréna Thanh-xuân Thomazo (63247)

Theofanis Orfanidis (57912)

Mathis Jean Vincent Dubecq (59591)

Submitted to Instructors:

Gonçalo Rebelo da Silva

Francisco Leonardo Ramos

TABLE OF CONTENTS

1 INTRODUCTION ...................................................................................................................................... 2

2 MATERIALITY .......................................................................................................................................... 3

2.1 Benchmark ............................................................................................................................................. 3

2.2 Overall materiality ................................................................................................................................. 3

2.3 Performance Materiality........................................................................................................................ 3

2.4 Clearly trivial amount ............................................................................................................................ 4

3 ANALYSIS OF FINANCIAL STATEMENTS ................................................................................................... 5

3.1 The profitability analysis ........................................................................................................................ 5

3.2 The liquidity analysis .............................................................................................................................. 6

3.3 The debt analysis ................................................................................................................................... 7

4 SIGNIFICANT CAPTIONS .......................................................................................................................... 8

4.1 Balance Sheet ........................................................................................................................................ 8

4.2 Income Statement.................................................................................................................................. 9

5 SUBSTANTIVE TESTING ......................................................................................................................... 10

5.1 Rationale for the choice ....................................................................................................................... 10

5.2 What the test will cover and how it will be performed ........................................................................ 10

5.3 Assertion covered................................................................................................................................. 10

6 APPENDIX ............................................................................................................................................. 12

6.1 Consolidated financial statement 2021/2022 ...................................................................................... 12

6.2 Consolidated financial statement 2018/2019 ...................................................................................... 14

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1 INTRODUCTION
Air France-KLM group is one of the major players in the global aviation industry, embodying the con-
vergence of European air travel. It was created on 5 May 2004 and is a French holding company based
in Paris. The company has a global network of over 300 destinations, with flights operated by Air France,
KLM Royal Dutch Airlines, Transavia, Cityhopper and Air France Hop. Air France was France's na-
tional airline before it was privatised when it merged with KLM, although the French state still holds a
significant stake. The group's main areas of expertise are air transport, cargo, aircraft maintenance and
services. Air France-KLM has major strategic advantages, such as hubs at Paris Charles de Gaulle and
Amsterdam Schiphol airports, which enable it to provide a maximum number of connections throughout
the world. Its network also enables it to cover economic and geopolitical risks thanks to its activities in
various geographical areas.

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2 MATERIALITY

2.1 Benchmark

In order to determine the materiality threshold, a number of factors need to be taken into account, such
as the nature of the entity, the industry in which it operates, and the material items presented in the
financial statements.

To determine Air France-KLM's materiality, we evaluated the following three benchmarks: profit before
tax, total revenue, and gross profit and total expenses. Although the profit before tax benchmark is gen-
erally considered to be the most important and most appropriate metric for determining materiality, its
volatility is very high. We have therefore chosen total revenue as the benchmark, which we consider to
be more stable and appropriate for the Air France-KLM group, and also because of the needs of the
stakeholders. We find gross profit and total expenses less adapted, as it is very sensitive to variations in
costs and therefore less reliable from one period to another.

Given the characteristics and performance of Air-France KLM such as its low profit margin, we will
therefore use total revenue as benchmark for our analysis, which is the most relevant one.

2.2 Overall materiality

Using our professional judgement, and considering the characteristics of the group, we have determined
that a threshold of 0.5% of total revenue is appropriate for Air France-KLM, based on the report on the
CEAOB survey and the materiality guidance of the major public accounting firms. Based on this anal-
ysis, we have determined a materiality of 132 million euros, calculated as 0.5% of Air France-KLM's
total revenue in 2022 which is 26,393 million euros1.

2.3 Performance Materiality

Defining a performance materiality level reduces the risk of misstatements which, as indicated in ISA
320.9, may accumulate and reduce the materiality level for the financial statements as a whole.

Air France-KLM has a strong control governance structure. The board of directors supervises a compli-
ance committee and an audit committee, the CEO committee has its own internal audit and each of the
business management and control activities has its own internal control coordinators. The company fol-
lows international frameworks and standards. There are insurance functions which are responsible for
identifying the at-risk sectors of the group which are likely to have an impact on operations and financial

1
Appendix 6.1 Consolidated income statement
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results. The Air France-KLM group has an independent internal audit function,
which carries out audits at group and subsidiary level. The intermediate audit function carries out actions
such as operational audit, compliance audit, consulting assignments, fraud investigations or enterprise
risk management. They then summarise the findings of these audits in a report, highlighting risks and
recommendations, and put in place corrective action plans to rectify this in the following months. As-
suming these controls are effectively implemented, no adjustments are anticipated.

According to the materiality guidance of the major public accounting firms, the performance materiality
is set at 75% of the overall materiality amount. This gives a performance materiality level of 99 million
euros, calculated as 75% of 132 million. This ensures that potential misstatements are identified without
being overly conservative.

2.4 Clearly trivial amount

As indicated in ISA 450.5, misstatements considered to be clearly trivial do not hold the auditor respon-
sible. The threshold for such misstatements, according to the report on the CEAOB survey, is around
5% of overall materiality, corresponding to the high average of the big 4 firms. Taking into account this
information and our professional judgement regarding the internal control environment of Air France-
KLM, we found a clearly trivial threshold of 6.6 million euros, calculated as 5% of the overall materiality
of 132 million euros. Below this threshold, an identified misstatement should be evaluated by its nature
to determine whether it is material to users of the entity's financial statements. If the auditor considers it
immaterial, then it may be disregarded as set out in ISA 450.5, taking into account the criteria of size,
nature and circumstances. However, a repetition of small errors may be an indication of fraud, so the
frequency of such errors should be considered by the auditor. Above this clearly trivial threshold, mis-
statements are considered material because they are likely to have a significative impact on the compa-
ny's financial statements.

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3 ANALYSIS OF FINANCIAL STATEMENTS
In this section of the report, we will analyze the consolidated financial statements of the Air France –
KLM group for the period 2021 – 2022. It is important to note that during this time, the group faced a
very difficult period, due to the COVID 19 crisis that occurred in the early 2020. Because of this crisis,
the air traffic experienced a drastic reduction during at least one year as people were unable to travel.
The entire aerospace industry suffered a major crisis, leading to the issuance of exceptional aid during
this period. To better analyze the financial health of the group, we will not only use the data of 2022 and
2021, but also that from 2019, which predates the crisis.

3.1 The profitability analysis

Upon initial examination, it is im-

Profitability
portant to note that in 2022, the
2022 2021 2019
Air France-KLM Group reported Revenue 26 393 14 315 27 188
its first positive net income (€744 Net income 744 (3 294) 270
million) since the onset of the EBITDA / Sales margin 13,7% 5,2% 15,2%
Covid crisis. This marks a significant improvement in the group's financial performance, considering
that the net income for 2021 was a loss of over €3 billion. This performance is attributed to the nearly
doubling of total revenue between 2021 and 2022, which has now almost reached the level of revenue
seen in 2019. Moreover, the significant increase in the EBITDA/Sales margin ratio (from 5.2% in 2021
to 13.7% in 2022) is also a positive indicator of the firm's recovery capacity, as this ratio is nearly aligned
with the 2019 figure (15.2%).

Profitability from Investments When we look at the profitability from investments ta-
2022 2021 ble, it is noteworthy that the group generated signifi-
Asset turnover 81,7% 46,7% cantly more sales from its assets in 2022 compared to
ROA 2,3% -10,7%
ROE - - 2021, as evidenced by the nearly doubling of the asset
ROCE 2,1% -9,5% turnover ratio within one year. This is once again a
proof that the group’s sales revenues increased significantly. Additionally, AF/KLM has managed to
achieve positive returns on assets and return on capital employed in 2022. However, these two ratios are
still dangerously low, and will have to be monitored in the next few years.

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3.2 The liquidity analysis

Liquidity analysis
(In € million) 2022 2021 ∆% 2021/2022
Current assets 11 007 10 729
Current liabilities 13 662 11 726
Current ratio 0,81 0,91 -12%
Cash and cash equivalents 6 626 6 658
Current liabilities 13 662 11 726
Cash ratio 0,48 0,57 -15%
Current assets 11 007 10 729
Inventories 723 567
Current liabilities 13 662 11 726
Quick ratio 0,80 0,87 -7%

In conducting the liquidity analysis, we observe that between 2021 and 2022, the current liabilities in-
creased more than the available cash designated to repay the current debt. Consequently, we observed
a decrease in all liquidity ratios. This trend highlights the group’s struggle to meet its short-term liabil-
ities. However, we have to keep in mind that the increase in short-term liabilities is correlated with the
increase in long-term debt, In the following years, the challenge for the group will be to manage these
significant short-term payments by increasing its short-term treasury and assets. While the current ra-
tio values are not alarming at the moment, it could become a major problem in the future if the imbal-
ance between current assets and current liabilities continues to increase.

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3.3 The debt analysis

In analyzing the debt ratios, we can observe the difficult situation faced by the group regarding the debt
management. First, it is notable that in both years, the debt value exceeds the asset value, primarily due
to the negative equity of the group. In- Total equity
deed, AF/KLM has had negative equity (In € million) 2022 2021 2019
since 2020 and the Covid crisis. Restoring Total equity (2 480) (3 816) 2 299
positive equity is definitively one of the most important challenges for the group in the coming years.

Capital structure & Solvency ratios Additionally, we observe

(In € million) 2022 2021 ∆% 2021/2022 that the Debt/EBITDA ratio
Total debt 34 785 34 499 was 46 in 2021, an extreme
Total assets 32 305 30 683 value indicating a critical fi-
Debt-to-assets ratio 1,08 1,12 -4%
nancial situation. Fortu-
Total debt 34 785 34 499
nately, this ratio dropped by
EBITDA 3 615 745
Debt to EBITDA ratio 9,62 46,31 -79% nearly 80% in 2022, but the
EBIT 1 194 (2 532) debt repayment remains
Interest expenses 852 1 017 overly dependent on operat-
Interest coverage ratio 1,40 - ing activities (this ratio was
25% lower in 2019). The interest coverage ratio remains very low in 2022, indicating once again the
firm's difficulties in meeting debt expenses.

To conclude, we can say that even if the debt recovering remains a huge challenge for AF/KLM, the
2022 data is encouraging. If the group continues on this trend, we can expect a full recovery in the next
few years.

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4 SIGNIFICANT CAPTIONS
The financial statements of the company have been scanned, and three relevant captions have been se-
lected that should be analyzed in detail by the auditors as they do not only provide valuable insights into
the company's financial performance and operational efficiency, but also carry significant inherent risk.

4.1 Balance Sheet

Air France-KLM’s fixed assets amount to 21,3 billion euros, accounting for roughly two thirds of the
company’s total assets (32,3 billion euros). The largest component within fixed assets is “Flight equip-
ment”, comprising more than 10,6 billion euros. According to the Notes within the Financial State-
ments, owned aircraft represents around 80% of flight equipment.

Not only because it makes up most of the company’s assets, also because of the fact that in the aviation
industry significant capital is necessary to acquire aircraft and infrastructure, large portion of airlines'
debt is backed by assets, which is why carefully auditing this caption significantly reduces risks for
lenders.

This is especially interesting and complex due to the dynamic nature of these assets as they frequently
change locations. Therefore, the responsibility for the physical custody and control of aircraft differs
significantly from that of non-mobile fixed assets which makes it difficult for auditors to test existence
and completeness.

Although rare, some airlines lease flight equipment to other carriers. It is crucial for the airline and its
auditors to carefully review such leases to ensure that the assertion of rights and obligations is not dis-
regarded.

Last but not least, assessing aircrafts’ useful lives and residual values depends on each company's pro-
jections for aircraft replacement timing, financing capacity, takeoff and landing frequency, flight dura-
tions and other factors that affect the costs of maintaining aircraft. This can lead to errors or misstate-
ments in fixed assets’ valuation.

The second caption that is especially relevant for the auditors of the firm is “Deferred revenue on ticket
sales”. This position belongs to current liabilities and amounts to 3,7 billion euros at the end of year
2022. It comprises 27,2% of Air France KLM’s current liabilities, 11,5% of the firm’s total equity and
liabilities and is more than twice as high as Trade Receivables (1,8 billion euros).

This line is considered to have significant importance and inherent risk because airline tickets are often
sold and issued well in advance of the scheduled flight dates. Therefore, the funds received at the time
of sale are technically considered unearned revenue. As a result, airlines typically defer this revenue and
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initially classify it as a liability on their balance sheets. After the flight service is
provided, the revenue is reclassified as earned revenue on the airline's profit and loss statement. At the
same time, the liability figure is appropriately reduced. Consequently, the airline industry's revenue
recognition process involves quantifying and presenting four key balances related to transportation rev-
enues: earned revenue, unearned revenue, accounts receivable, and accounts payable. Given the com-
plexity of this process, especially the assertions regarding proper presentation and classification are con-
cerned.

4.2 Income Statement

Following the same logic as above, the audit team clarified “Revenues from ordinary activities”,
amounting to almost 26,4 billion euros in 2024, as a caption from the Income Statement that is worth a
great deal of attention. Revenue management is crucial from a financial point of view of the airline
industry. It involves optimizing ticket prices and seat availability to maximize revenue. Effective reve-
nue management strategies are instrumental in helping airlines enhance both revenue and profitability.

Due to the high volume of transactions, diverse ranges of fares for the same service, and potential sce-
narios where one or more flight segments may involve another airline, this line within the Income State-
ment is very susceptible to errors. As explained within the previous caption, the exact timing of revenue
recognition is a major concern for the audit of a firm in the aviation sector as several assertions can be
affected, i.e. cut-off, occurrence, classification, accuracy and completeness.

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5 SUBSTANTIVE TESTING
Given the fact that the auditor’s assessment of risk is judgmental and therefore may not identify all risks
of material misstatement given that there are inherent limitations to internal control, conducting sub-
stantive testing for captions that have elevated inherent risk is beneficial.

5.1 Rationale for the choice

As previously noted, “Revenues from ordinary activities” are considered to be very susceptible to
errors and material misstatements. This problem arises from the fact that airline tickets are usually sold
well in advance of the scheduled transportation date. Therefore, the date of ticket sales rarely aligns with
the revenue recognition date. The main risk associated to revenue is that the company over- or under-
states revenue, depending on its specific targets and priorities.

Therefore it is important for the auditor to understand the company's revenue recognition process to
ensure an efficient and accurate audit and be able to obtain reasonable assurance and decrease the audit
risk to an acceptably low level.

5.2 What the test will cover and how it will be performed

Given the caption that was chosen to be subject of substantive testing, the decision was taken to conduct
Tests of Details instead of Substantive Analytical Procedures. As Air France KLM’s Revenues from
ordinary activities are composed of a disproportionate amount of transactions, it is not possible to give
an audit opinion within a regular time frame when trying to test the entire population. Being the judg-
mental selection of specific items subject to non-sampling risk and additionally not providing audit ev-
idence concerning the remainder of the population, it was decided to carry out substantive sampling in
order to obtain audit evidence about the reported Revenues from ordinary activities. Thus, a sample size
sufficient to reduce sampling risk to an acceptably low level needs to be selected applying a statistical
approach.

5.3 Assertion covered

In this case, the covered assertion relates to the question whether transactions and events have been
recorded in the correct accounting period, namely the cut-off assertion. However, examining the exist-
ence and occurrence of revenue transactions is also crucial. For the majority of businesses, an effective
testing method involves verifying amounts by tracing them from the general ledger/sales journal back
to the original source documents (such as invoices and shipping records). In essence, the procedure

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involves choosing revenue transactions from the sales journal (which aligns with
revenue in the financial statements) and acquiring the relevant invoice and shipping documentation to
substantiate the dispatch of goods to the customer. Additionally, the audit team should confirm that the
customer made payment for the goods.

To ensure that the airline revenue accounting fulfills its two main responsibilities, which are to record
unearned revenue when a ticket is sold for a future scheduled service and subsequently recognize reve-
nue when the carrier provides the transportation service, the auditor should anticipate the following
control procedures:

- Daily reconciliation of the numerical sequence of tickets and all other accountable documents
through inventory reports,
- Segregation of duties exists between the sale of tickets and collection of cash, the recording of sales,
the recording of accounts receivable, and the processing of lifted coupons,
- Deposits are made daily, and bank reconciliations are prepared by a person independent of the cash
receipts function.

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6 APPENDIX

6.1 Consolidated financial statement 2021/2022

12
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6.2 Consolidated financial statement 2018/2019

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