School of Aviation Finance. Accounting for Leases. Ronan Doyle, Partner, PricewaterhouseCoopers

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1 School of Aviation Finance Accounting for Leases Ronan Doyle, Partner, PricewaterhouseCoopers

2 Lease accounting Ronan Doyle Partner PwC Dublin

3 Company Law Regime Accounts must be prepared each year and approved by the directors Accounts subject to audit by registered statutory auditor very limited exemption Public filing of accounts in most cases Tiered levels of disclosure/compliance depending on GAAP applied Size Directors Compliance Statement * Confirmation to the statutory auditor Audit Committee * Disclosure on directors interests, directors emoluments and related parties is extensive * * New in 2014 Companies Act Not all yet effective Slide 3

4 Basis of preparation of financial statements All Irish registered companies require a set of financial statements every year These statements must be approved by the directors Choice of accounting principals International Financial Reporting Standards (IFRS) Irish GAAP FRS 101 IFRS measurement with limited disclosure FRS 102 Irish GAAP principals Certain changes in this regime were effective from 1 January 2015 Slide 4

5 Lease Accounting today Existing standards are SSAP21 and IAS 17 (as well as ASC840 under US GAAP) Differentiation between an operating and a finance lease Operating lease accounted for as an annual income/expense on a straight line basis No asset or liability on the balance sheet Finance lease accounted for a financing with an interest charge and depreciation Both asset and liability to pay for asset on the balance sheet Tests commonly used to differentiate between the two Other guidance to cover sale and leasebacks, bargain purchase options, rent free periods, extensions to leases etc Slide 5

6 IFRS 16 Lease Accounting The end of the world as we know it? Traditionally, much of the world s leased assets were off balance sheet for their operators Hides leverage Undisclosed commitments Lack of comparability within industry New rules will end this treatment bringing all leases back on balance sheet of lessees Rents will be replaced by interest costs and depreciation (as if asset were owned) International accounting rules final and effective 1 January 2019 (but can adopt earlier) US GAAP rules not yet finalized likely before end of Q No impact on Irish GAAP YET Reporting rule adds $3tn of leases to balance sheets globally. A new financial reporting standard the culmination of decades of debate over offbalance sheet financing will affect more than one in two public companies globally. FT 13 January 2016 The distinction between operating leases and finance leases that is required by present standards is arbitrary and unsatisfactory. The comparability (and hence usefulness) of financial statements would be enhanced if the present treatment of operating leases and finance leases were replaced by an approach that applied the same requirements to all leases. Accounting for leases a new approach (1996) Slide 6

7 The Highlights IFRS 16 Lessees will be required to 1. Recognise a lease liability for present value of future lease payments 2. Recognise a right of use asset reflecting the benefit to be gained from the leased asset over the term of the lease The calculation of the asset and liability are tightly defined 1. Use of Asset vs Service Costs 2. Fixed vs Variable Rents 3. Term of the Lease 4. Discount Rate 5. Contingent Rents 6. Costs of Restoration Subsequent accounting comprises an interest charge on the liability and amortization of the asset Some limited exemptions for smaller/short term assets Direct impact on lessors less significant (change in definition of a lease) but significant secondary impacts likely US GAAP likely to permit straight line accounting in the income statement in certain cases Slide 7

8 Illustrative Example under IFRS 16 - Lessee Total Depreciation 1,554 1,554 1,554 1,554 1,554 1,554 1,554 1,554 1,554 1,554 15,540 Interest Expense 1, ,359 Combined Expense 2,573 2,509 2,437 2,359 2,273 2,178 2,074 1,960 1,836 1,701 21,899 Current Accounting 2,190 2,190 2,190 2,190 2,190 2,190 2,190 2,190 2,190 2,190 21,899 - Impact on Profit and Leverage (200) (400) (600) (800) (1,000) (1,200) Profit Impact Leverage Impact (1,400) (1,600) (1,800) (2,000) The chart above depicts the impact on earnings and leverage for a basic 10 year lease with an initial annual rent of $2,000, a 2% annual escalation rate and an assumed incremental borrowing rate of 7%. Slide 8

9 Practical Implications Changes from current off balance sheet accounting Balance Sheet Assets Liabilities Income statement Lease expense Depreciation Interest expense EBIT EBITDA EBITDAR EPS Cash flow statement Cash from ops Cash from finance Many KPIs are redefined: - Current ratio - Asset Turnover - Interest cover - Net income - ROCE - ROE - Operating cash flows Impacting various arrangements: - Financing arrangements and covenants - Supply arrangements - Remuneration and employee schemes - Tax arrangements - Hedging arrangements May also impact future transactions: - (re) financing or raising capital to fund growth - Acquisitions and Mergers - Sale and leaseback - Lease versus buy decisions Need to manage stakeholders: - Banks/lenders - Investors/analysts - Rating agencies - Suppliers - Management/staff - Tax authorities - Oversight bodies Slide 9

10 The potential impact of IFRS 16 field testing the requirements Slide 10

11 The Balance Sheet Other Matters Aircraft assets should be booked at their initial costs Recognise premium/discount on lease if purchased with the aircraft Capitalisation of directly attributable costs only Spilt out of acquired maintenance reserves SEC view on the use of business combination accounting Often requires the booking of a maintenance asset Could result in goodwill Impairment Testing Choice of Assumptions (discount, downtime, release rate, transition costs) Third Party Appraisers Useful Lives Residual Value Guarantees Slide 11

12 The Income Statement - Other Matters Accounting for maintenance/supplemental rents Considerable variation in treatment Typically recognised as a % of the supplemental rent received or on termination of the lease IFRS 15 (Revenue) likely to restrict the options Financial Instruments Typically limited use of hedging derivatives should be at fair value More instruments at fair value (care with Profit Participating Notes) Level Yield/Effective Interest Rate accounting for interest expense Slide 12

13 IFRS vs US GAAP Currently, Irish GAAP/IFRS and US GAAP are broadly aligned. Finance vs operating lease Depreciation on a straight line basis Interest on debt on an accruals basis There are some differences Purchases of aircraft with leases attached Accounting for maintenance Impairment (Discounted vs Undiscounted) Slide 13

14 Q&A Slide 14

15 Leadership in Global Leasing Ronan Doyle Partner - Assurance Telephone: +353 (0) Yvonne Thompson Partner - Tax Telephone: +353 (0) Brian Leonard Partner - Tax Telephone: +353 (0)

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