New accounting standards have impacts on those to which the rules apply. In the case of IFRS 16, which takes effect in January 2019, the impacts could be significant for airlines, lessors, and financiers. Airlines in the US will deal with ASC 842, in which operating leases are on balance sheet, but doesn’t change P&L reporting in the same was as IFRS 16 internationally.
Essentially, IFRS 16 forces airlines to recognize lease payments as liabilities, and operating leases that were once “off balance sheet” are now “on” the balance sheet, impacting leverage ratios and loan covenants. That will have a significant impact on airlines. In addition, internationally, the capitalization of leases will essentially raise EBITDA and EBIT for airlines that more heavily utilize operating leases outside the US.
Airlines that rely heavily on leased, rather than owned, aircraft, may be forced to renegotiate some of the terms and conditions of aircraft leases and create new standard terms for aircraft leases. Airlines will seek to reduce liabilities and minimize any impacts on leverage ratios. The question is whether lessors, who have little incentive to do so, will agree to change conditions. Many in the industry believe most will, as the industry will seek standardized terms and stability.
Operating Leases – Impacted by Rule Changes?
The off-balance sheet nature of operating leases will likely be the most impacted by IFRS 16, as that key advantage disappears. In a recent Deloitte survey of industry participants, 47% believed that the number of operating leases would decrease as a result of IFRS 16, with 20% predicting no change and 33% predicting an increase. Operating leases tend to be more expensive in the long run, but provide several advantages, including flexibility, faster access to popular aircraft, and lower initial capital requirements. As a result, they remain popular, particularly with LCCs and start-up carriers.
Sale and Leasebacks will Also be Impacted by Accounting Treatments
Aircraft that are sold and rented back by airlines will also move onto balance sheets under IFRS 16. The unknown issue is how this will impact demand for sale and leaseback transactions as if the asset remains on the balance sheet, either way, a major incentive disappears. This could result in this segment of the aircraft leasing market potentially seeing decreased demand. We believe that the financial community will be creative, and that such creativity will result in different forms of aircraft leasing that will have variable payments and thus under IFRS 16 will not be forced to appear on the balance sheet.
This type of “flexible” lease arrangement will likely result in changes in lease terms to base payments on utilization rather than a fixed rate to remain off-balance sheet under the new rules.
Will Leases be Restructured?
One of the mechanisms to reduce the impact is for airlines to seek shorter lease terms, with renewal provisions, to minimize overall debt burdens and leverage ratios. The question is how auditors will treat lease extension provisions with respect to the new rules. Lessors do not like shorter terms as they increase re-marketing risk, which leads to higher rates.
IFRS 16 requires currency translation of liabilities on the balance sheet, which adds an element of currency risk. Airlines current purchase and lease aircraft in US dollars, but will be required to add the liability of leases to their balance sheets in local currency. This increases the currency risks that airline CFOs will need to manage.
The Bottom Line
The financier’s today already take into account operating leases when evaluating the creditworthiness of an airline. IFRS 16 will formalize that practice and incorporate it into accounting rules. This will result in changing balance sheet metrics that will impact loan covenants, likely making it more likely for airlines to violate them. A key task for airline CFOs in 2018 will be to review existing loan documentation to ensure that any covenants that will be impacted by the new accounting rules are modified to reflect the new rules.
International comparisons, due to differences in treatment of income statements and cash flows between the US ASC 842 and international IFRS 16 will result in apples to oranges when looking at airline financial statement. Comparing AF-KLM with Delta, or Lufthansa with United will require a restatement of one of the parties for comparison due to conflicting P&L treatment of operating leases.
Leasing is an essential element of aircraft financing, and we don’t foresee major movements or changes in the industry financing process. But in the interim, we do expect an increase in fee revenues for auditors and potential headaches for CFOs who will need to change accounting treatment of their existing leases, and ensure that those treatments don’t negatively impact loan covenants.
© 2017, Ernest S. Arvai. All rights reserved.