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How will the Aviation Industry be affected by IFRS 16?

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Summary: From January 2019 a new accounting standard, International Financial Reporting Standards (IFRS) 16 'Leases', will come into effect. Research conducted by PWC suggests that, of the world-wide companies using IFRS as their financial reporting framework, the aviation industry will be second only to retail as a sector most affected by the new rules.

What then are the key changes for the aviation industry and what are some of the steps that should be taken to mitigate the impact of those changes?

Overview – what are the changes?

IFRS 16 will introduce a single accounting model, similar to the existing finance lease model,  which eliminates the distinction between finance and operating leases. The new standard will apply to existing leases as well as those entered into after 1 January 2019. The changes will mean that, as a general rule, all leases will now be on balance sheet. An agreement will be defined as a lease if the fulfilment of the contract requires the right to control and use an identified asset. This means that agreements that do not initially appear to be leases may be defined as such if these criteria are fulfilled. Rental expense will be replaced by interest costs and depreciation (as if the assets were owned) and companies will be required to recognise a lease liability for the present value of future lease payments. Whilst there are some exemptions for leases that have a duration of less than 12 months, or have an asset value of less than USD 5000, this exemption is unlikely to benefit business with high value assets such as aircraft. 

How will these changes impact the aviation sector?

Commentators are in agreement that the new standard will not make any substantial difference to aircraft lessors, as lessor accounting will  remain largely unchanged. However, lessors may not be let off the hook entirely as they will need to respond to changes in their customers’ behaviour as a result of the impact the changes will have on lessees. Not only may airlines wish to renegotiate leases to address some of the issues highlighted below, but lessors may also see a contraction of the sale and leaseback market as those airlines, which were participating solely for the purpose of keeping aircraft off balance sheet, retreat from the market.

The introduction of IFRS will, by contrast, have a far greater impact for those airlines using IFRS as their financial reporting framework. Airlines will now be required to recognise almost all leases on the balance sheet and, as a result, will account for substantial new assets and liabilities. This in turn will impact on reported profit and performance measures, such as debt and gearing ratios, EBITDA (this will increase as rental expense is replaced by interest, depreciation and amortisation), and Return on Capital Employed (ROCE).

Similarly, airlines will also be more greatly affected by currency volatility because when the lease liability is retranslated at each reporting date any movements will be recorded on profit and loss account. This may lead to an increased demand for lease rentals to be denominated in local currency which lessors will need to anticipate and eventually respond to.

The changes may affect, not only the leases pertaining to aircraft, but any ancillary agreements such as the lease of spare parts embedded in maintenance contracts or leases of intangible assets such as landing slots.  Wet-leases of aircraft, for a period of longer that 12 months, are unlikely to be classified as leases if the contracts contain a right for the lessor to substitute aircraft. This is because the right of substitution means there is no identifiable asset. 

Next Steps

From a legal perspective, lenders, lessors, and lessees will need to review agreements which contain any financial covenants to understand how the new standards may impact on the calculation of those covenants. If the agreements do not contain language protecting the borrower/lessee against changes in accounting rules, airlines may find that they will breach financial covenants once the changes are implemented. Parties may now also find that definitions such as “Financial Indebtedness” capture all leases where previously operating leases would have been excluded and that this, in turn, may trigger a breach of covenant.  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.

Conclusion

The introduction of IFRS 16 marks a significant change in the accounting treatment of leased assets. Going forward those involved in the airline industry, and particularly airlines, will need to be aware of the impact of this new accounting standard on agreements containing any form of leasing arrangement.

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