Accounting For Leases Of Aircraft Fleet Assets

Accounting For Leases Of Aircraft Fleet Assets Group MembersAbhishekSimranSonamIshaanVivekShipraShwetaLabhanshi

BACKGROUNDLease finance is a significant source of funding for many airline ,particularly in relation to fleet.When it comes to Leases it is a question that weather it is treated as an operating lease or a finance lease and thus whether it is off or on balance sheetIn a special report Accounting for leases: a new approach dated July 1996,which arouse a joint working group of 7 major accounting standards bodies. It concluded that the present frame work of leases needed a radical rethink and conceptualizes an entirely new approach which would result in the great majority of non-cancellable operating leases being brought on balance sheet OBJECTIVESTo make recommendations in relation to the methods of distinguishing between finance and operating leases.Recognizing the impracticality of setting upon a single approach , suitable to all major territories, with diversity in accounting standards.To achieve an understanding of the airlines lease portfolio and therefore making a meaningful comparison between the airlines.GENERAL PRINCIPLES1.The concept of economic ownership of the lease assets.widely adopted since the 1970E.g. in Australia, the Netherlands, the UK and US.Contained in the International Accounting standard Accounting for Leases(IAS 17)2.Legal ownership of the assets.Applicable in certain European countries,(particularly those where the requirements for statutory accounts is essentially fiscally driven)

Economic Ownership The broad objective of the economic ownership concept is to bring in substance purchase transactions on balance sheet as finance leases and account for them as if they were purchased assets. Thus for finance leases the following treatments arise:

(i)The asset and lease liability are included on the balance sheet, typically measured by reference to the discounted minimum lease payments over the lease term;

(ii) The interest and inherent in the lease payments are identified , the famous being charged to the income statement, the latter reducing the lease liability;

(iii) The asset is depreciated in line with policies applied to similar purchased assets, having regard to the lease term.

The accounting treatment arising from operating leases is entirely different ;neither the asset nor the lease liability are included in balance sheet.

In most lease accounting standards quantitative criteria are provided to assist in distinguishing between operating and finance lease.

Substance Over FormIn practice the classification of leases is determined predominantly by the application of the quantitative tests.

However , IAS 17 endeavours to give greater focus to the substance of the lease structure.

Some standard setters have issued standards of wider application.

FRS5 introduced the concept of lenders return as one of the test for assessing the commercial logic

Where a transaction involves only two parties, one of which receives a lenders return but no more,

Then that indicates that the substance transaction is that of a secured loan.

This is because the lessor (lender) is not compensated

Accordingly, under FRS5, it is asserted that such lease agreements should be accounted for as finance lease.

FRS5 specifically addresses the effect of option arrangements

European UnionAt present there is no preferred method of lease accounting supported by the European Commission .

A number of countries have local filling requirements which demand that the legal ownership approach is followed.

It is noteworthy that some international companies based in these countries prepare group accounts in which policies are adjusted to reflect the economic ownership concept.

Accounting For Leases: A New ApproachIts a result from a joint working group involving accounting standards setters.

It is critical manner in financial structures are employed .

There is propensity to rely on the quantitative criteria of lease standards for determining lease classification.

It results in many leases which are long-term financing arrangements being packaged as operating leases.

Joint working group has forwarded the proposals which would radically impact on financial statement CLASSIFICATION OF LEASES The accounting Policy task force endorses the concept of economic ownership. The leases can be classified as follows:

Short term or controversial

Long term

The lease must be classified since its inception but should be reviewed frequentlySALES AND LEASEBACK TRANSACTIONSThe sales and leaseback of aircraft is common amongst airlines . The reasons for entering into such transactions are as follows:

Realize economic gainsGenerate cash flowsIncrease fleet flexibilityAlter the Balance sheet treatment of the aircraft by leasing back under operating lease.

SALES AND LEASEBACK TRANSACTIONSIAS 17 recommends that any profit or loss arising from such transactions is treated as follows:

If a sale or a leaseback transaction results in a finance lease.If a sale or a leaseback transaction results in an operating lease. For operating lease, if the fare value at the time of a sale and leaseback transaction is less than the carrying amount of an asset.

TERMINATION PAYMENTS:Many leases structured as operating leases contain market value options to purchase the aircraft at specific breakpoints.A failure to exercise the option or extend the lease will often result in the payment of a termination sum.

BENEFITS ARISING FROM COMPLEX LEASE STRUCTURES: Examples of various lease financing structures are: Japanese Leveraged Lease (JLL) US Leveraged Lease (USLL) Foreign Sales Corporation (FSC) These financing structures are often further complicated by the use of additional double-up leases which are set up in order to gain

further tax advantages. The tax benefits accruing to the investors are usually shared with the airline by the following ways: Cash payments made to the airline at the commencement of the lease; or reduced rentals over the peiod of the lease.

DEFEASANCE: Certain aircraft financing structure give rise to the defeasance of lease obligation, which is typically achieved as follows: By means of a lease assignment;

Contd..A payment made to a third party to assume the airlines obligation to repay the debt;Elements of the lease financing;Equity investors under a leveraed lease agreeing to accept a security in full settlement of the debt.

RecommendationsThe task force notes that a number of major accounting standards bodies have consensus about the eefectiveness of lease accounting standards.Aside from additional disclosure the task force has the following specific recommendations:It endorses the concept of economic ownership in accounting for leases.Appendix 2 of this guideline should be taken into account in determining how a lease is classified.The lease should be treated as a finance lease.Any lease structure under which the lessor is in substance merely a provider of finance and is not compensated for the risk of ownership,should be treated by airline as a finance lease.If a sale and leaseback transaction results in a finance lease any profit or loss should be deferred and amortized over the lease term.

DisclosuresThe value of obligations arising under operating and finance leases split b/w the annual and total commitment.In respect of purchase options contained in existing operating leases the following should be disclosed in summary form.The amount of deferred lease benefits should be disclosedIn circumstances where defeasance is permitted the following should be disclosed in the financial year in which defeasance first occursThe aggregate carrying amount of assets given up for the purpose of defeasance.

The aggregate carrying amount of debt extinguished by defeasance.The net gain or loss arising.The nature of the defeasance.