The New IFRS: A Major Shake-up for Airlines
Originally posted on March 16, 2017 by Aisha Natamkar in The Market Mogul
From January 2019, the International Financial Reporting Standards (IFRS) will implement a new accounting standard: the ‘IFRS 16 Leases’. These accounting rules will specify how companies should report their lease obligations going forward – and the aviation industry will be one of the worst hit. The FT predicts that $2.9 trillion worth of leasing obligations will be added to on-balance sheet liabilities, and in a report conducted by PWC, around 50% of airlines will report a 25% or greater increase in their on-balance sheet liabilities.
What Are Leases?
A lease is a contract that states the terms by which one party (the ‘lessee’) agrees to rent an asset from another party (the ‘lessor’). The contract guarantees the lessor payments for the use of the asset, while assuring the lessee the right to use that asset.
There are two types of leases: operating leases and finance leases. An operating lease is an off-balance sheet liability. Off-balance sheet financing is a method to keep certain large expenditures off a company’s balance sheet in order to keep leverage low, especially as a way to manage risk and source additional financing when a company is almost at its borrowing limit.
In an operating lease, rental payments for the asset are recorded through the income statement. But the asset itself, and therefore total lease obligations – Assets = Liabilities + Equity, if one is not included then neither is the corresponding item – is not recorded on the balance sheet.
A finance lease on the other hand requires the lessee to report the asset on the balance sheet, and therefore increase liabilities. The IFRS criteria for recognizing a finance lease includes: the lessor transferring ownership of asset to the lessee by the end of the lease term, the lessee purchasing the asset at the end of the term at less than fair value, or if the lease term is for the majority of the economic life of the asset. What is important to note here is that the lessor receives their entire investment back over the lease term.
The New IFRS: Accounting Treatment
IFRS 16 aims to harmonize these two lease structures and introduce a single accounting model: the finance lease model, eliminating the dichotomy of finance and operating lease. The only exception will be very short lease terms (less than a year) and small-ticket items (under $5,000).
There are pros and cons of both operating and finance leases. However, from an accounting perspective, a finance lease will result in higher payments at the start of the term and lower payments in later years, whilst an operating lease will have fixed payments over the course of the term. This is because finance lease expenses include depreciation and interest payments, which will be higher when there is a larger quantum.
Fluctuating payments introduces volatility into financial reporting, as rental expenses go through the income statement. Finance leases have higher payments towards the start of the lease, resulting in a lower net income than if the lease was reaching maturity. In addition, the new legislation will be retrospective, affecting all agreements including those entered prior to 2019.
Impact on the Aviation Industry
The new regulation will have a significant impact on the airline industry, with the FT reporting that already less than a third of EasyJet’s fleet is leased – and, by 2019, fewer than 10 of Ryanair’s aircraft (of its current fleet of 300) will be leased. There will be effects on financial performance as well as how leasing will be structured for airlines in the future.
IFRS 16 will not make any considerable impact on lessors, though, and lessor accounting will most likely remain the same. The only issue that could arise for lessors is a change in market dynamics and in the demand for rented aircraft.
The change in lessee behavior may have a ripple effect on lessor behavior. As the financial indebtedness of airlines increases, lessors may find that their customers start to move away from leasing, effectively drying up the market. Those who can afford to buy will buy, while airlines with weaker financials will end up being the only trading counterparties left in the leasing market.
Financial Consequences for Airlines
Financially, there are a few issues that arise for lessees. One, which was briefly touched upon above, will be the effects reported profit and performance, such as return on capital employed (ROCE). This is a significant problem for airlines as they are a heavily capital-intensive business.
With liabilities increasing, financial ratios such as debt-to-equity will appear much worse to investors. Therefore, airlines may become a less attractive investment opportunity going forward.
However, even though financial indebtedness may increase, overall transparency in airline operations will increase. All investors, not just aviation experts, will gain a better understanding of the financial health of airlines, and thus be able to make more informed judgements.
Further, an immediate benefit of on-balance sheet leasing is the ease of comparison between airlines. Historically, to make the results of airlines comparable, analysts used an 8x multiple of the annual aircraft operating lease cost as a proxy for the debt relating to these leases (the assumption being that the average lease term is eight years). In reality, all airlines have varying lease terms, even within the same company, resulting in a very rough estimate of the total lease obligations. Moving all lease obligations to the balance sheet provides a more reliable estimate of all the liabilities that a company has.
Another financial consequence may come through breaches in financial covenants. For most airlines, definitions like ‘financial indebtedness’ in legal documentation previously excluded operating leases. A large increase in liabilities may inadvertently trigger a breach of covenant. As airlines restructure their debt structure to avoid this in 2019, they may find that their borrowing costs have increased.
Finally, as mentioned above, the regulation has some exemptions including if the asset is valued under $5,000 and if the lease term in less than 12 months. While the first will have little impact on assets whose worth is in the millions, the second one raises an interesting point. Particularly indebted airlines may enter into shorter leases, preferring to renew every year. This will create more churn in the market, effectively increasing re-lease risk for lessors, and volatility in market prices of rental payments for lessees.
IFRS 16 signals a significant shift in the aviation industry. No longer will airlines be able to report lower liabilities by advantageously structuring their leases off-balance sheet. While the impact on lessors looks to be minimal, the brunt of this standard change will fall on the lessees, who use leasing as an easy source of financing for aircraft. The new standards are set to have a definite impact on their financial statements and, eventually, on their key performance metrics.