2.4 Financing and Accounting Issues
2.4.2 Accounting
higher percentage (given that most no-frills cost-savings are in the indirect categories).
The different treatments illustrate the characteristics of managerial accounting, which provides the internal metrics needed to guide operations and facilitate planning and control, and financial accounting, which allows those external of management to assess the financial condition of a company.
For airlines, managerial accounting provides information to assess the impact of equipment changes and the costs of flying different routes, to calculate breakeven load factors, and to make competitive benchmark comparisons, for examples. Like most other large businesses, the industry uses accrual accounting in which revenues are recognized when services are rendered. The IATA Clearing House (ICH) provides the means of settling airline-to-airline financial transactions that arise when a passenger books trip sectors on different carriers (i.e., interlining). The Airlines Reporting Corp. is the clearinghouse for ticket transactions with travel agents.
Although classifications into direct and indirect components are obviously of great usefulness and simplicity, the drawback is that the approach has limited ability to guide a carrier on decisions pertaining to pricing or overall economic viability of providing services on specific routes. To make such evaluations, analysts must turn, as Doganis (2001, p. 92) suggests, to the concept ofescapability of costs. Some costs can be escaped over the short run whereas others only over the long run.80 Also, calculation of accounting profits using the cost categories in Table 2.7 does not encompass the notion of economic profit which equals Table 2.7 Major airline
operating cost categories Direct operating costs Flight operations Maintenance and overhaul Depreciation and amortization Indirect operating costs Station and ground expenses Passenger services
Ticketing, sales and promotion General and administrative Other
Source: ICAO and Doganis (2002, p. 79). Accounting treatments that depart from the standard are primarily in the flight operations category and pertain to airport and en route charges and to depreciation of rental leases of equipment and crews
80Escapability of the first type can be done by, say, reducing the number of weekly departures from an existing base station, while escapability of the second type can be achieved through reduction of fleet size or changing of equipment financing strategies depending on changes in long- term interest rates. All such decisions are facilitated in an accounting sense by classifying costs more specifically into variable (immediately escapable) and fixed components (which are direct operating costs that do not vary over the short run with particular flights or series of flights).
accounting profit less opportunity cost. Economic profit is not typically stated because opportunity costs are difficult to explicitly estimate.81
Leases Some 85 % of airlines presently lease all or part of their fleets, and equipment leasing is another area in which there may be accounting ramifications that are of analytical importance. According to US generally accepted accounting principles (GAAP), leases are classified as being either of the operating or of the capital (finance) type. Both types are governed by rules spelled out in Financial Accounting Standards Board (FASB) statement 13. The finance lease gives priority to the concept ofeconomicownership of the lease asset, accounting for it on the balance sheet as if it were purchased. In contrast, the operating lease prioritizes the concept oflegalownership of the asset. The difference between the two types may have a substantial impact on reported earnings.
For example, in the case of an operating lease, as lease payments become payable by the lessee, they are charged as a period expense over the term of the lease. Following FASB 13, “if rental payments are not made on a straight-line basis, rental expense nevertheless shall be recognized on a straight-line basis unless another systematic and rational basis is more representative of the time pattern in which use benefit is derived from the leased property.”
Critics and regulators had, however, long complained that such operating lease accounting—in which some airlines show no airplane assets or liabilities for money they are committed to pay in the future—presents a distorted picture of a carrier’s financial health because the actual leverage is hidden: Companies have been generally able to classify almost all leases as operating and to thereby keep them off balance sheets.
As a result, new rules (likely to be effective by 2018) have been proposed by the International Accounting Standards Board (and in the US, by the FASB). These rules call for an airline entering into a lease to show as an asset the right to use the equipment and also an equal liability based on the current value of the lease payments the company is obligated to make. If implemented, this change would not only enlarge balance sheets but also make the accounting similar to the way it would be if the company had directly borrowed money to buy the plane.82
In the case of a capital lease, however, FASB 13 says that “the lessee shall record a capital lease as an asset and an obligation at an amount equal to the present value at the beginning of the lease term. . .[and]. . . the asset shall be amortized in a manner consistent with the lessee’s normal depreciation policy except that the period of amortization shall be the lease term.” To be classified as a capital lease, the lease must meet one or more of the following criteria. Otherwise, it is an operating lease. Also, sale-leaseback transactions may be of either type depending on the criteria met by the lease.
81See Vasigh et al. (2015, pp. 20–21).
82In the proposed changes, this accounting would differ from most real estate leases, in which the value would be based on the expected size of lease payments over the life of the lease. See Norris (2013) and theWall Street Journal, November 11, 2015. The new lease accounting will boost reported leverage for airlines and restaurant chains.
2.4 Financing and Accounting Issues 107
• A capital lease transfers ownership of the property to the lessee by the end of the lease term.
• It contains a bargain purchase option
• The lease term is equal to 75 % or more of the estimated economic life of the leased property.
• The present value of the minimum lease payments, including certain adjust- ments, is 90 % or more of the fair value of the leased property at the inception of the lease.
A capital lease will thus transfer substantially all the benefits and risks inherent in the ownership of a property and will directly appear as an asset and a related liability on the balance sheet and with financial statement footnotes providing details on minimum obligations. In contrast, with an operating lease, which is cancelable and requires the regular payment of rent, equipment assets and liabilities do not appear on the balance sheet (although information about minimal obligations would appear in financial statement footnotes). Lease rentals are charged evenly to the income statement over the lease term.83
This difference may materially affect the comparability of transportation service company balance sheets and financial ratios. For example, in the first year, expenses for a lessee under a capital lease (i.e., interest expense and depreciation) are greater than expenses under an operating lease (i.e., rent expense). In later years, however, as the interest component on a capital lease diminishes, annual expense becomes greater with operating leases. Reported period net earnings would, all other things equal, then depend on a company’s mix of leasing versus asset-purchasing strate- gies. However, for companies that have already encumbered much of their free cash flow, leasing allows the company to hold onto more cash over the near term than would otherwise be possible.84
One last complication—as if there aren’t enough already—is that international treatments for leases may differ from those in the United States even though the finance/capital lease approach, based on a concept of economic ownership of the asset, is the treatment suggested by International Accounting Standard—
83Although the criteria for classifying leases appear in theory to be unambiguous, in practice, there can be different interpretations. Over the years, the FASB has thus attempted through the issuance of several additional statements to clarify certain aspects of FASB statement 13. Weil (2004) writes that the FASB is beginning to reconsider lease accounting standards. An important implication for lenders is that airlines in bankruptcy are able to reject their aircraft leases and return planes to their owners without financial penalty.
Another type of operating lease is known in the industry as thewet lease, which includes aircraft, crew, maintenance and insurance (ACMI) as opposed to adry lease, which only includes leasing of the aircraft. Wet lease is similar to the chartering of aircraft except that the lessee would have the necessary operating licenses and permits and would operate the wet-lease flights with its own flight designation. Although ACMI transactions are more complex, the margins tend to also be higher because of the greater tailoring of the contracts. Leasing is extensively covered in Vasigh et al. (2015, pp. 496–534).
84The lease versus purchase decision is discussed in more mathematical detail in Stonier (1998).
Accounting for Leases (IAS 17). In Europe and Japan “finance leases were often excluded from the balance sheet because the airline did not have legal title or ownership. In the UK and US, however, these leases are capitalized and placed on the balance sheet.”85
Aside from the financial accounting implications, operating leases permit the carrier to respond rapidly to changes in market conditions, are of relatively short term (averaging 5 years), and give the carrier use of the equipment without incurring an obligation to pay off the aircraft at full cost. However, finance leases (also called full-payout leases) that are used for about half of the fleets in North American carriers often extend over an average of 10–12 years and involve a relatively large amount of debt and smaller amounts of equity (20–40 % of the equipment’s value).
Such leases are somewhat varied and depend to an extent on the country in which the lease originates and in which the aircraft is predominantly operated.86
Even though lease valuations are approached in many different ways they will, nevertheless, be always grounded in Net Present Value (NPV), Internal Rate of Return (IRR), and the associated discounted cash-flow (DCF) concepts. Monte Carlo (i. e., probabilistic) analyses of risks are also sometimes applied to DCFs.
And the average expected cost of debt and equity financing—the Weighted Aver- age Cost of Capital (WACC)—is also inherently included in operating lease valuations, which always include the capital cost of the depreciating aircraft, the implicit interest charge, and the cost of risk transfer.
Sale-Leasebacks The sale and subsequent leaseback of aircraft is a frequently used airline financing strategy that can generate cash, realize economic gains, and
85Quote is from Morrell (1997, p. 49), who further notes that UK rules for accounting for leases define a financial/capital lease—also known asfull pay-out lease—requiring placement on the balance sheet as: “a lease that transfers substantially all the risks and rewards of ownership of an asset to the lessee. It should be presumed that such a transfer of risks and rewards occurs if at the inception of a lease the present value of the minimum lease payments amounts to substantially all (normally 90 % or more) of the fair value of the leased asset.” In addition, “a more difficult problem occurs with extendible operating leases, which usually have a lease term that covers the economic life of the aircraft, but give the lessee airline the opportunity to break the lease at no penalty. . .at various intervals over the term. British Airways have a number of aircraft leased in this way, and originally left them off balance sheet.”
Although U.S. GAAP and International Financial Reporting Standards (IFRS) have begun to converge, some differences remain. Both GAAP and IFRS recognize the economic substance of leases for both the lessor and lessee. But IFRS terminology refers to leases as finance leases;
GAAP as capital leases. Under GAAP, leased assets consist only of property, plant and equipment, whereas under IFRS, other types of assets, including leases to explore mineral resources and to exploit other licensed property agreements (including movies and manuscripts) may be included.
Also, GAAP is more rules based as compared to IFRS. Other differences for lease accounting are discussed in Siegel and Shim (2010).
86As Morrell (2001, p. 200) notes, in the Japanese Leveraged Lease (JLL), 20–30 % of the financing comes from Japanese institutions, with the remainder from banks, whereas leveraged leases in the US provide maximum benefits for aircraft based and registered in the United States.
Non-US carriers may also be able to make lease deals similar in structure to that of the JLL variety by implementing the provisions of the U.S. Foreign Sales Corp. (FSC).
2.4 Financing and Accounting Issues 109
increase fleet flexibility. According to the International Accounting Standards statement 17 (see IATA Airline Accounting Guide No. 6), if a sale-leaseback transaction results in a capital (finance) lease, any profit or loss should not be recognized immediately through income but should be deferred and amortized over the lease term.
However, if such a transaction results in an operating lease and it is clear that the transaction is established at fair value, any profit or loss should be recognized immediately. It should further be noted that this treatment is not consistent with US GAAP (Generally Accepted Accounting Principles) which requires that all gains arising on operating leasebacks be deferred and amortized over the minimum lease term in proportion to the gross rental charged as an expense. Notably, GAAP methods also differ from International Financial Reporting Standards (IFRS) in some important ways and the two approaches are not entirely compatible.87
In summary, for airlines, the advantages of leasing (which may, in part, also be derived from outsourcing of other major equipment assets and services) are as follows:
• Volume discounts for aircraft purchases can be obtained and passed on to the airline.
• The airline conserves working capital and credit capacity.
• Up to 100 % of the equipment is financed with no deposits or pre-payments required.
• The airline shifts the burden of risk of obsolescence to the lessor.
• It is sometimes possible to exclude leasing finance commitments from the balance sheet.
• The tax status might become more favorable.
The disadvantages of leases are as follows:
• The cost may be higher than for straight-debt financing.
• The profit from eventual sales of the equipment accrues to the lessor, not the airline.
• Higher debt-equity (gearing) ratios may result.
• Aircraft equipment specifications may not be fully compatible with the airline’s needs.
87As explained in Vasigh et al. (2015, p. 147), IFRS and GAAP differences involve:
• last in, first out (LIFO) inventory costing, which is precluded in IFRS
• IFRS uses a single-step method for impairment writedowns whereas GAAP uses a two-step method.
• There are different probability thresholds for contingencies and curing of debt covenant violations after year-end.
It is expected that both methods will gradually converge. See also AICPA (2008).
Other Elements Given that modern airline companies must finance large capital equipment purchases by incurring significant debts, it is not unusual to find that airlines may attempt to shunt as much debt as possible to off-balance sheet affiliates called special-purpose entities (SPE). A parent company (under the accounting rules of the early 2000s) can own up to 97 % of the investment in the SPE without having to consolidate the affiliate’s balance sheet into its own accounts. By this means, large debt obligations for plane leases will not appear on the airline’s balance sheet even though the parent company remains financially exposed and responsible for service of such obligations.88
Other elements specific to the airline business include accounting for frequent- flyer programs and acquired gates, routes, and airport landing slots. Airlines will generally record, under an accrual approach (also known as theincremental cost method) an estimated liability for the incremental cost associated with providing the related free transportation at the time a free travel award is earned. The liability will then be periodically adjusted for awards redeemed and earned or for changes in program requirements.89Most airlines utilize the incremental cost method.
However, as noted in IATA Airline Accounting Guideline No. 2, adeferred revenue approachmay also be used. Under this procedure a proportion of passenger revenue generated from the sale of tickets conferring frequent-flyer benefits is deferred until such time as a ticket associated with the use of the frequent-flyer award is granted and used.90The same approach pertains to revenues generated
88For example, see “Who Else Is Hiding Debt,”Business Week, January 28, 2002.
89Technically, this is done on the income statement by increasing passenger services expenses by the incremental costs (including food, fuel, taxes, etc.) of carrying the award passengers at a future date while the same amount is recorded on the balance sheet as an accrued liability. Then, when the award passenger is carried, the incremental cost is deducted from expenses and the liability on the balance sheet is extinguished. Using this method, the operating profit in each year is not distorted by the award. Since 1999, the methods follow Securities and Exchange Commission Staff Accounting Bulletin 101, which requires that revenue from sale of mileage credits is deferred and recognized when transportation is provided. Such frequent flyer/traveler award programs began in the early 1980s and were originally patterned on the “green stamps” that food retailers used in the 1950s and 1960s to encourage customer loyalty.
By 2008, airlines had given away many more miles than could be accommodated by increases in capacity. The programs had become an important source of profits, in some cases up to $1 billion a year, but also had evolved from being an airline’s loyalty program to a currency program for the customers of other companies in other industries. Generally, these other companies can purchase the miles at prices of between one to three cents. The number of unused miles has also become staggering. Delta had 488 billion miles, and American 613 billion by the end of 2007.
AMR’s American Airlines unit awarded 200 billion miles, while only 150 billion were redeemed.
See also Garvett and Avery (1998),Business Week, March 5, 2000; Elliott (2004); Trottman and Carey (2007); Sidel and Carey (2008); Stellin (2008); Maynard (2009a), and especially Vasigh et al. (2015, pp. 154–173) for detailed explanation.
90Calculation of the level of deferred revenue depends on assumptions concerning the proportion of points to be redeemed and the mix of awards to be taken up and also on the yield assigned to the mileage or points attributed to the expected take-up of free travel awards. As noted in the IATA Accounting Guide, the redemption rate is affected by the threshold of points required before a member can redeem a reward, the time until award expiration, and the award redemption
2.4 Financing and Accounting Issues 111