Air Canada is Canada's largest domestic and international airline, providing scheduled and charter air transportation for passengers
Air Canada is Canada's largest domestic and international airline, providing scheduled and charter air transportation for passengers and cargo. The airline industry has suffered many difficulties and financial setbacks in the past decade. The high costs associated with operating an airline have claimed many "victims," including Canadian Airlines, which was purchased by Air Canada in 2000 in a highly publicized takeover battle. One of the largest cost components on Air Canada's income statement is aircraft fuel.
Since aircraft fuel is a commodity good, its price is subject to significant fluctuations. The cost of a barrel of aircraft fuel is determined by supply and demand relationships and other global economic conditions that affect production. As a result, Air Canada, like all other airlines, faces a high amount of uncertainty about the cost that it will be required to pay for aircraft fuel. In order to reduce the uncertainty and attempt to limit exposure, Air Canada uses a fuel hedging strategy to manage the risk. The notes to the company's 2014 financial statements describe the airline's strategy for its fuel hedging and provide additional disclosure as follows:
Fuel Price Risk Management
Fuel price risk is the risk that future cash flows will fluctuate because of changes in jet fuel prices. In order to manage its exposure to jet fuel prices and to help mitigate volatility in operating cash flows, Air Canada enters into derivative contracts with financial intermediaries. Air Canada uses derivative contracts based on jet fuel, heating oil and crude oil based contracts. Air Canada's policy permits hedging of up to 75% of the projected jet fuel purchases for the next 12 months, 50% for the next 13 to 24 months and 25% for the next 25 to 36 months. These are maximum (but not mandated) limits. There is no minimum monthly hedging requirement. There are regular reviews to adjust the strategy in light of market conditions.
• Air Canada recorded a loss of $36 million in Fuel and other derivatives on Air Canada's consolidated statement of operations related to fuel derivatives (loss of $6 million in 2013).
• Air Canada purchased crude-oil and refined products-based call options covering a portion of 2014 and 2015 fuel exposure. The cash premium related to these contracts was $44 million ($39 million in 2013 for 2013 and 2014 exposures).
• Fuel derivative contracts cash settled with a fair value of $24 million in favour of Air Canada ($29 million in favour of Air Canada in 2013).
As of December 31, 2014, approximately 22% of Air Canada's anticipated purchases of jet fuel for 2015 was hedged at an average West Texas Intermediate ("WTI") equivalent capped price of US$97 per barrel. Air Canada's contracts to hedge anticipated jet fuel purchases over the 2015 period are comprised of call options with notional volumes of 6,267,000 barrels. The fair value of the fuel derivatives portfolio at December 31, 2014 was $4 million in favour of Air Canada ($20 million in favour of Air Canada in 2013) and is recorded within Prepaid expenses and other current assets.
Discuss the various accounting issues that arise as a result of Air Canada's aircraft fuel hedging strategy. Specifically, discuss whether or not it makes sense for the company to use hedge accounting (which is optional) and, from an accounting perspective, what type of hedge this is.
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