Balancing the Books
Getting readers’ attention with a post about an accounting standard is not easy.
But when in a survey 90% of executives in an $800 billion industry suggest that one of the key pillars of their business will be subject to contract renegotiations because of accounting changes, some might want to listen up.
I’m talking about the impact IFRS 16 Leases will have on the airline industry when it comes into effect as of 1 January 2019.
What’s going on?
To understand the impact of IFRS 16 on airlines it is essential to first explain some of the basics of aircraft management, i.e. how airlines operate their fleets.
Of the roughly 26,000 commercial aircraft globally today, 38% are no longer owned by conventional airlines, data from the Airfinance Journal Fleet Tracker shows. Increasingly, planes are instead leased from specialist lessor companies. The two largest lessors, General Electric’s GECAS and Netherlands-based AerCap own and manage about 2,000 and 1,500 aircraft respectively. In the words of The Economist, they are “airlines with no passengers”.
Leasing makes sense for most airlines. Because leasing allows them to scale fleets up or down quickly when demand changes, it reduces their exposure to volatile aviation travel markets.
Leasing is also less capital intensive than buying aircraft outright.
There’s something else, though:
If an airline buys a plane and finances it with debt, the plane will show up on the balance sheet as an asset, and the associated debt as a liability. If, however, the same plane is added to the airline’s fleet under an operating lease agreement, there’s no asset or liability to be recognised under the current standard for lease accounting, IAS 17. Operating leases are – until now – means of off-balance sheet financing.
That’s advantageous for airlines, because it means that operating leases have no impact on a number of key performance metrics, such as gearing, EBITDA, or return on capital employed (ROCE).
This off-balance-sheet treatment of operating leases will change when IFRS 16 kicks in in less than 12 months. According to Fleet Tracker, a whopping $325 billion of aircraft assets will then transfer to airline balance sheets.
The impact of the associated “new” liabilities on performance metrics could cause certain domino effects. For instance, in some cases credit ratings might change. Or airlines might break certain performance-related covenants in contracts.
And that’s why airlines think that operating lease contracts will be renegotiated.
When Euromoney Thought Leadership, working in conjunction with Deloitte, recently surveyed industry experts, 90% of airline executives told us that this is what they are expecting to happen. Even a huge majority of lessors agreed.
If the airlines are right, the sector should get ready for flurry of activity to renegotiate lease contracts, in particular, according to the survey, with regard to the lengths of leases, lease rates, and security deposits. The lessors though, despite similar expectations, might be somewhat reluctant.
David Breen, for instance, is sceptical about renegotiating. The Head of Finance at Avolon, a lessor with a portfolio in excess of 900 aircraft, told Euromoney Thought Leadership that lessors – who face extra remarketing costs from shorter leases – would resist shorter leases.
There’s also little indication that the market for aircraft leases will dry up, even if some of the advantages of leases might be less pronounced under IFRS 16.
“The core commercial reality of lease rates and lease terms will remain consistent with the supply and demand we currently have in the market,” Breen says.
The survey data, at least, does not show that the market is about to collapse. 47% of respondents said the number of operating leases would decrease, leaving a small majority to predict either no change, or even an increase.