As we open our Advent Calendars each December, thoughts inevitably turn to Christmas, the New Year, and to what the next year will bring.
But this year we are also looking 12 months ahead to New Year 2019.
Why? Because January 2019 will see International Accounting Standard (IAS) 17 replaced by International Financial Reporting Standard (IFRS) 16.
Now accounting standards may not be the most festive or exciting of topics, and to many of our readers that may sound like an insignificant change. Indeed the legislators themselves have said that it should cause “only minor changes from the current standards”. However, the general consensus is that in the aviation industry, the effects may be more profound.
The introduction of IFRS 16 will bring about a new accounting model. This new standard will apply to existing lease agreements, as well as to new ones and will require airlines and other lessees to recognise assets and liabilities for all leases (unless their leases are for a term of less than twelve months).
What does this mean in practical terms?
It means that any rental obligation under a lease will be treated as if it was debt obligation of the lessee – and so, as a general rule, all leases will now be on balance sheet.
For investors in, and creditors of, airlines, this may make sense: IAS 17 is intended to promote transparency as to an airline’s real cost structure and the extent of its long term liabilities. This in turn benefits airlines – investor confidence is inversely proportionate to borrowing cost.
This does give rise to a number of points that financiers, operating lessors and airlines alike need to be aware of (although lessor accounting itself will remain largely unchanged):
- there will be an impact on profitability measures and, as a consequence, on associated metrics such as the debt and gearing ratios. This means that many lessees may find themselves unintentionally in breach of the existing covenants in their lease and financing agreements as to the permitted levels of borrowings and other debt liabilities. For example:
- definitions such as “Financial Indebtedness” may now capture all lease agreements, where previously operating leases would have been excluded (which may trigger a breach of covenant);
- debt/equity ratios may be breached and will need to be adjusted accordingly; and
- EBITDA will increase as rental expenses are replaced by interest, depreciation and amortization;
- airlines will often account in their local currency and so will need to work out how to value leases, which typically provide for lease rentals in USD – we may see more leases denominated in the airline’s “local” currency and accordingly lessors may need to be sensitive to their customers’ demands in this regard (and there may need to be provision in leases for exchange rate mechanisms);
- the sale and leaseback market may be less attractive to those airlines who utilised the structure effectively as a form of off-balance-sheet finance;
- for wet leases, it should be possible to separate the payments for the aircraft with the payments for the associated “services” – the accounting changes will only impact the former;
- although lessor accounting will not be subject to changes as such, lessors may need to be responsive to the requirements of their airline customers as a result of the changes; and
- agreements should also be reviewed to see whether there is any provision for contingent rent, renewal/purchase options, maintenance and other services which may affect the calculation of lease liabilities.
Many agreements will contain protective language providing for changes in accounting rules, but as we approach the New Year, it would be a worthwhile exercise for all parties to aircraft operating leases to review the relevant provisions of their documents and using 2018 to make sure that they are in good shape for the introduction of these changes.