6. Risk report
In order to secure its competitiveness in the long term, MTU regularly analyzes and evaluates the risks inherent in its day-to-day business through the instrument of an integrated risk management system. No major change was identified in the company’s risk exposure compared with 2009.
Risk is an inherent part of any entrepreneurial activity. To meet the expectations of its shareholders, MTU must exploit opportunities, which entails a certain degree of risk.
MTU has an integrated opportunity and risk management system in place, which is linked to the group’s value-oriented performance indicators and its organizational structure. The system ensures compliance with statutory requirements and is based on the internationally recognized COSO II Enterprise Risk Management (ERM) Framework.
The systematic consideration of significant risk factors is of vital importance to the MTU group, and serves as a fundamental basis for value-oriented controlling functions and sustained business success. MTU knows the risks it faces, is aware of their effects and can manage them appropriately.
6.1. STRATEGY AND MANAGEMENT
MTU regards a suitable control environment as being essential for a functioning risk management system. The following are considered the main elements of such an environment:
- management style and philosophy,
- integrity and ethical values,
- staff training and development.
The concept of learning from mistakes is embodied in the MTU Principles, which describe this as a means of facilitating teamwork and promoting constructive behavioral attitudes. The goal of continuous improvement is supported by the company’s CIP organization (Continuous Improvement Project), which aims to encourage employees to deal openly with weak points and create a culture that provides the basis for a functioning risk management system.
RISK MANAGEMENT OBJECTIVES AND RISK STRATEGY
The ultimate objective of MTU’s risk management system is to ward off risks to the substance of MTU, and to safeguard the company’s existence and future business success.
MTU does not merely limit itself to ensuring compliance with statutory requirements. It has integrated its corporate risk management system, including opportunity management, into all essential management processes, from strategic planning right through to reporting to the Board of Management and the Supervisory Board.
IDENTIFICATION, ANALYSIS AND MANAGEMENT OF RISKS
MTU regards risk management as a continuous, end-to-end process to ensure responsible behavior when dealing with specific risks at business unit level and general risks affecting several business units or the entire group, including risks which need to be assessed on a wider scale.
The risk inventory of the group, which encompasses all the business units and all the risk factors to which MTU is exposed, forms the basis for identifying risks. According to the COSO Framework, it is divided into governance and compliance, strategy and planning, operations and infrastructure, and reporting.
The affiliates and business units are responsible for identifying, assessing, controlling and monitoring the risks in their specific areas and documenting them in risk maps. They submit reports to the central risk management department for risks exceeding an amount of € 1 million over the five-year period under consideration, at dates allowing them to be reviewed together with the quarterly financial results. Risks are assessed based on uniform definitions of the probabilities of loss occurrence and, as far as quantifiable, as a possible deviation of the group performance indicators ‘EBIT (adjusted)’ and ‘free cash flow’ from the currently valid operational planning figures.
The central risk management department aggregates and consolidates the risks and evaluates the overall risk position at group level.
RISK REPORTING AND COMMUNICATION
The Board of Management receives a risk report once a quarter and is kept informed of the group’s current risk situation. The Top Risk Map comprises all risks above € 5 million and gives details of their probability of occurrence as well as potential countermeasures.
Opportunities and risks are not offset. Moreover, the Top Risk Map for the group forms part of the regular reports submitted to the Board of Management and Supervisory Board.
MONITORING THE RISK MANAGEMENT PROCESS
Monitoring the risk management process is of crucial importance for ensuring the proper functioning and ongoing development of the risk management system.
In addition to verification of the system employed for the early recognition of risks by the auditor during the auditing of the annual financial statements, the risk management system is monitored and verified by a number of other functions:
- regular checks by the internal auditing department,
- supervision by the Supervisory Board,
- checking in the course of the EFQM audits,
- process reviews by the Risk Management Board in the form of a self-assessment.
6.2. MAIN FEATURES OF THE INTERNAL CONTROL SYSTEM AND THE RISK MANAGEMENT SYSTEM RELATING TO THE ACCOUNTING PROCESS
LEGAL BACKGROUND AND SUBJECT OF THE REPORT
In line with the explanatory memorandum to the BilMoG, a report on the main features of our internal control system (ICS) and risk management system (RMS) relating to the (consolidated) accounting process is included in MTU’s risk report so that the risk report presents a unified and integrated picture. We have also taken account of the German accounting standard DRS 5, which is still valid, and the amendment DRÄS 5.
The following statements apply to all group companies included in the consolidated financial statements.
OBJECTIVES AND COMPONENTS OF THE INTERNAL CONTROL SYSTEM AND RISK MANAGEMENT SYSTEM RELATING TO THE ACCOUNTING PROCESS
The Board of Management, Supervisory Board and Audit Committee of MTU attach the greatest importance to ensuring the regularity, accuracy and reliability of MTU’s financial reporting for recipients of MTU’s financial statements. The control and monitoring processes required for this purpose are tailored to the complex business model of the MTU group and are an important part of a comprehensive corporate governance approach that defines the basic framework for creating sustainable value for shareholders, customers, employees and the public. High-quality financial reporting to these recipients is regarded as imperative. The organizational, controlling and monitoring structures described below – which ensure that business data are recorded, processed and assessed correctly and in accordance with statutory and financial reporting requirements and are subsequently incorporated in individual accounting instruments – form part of a company-wide risk management system and internal monitoring system. The latter consists of a company-wide internal control system, company-wide controlling and internal auditing.
The internal control and risk management system of MTU guarantees an efficient accounting process that avoids errors as far as possible or at least uncovers them at an early stage.
- The accounting-related RMS is an integral part of the group’s comprehensive company-wide risk management system. It forms the basis for the uniform and appropriate handling of risks and for communicating them within the group. The risks entailed in financial reporting at group level are a part of the corporate risks to be monitored as a whole.
- The design of the accounting-related internal control system (ICS) at MTU meets the requirements of the German Accounting Law Modernization Act (BilMoG) as set out in the government’s explanatory memorandum, the definition of IDW (Institut der Wirtschaftsprüfer IDW e.V.), and the internationally recognized and established framework of the Committee of Sponsoring Organizations of the Treadway Commission (COSO I). MTU understands an internal control system (ICS) to be the principles, procedures and measures introduced at the company by its management that are aimed at the organizational implementation of the decisions taken by management to
- safeguard the effectiveness and economic efficiency of business operations, which also includes protecting the company’s assets
- ensure the regularity and reliability of internal and external accounting, and
- comply with statutory regulations relevant to the company.
The ICS of the MTU group is underpinned by an internal management system based on efficient and effective processes as well as process-integrated organizational security measures incorporated into the organizational structure and the process organization of the MTU group and its group companies. Checks integrated in the processes reduce the probability of errors occurring and help bring to light those that have already occurred.
- The internal auditing system, which is process-independent, plays an important role in checking the effectiveness of and improving the accounting-related ICS and RMS. The corporate audit department of MTU assesses controlling and monitoring systems and contributes to their enhancement. It is also considered to have an advisory function that aims at improving business processes and ultimately the effectiveness of the internal control system. The charter of the corporate audit department complies with national and international requirements of the Deutsches Institut für Interne Revision e.V. and the Institute of Internal Auditors. The corporate audit department is also bound by the code of professional ethics. The administrative standards of the internal auditing department are available to all employees for perusal on MTU’s intranet.
- The Audit Committee of the Supervisory Board deliberates on risk management and on the findings of internal auditing. In accordance with Section 107(3) of the German Stock Corporation Act (AktG), as amended by the German Accounting Law Modernization Act (BilMoG), the Audit Committee is also responsible for monitoring the effectiveness of the risk management system, the internal systems of control, the internal auditing systems, the financial reporting process and the audit of the financial statements, and, in particular, assessing their independence.
MAIN FEATURES OF THE INTERNAL CONTROL SYSTEM AND RISK MANAGEMENT SYSTEM RELATING TO THE ACCOUNTING PROCESS
- MTU has a clear management and corporate structure. Key functions spanning more than one business unit are managed centrally, although the individual subsidiaries have a certain degree of autonomy at the same time.
- The integrity and responsibility of all employees, also in terms of finances and financial reporting, are ensured by their undertaking to observe the company’s code of conduct.
- As a result of employing highly qualified staff, conducting targeted and regular advance training programs, strictly complying with the dual control principle, and consistently separating functions in financial accounting when creating and entering accounting vouchers and in controlling, it is ensured that national accounting rules and international accounting standards are observed in annual and consolidated financial statements.
- The IT systems are protected against unauthorized access by appropriate installations in the IT area. As far as possible, standard software is used in the finance systems area. Within the framework of the comprehensive IT strategy and the IT architecture, the IT system’s application controls are reviewed internally and externally on a regular basis against a background of a high level of automatic controls and plausibility checks. The IT general controls are checked during internal and external IT audits.
- All the annual financial statements of group companies included in consolidation are audited by an auditor at least once a year, who also reviews the condensed consolidated financial statements and interim group management report in the half-yearly financial report.
- An adequate system of guidelines has been drawn up and is updated in line with requirements.
- The departments and business units involved in the accounting process are suitably equipped and regularly trained both in quantitative and qualitative terms.
- Bookkeeping data received or forwarded are continually checked to see that they are complete and correct, e.g. by random checks. Programmed plausibility checks are carried out with the software used, e.g. in the course of payment cycles as well as during the consolidation process.
- Suitable controls are in place in all accounting-relevant processes (such as dual control, analytical checks).
- Accounting-relevant processes are also checked by the process-independent corporate audit department.
- The group accounting department, which is the immediate point of contact for the managing directors of subsidiaries regarding reporting and the annual and monthly financial statements, prepares and draws up the consolidated financial statements in compliance with IFRS.
- As every subsidiary and joint venture is obligated to report its business figures to the group holding company in compliance both with the local GAAP and with IFRS in a standardized reporting format, any planned/actual deviations during the year can be identified rapidly, enabling a swift and appropriate response.
- In the course of its monthly reports, Group Accounting monitors all the processes relating to the consolidated financial statements, such as capital consolidation, debt consolidation, consolidation of expenditures and revenues and the elimination of unrealized results of intra-group transactions, in consultation with the group companies.
- For particular issues in the group and at individual subsidiaries and joint ventures, such as special accounting issues etc., Group Accounting also acts at holding company level as a central point of contact and controlling body for reporting. Special evaluations are also carried out during the year at the request of various management levels. If a need for support arises at short notice in connection with special, complex IFRS issues or company acquisitions requiring examination, this demand is met by qualified staff or by employing the services of external auditors.
6.3. SPECIFIC RISKS
GENERAL RISKS AND INDUSTRY-RELATED RISKS
RISKS ARISING FROM GENERAL ECONOMIC TRENDS
Significant risks to the MTU group’s business development are presented by the U.S. dollar exchange rate, the level of commodity prices, and general economic factors. If the current, positive rate of economic growth should slow or go into reverse, and if the difficult situation still being encountered by certain companies fails to improve, this could impact the volume of passengers using business jets and the associated route planning, and prompt a more cautious approach to orders for new air transportation capacity. Other risks affecting industry in general include rising energy costs, the unavailability of suppliers, and delays in deliveries from suppliers. From the present point of view, there are no identifiable risks to the substance of MTU arising from general economic trends.
RISKS INHERENT IN THE AEROSPACE INDUSTRY
Because engines have long product lifecycles, MTU’s spare parts business is increasingly exposed to competition from companies that manufacture parts under the FAA’s system of Parts Manufacturer Approval (PMA). These companies are able to sell FAA-approved parts at lower prices than the original engine manufacturer because they have not had to bear the financial burden of high development costs and the loss-making early stages of volume production. MTU counters the risks inherent in the aerospace industry with its level of cutting-edge technology, which it constantly safeguards and advances.
Since air traffic is so dependent on economic factors – and susceptible to crises – airlines frequently encounter financial difficulties. The already strained situation may be further exacerbated by escalating fuel prices and by an intensification of the difficult financial situation of many airlines. As MTU operates in various sectors of the market and in different thrust ranges, it spreads this risk in line with the market.
At the present time, MTU does not expect any significant negative impact on the group’s operating results, financial situation or net assets.
RISKS ARISING FROM CORPORATE STRATEGY
The main forms of strategy risk are misjudgments when taking decisions concerning investments in engine programs, the establishment of new sites, and possible M&A activities. MTU’s business model is based on long-term processes, particularly in the OEM segment. In the commercial sector, many years can pass between the decision to invest in a new engine and the breakeven point, after a long period of development and the preparatory phases leading to volume production. The risk is that the original economic and technological parameters on which the decision was based might change over the course of time, and that the customers, i.e. the airlines, might change their minds and choose a different engine at a later stage of the project. MTU counters such strategy risks by engaging highly qualified specialists at the decision-making stage and by using documented processes to perform cost-benefit analyses, which make it compulsory to carry out the appropriate risk analysis on the basis of a variety of different scenarios. The company’s broad product portfolio – comprising engines in all thrust classes – helps to spread the risk and minimize its dependence on individual engine programs.
MTU has not identified any strategy risks at the present time that might endanger the substance of the company.
The customers in the military engine business are national and multinational agencies whose budgets vary widely with the level of public spending. When they are faced with budgetary constraints, there is a risk that contracts might be rescheduled or canceled. In the military engine business, the company is firmly embedded in international cooperative ventures, which tends to have a limiting effect on risks because the partners work together to protect their common interests. The terms of existing contracts in the military sector are generally defined to cover a prolonged period of time, thus effectively excluding the possibility of modifying prices.
The commercial engine market has an oligopolistic structure. MTU sells most of its products under risk- and revenue-sharing arrangements. The lead partners in the consortium determine the prices, conditions and concessions, while MTU, as a consortium partner, is bound by these conditions. It is involved in the leading engine programs of the major engine manufacturers in the context of these partnerships. The customers of these risk- and revenue-sharing partnerships in the commercial engine and MRO business are airlines. Various types of concessions to customers are common practice in the marketing of commercial production engines. MTU is obliged to absorb these concessions to the extent of its program share in risk- and revenue-sharing arrangements. The fact that the cooperation partners share a common interest helps to prevent excessive concessions during contract negotiations. Furthermore, risks are spread across the various programs. Concessions to major customers during the launch phase of a program are largely offset by a decline in the marketing expenses for older programs.
From the present point of view, there are no identifiable market risks to the substance of MTU.
In the commercial and military engine business, MTU undertakes to perform development work during which delays and additional costs may arise. The company nevertheless ensures strict adherence to time schedules and budgets by permanently monitoring project management and applying appropriate corrective measures where necessary. Furthermore, through its involvement in collaborative ventures, it works in partnerships that extend beyond corporate boundaries, thus spreading the risk.
MTU products are subject to extremely stringent safety requirements. The company requires numerous official certifications, particularly from the German Federal Office of Civil Aviation (LBA) and the U.S. Federal Aviation Administration (FAA), in order to carry out its activities. These certifi-cations are valid for limited periods and can be renewed only after further tests have been carried out. The production and repair processes are documented in detail to ensure compliance with all regulations.
PROCUREMENT AND PURCHASING RISKS
For some raw materials, individual parts and components and for the provision of specific services, MTU is dependent on suppliers and third-party vendors. Risks can arise in the form of the unavail-ability of suppliers, problems with quality, and price increases. MTU strives to reduce its reliance on individual suppliers by securing the services of several, equally qualified vendors for materials, parts and services. In the case of single-source suppliers, MTU enters into long-term agreements as a hedge against unforeseen shortages and to reduce the risk of sudden price hikes. The risks involved are manageable thanks to the broad diversity of the links in the supply chain.
At the present time, MTU has not identified any material or substantial risks arising from engine programs. However, because such programs involve long lead times, their measurement may be significantly affected by changes in the underlying interest rates and by the postponement of deliveries.
MTU has drawn up guidelines and a code of conduct that are valid for all of its employees throughout the world and by means of which it strives to establish binding rules for internal and external communication. Employees who are entrusted with confidential or insider information make a solemn commitment to abide by the applicable regulations, such as those laid down in the German Investor Protection Improvement Act (AnSVG), and to exercise the appropriate integrity when handling such information.
The commitment, motivation and skills of the company’s employees are major contributory factors to its business performance. There is considerable rivalry in the recruitment market for the aerospace sector, as companies compete to find the best-qualified employees to work on the development, manufacture and maintenance of cutting-edge technical products. This harbors a fluctuation risk. MTU minimizes the associated risks by means of fast-track professional training and development programs, performance-related compensation, mentoring schemes and early successor planning.
A high development capacity will be needed in the coming years to meet the demands of the new engine programs. MTU is meeting this challenge by setting up new development centers in Munich and at its site in Poland, and by collaborating with universities.
Variations in business volume present MTU with the challenge of managing its capacities according to current needs. The company has responded by redeploying and retraining employees to work in other business units. MTU is also taking advantage of natural fluctuation and using the system of flexible working hours to encourage employees to reduce their flextime credit.
Insurance policies are in place to limit potential liability risks that might be caused by individuals employed by the company. The level of personnel risk is considered to be low.
The loss of confidential data through espionage or system failures is the main risk in the IT area. Due to its business with military customers, MTU is particularly sensitive about how confidential data are handled and has a very advanced data and security system. When new IT systems are launched, there is a possibility of workflows being disrupted. MTU minimizes these risks by employing qualified experts and using professional project management. MTU regards the risks in this area as being manageable.
CURRENCY RISK, CREDIT RISK AND HEDGING TRANSACTIONS
More than 80% of MTU’s revenues are generated in U.S. dollars (equivalent to approximately € 2,250 million in 2010). On the other hand, a large proportion of expenses is likewise invoiced in U.S. dollars, providing a ‘natural hedge’. Most other expenses are incurred in euros and, to a lesser extent, in Polish zloty, Chinese yuan renminbi and Canadian dollars. Earnings are dependent on changes in the exchange rate parity between the U.S. dollar and the cited currencies from the order date to the delivery date, in the measure to which MTU does not make use of financial instruments to hedge against its current and future net exposure. In line with the corporate policy of generating profit solely on the basis of its operating activities and not through currency speculation, MTU makes use of hedging strategies for the exclusive purpose of controlling and minimizing the effect of U.S. dollar exchange rate volatility on EBIT.
The financial instruments employed by MTU cover the greater part of the net exposure to currency risk, leaving only a small proportion of the U.S. dollar surplus exposed to this type of risk. The unhedged portion of forecast transactions is calculated at the euro cash rate on the date payment is received.
MTU holds a long-term hedge portfolio comprising financial instruments with terms to maturity stretching over several years.
For accounting purposes, MTU prudently only designates a portion of its hedged future cash flows as hedged items to reduce the expected net currency risk exposure. Forward foreign exchange contracts are the main hedging instrument used.
Further explanatory comments concerning financial instruments (including the derivative financial instruments held at December 31, 2010) are provided in Note 41. to the consolidated financial statements (Risk management and derivative financial instruments).
The company’s long-term hedging strategy makes currency risks manageable.
In the commercial engine business and commercial MRO, airlines are indirect and direct customers of MTU. These companies may find themselves facing financial difficulties, with the result that their situation affects the receivables of MTU and its partners. The consortium leaders in the commercial engine and spare parts businesses have extensive receivables management systems in place. In the commercial MRO business, the responsible MTU departments track open accounts receivable in short cycles. Before a deal is finalized, risks are assessed and necessary precautions taken. Wherever possible, the company takes advantage of export credit guarantees (Hermes coverage) to protect itself against political and credit risk. As a matter of principle, the group avoids signing contracts for which the parameters cannot be calculated. Hence MTU considers non-payment risks to be transparent and manageable.
Compliance risks exist in all areas of the company. They arise when managers or employees of the company fail to comply with laws and regulations or fail to observe internal rules. This can be particularly critical in areas where the protection of confidential documents and information plays a significant role.
To minimize risks and to safeguard compliance, MTU has implemented a number of measures:
- globally binding rules of conduct valid throughout the group,
- online compliance training of all business units and employees affected,
- setting up a central office to receive reports of suspected misconduct,
- setting up a Compliance Board,
- regular security checks of employees.
The possibility of legal action in respect of compliance issues can never be entirely ruled out, whether this be due to lack of knowledge on the part of individual employees or to criminal intent.
In the aviation industry as elsewhere, accidents can still occur despite strict compliance with manUfacturing quality standards and utmost diligence in performing maintenance work. In the military engine business (excluding exports), MTU is largely exempt from product risk liability through government agency indemnification. The remaining forms of liability, especially in the commercial engine business, are covered by contractual clauses and by high-coverage insurance policies, including aircraft liability insurance. Other risks that could threaten the continued existence of the company, such as loss of income through fire or the interruption of business operations, are similarly covered. By limiting liability risks and taking out insurance cover, the risks are rendered transparent and manageable.
RISKS ARISING FROM GENERAL AND TAX LEGISLATION
MTU sees no important risks arising from general or tax legislation that could have a significant impact on the company’s net assets, financial situation or operating results.
MTU is subject to numerous laws and regulations aimed at protecting the environment. Any tightening of the applicable environmental requirements in connection with the use of chemicals in manufacturing or test rig emissions may give rise to additional investment costs. Further information can be found in Section 1.5. (Corporate responsibility). MTU requires special certification in order to operate certain production facilities. The regulations must be strictly observed and all procedures fully documented. An environmental management system certified to DIN EN ISO 14001 minimizes the risks in this area.
The company has not identified any risks arising from controlling and monitoring systems or relating to organization and management.
MUTUAL RISKS OF JOINT VENTURES
In jointly controlled entities where decisions have to be made by consensus, there is always a risk of differences of opinion.
6.4 SWOT ANALYSIS
6.5. OVERALL PROGNOSIS OF MTU’S RISK EXPOSURE
At 31 December 2010, there had been no substantial changes in MTU’s risk exposure compared with the end of the previous year. The group is of the opinion that it would serve no purpose to aggregate the most important individual risks, on the grounds that it is improbable that hypothetical risks would arise simultaneously.
The level of risk exposure is manageable; from the present point of view, the MTU group’s continuing existence as a going concern is not endangered. MTU does not anticipate any fundamental changes in its risk exposure at the present time. MTU has taken every possible organizational measure to ensure early awareness of potential risk situations.