The Covid-19 pandemic has caused the grounding of more than 16,000 passenger jets worldwide and has brought with it what some consider to be the greatest challenges to ever face the aircraft and engine leasing industry. Lessors are dealing with unprecedented times including rent deferral requests from airlines and declines in value for certain aircraft and engine types. In response to this, a number of lessors have reviewed orderbooks with a view to reducing capital commitments in the short-term at least to align with the latest expectations of aircraft demand. To help lessors prepare IFRS financial statements for annual or interim reporting periods ending in 2020, EY Financial Services Senior Manager Niamh Tobin summarises key considerations from an accounting perspective for the June issue of Aviation Finance.
The financial reporting considerations highlighted in this article are as follows:
The issues discussed are non-exhaustive and their applicability depends on the specific facts and circumstances and should be assessed on a case by case basis.
The going concern basis of accounting is a fundamental principle in the preparation of financial statements. When preparing financial statements, management is required to make an assessment of an entity’s ability to continue as a going concern1. In assessing whether the going concern assumption is appropriate, management should consider both existing and expected impacts of the Covid-19 pandemic including deterioration in cash receipts of lease income, scheduled debt repayments and capital commitments. In Ireland, the period used by those charged with governance in making their assessment is usually at least one year from the date of approval of the financial statements.
When management is aware of material uncertainties related to events or conditions that may cast significant doubt upon the entity’s ability to continue as a going concern, those uncertainties must be disclosed.
Updates to significant judgements included in management’s going concern assessment, up to the date of issuance of the financial statements, may be required given the inherently uncertain future outcomes of events or conditions.
The degree of analysis required, conclusions reached and required level of disclosure in relation to current uncertainties will depend on the facts and circumstances in each case. When an entity has ready access to financial resources, the entity may reach a conclusion that the going concern basis of accounting is appropriate without detailed analysis. In other cases, management may need to consider a wide range of factors relating to current and expected profitability, debt repayment schedules and potential sources of replacement financing before it can satisfy itself that the going concern basis is appropriate.
The revised ISA (Ireland) 570 – Going Concern is applicable for audits of financial statements with accounting periods beginning on or after 15 December 2019. The revision has expanded the requirements for the auditor to evaluate management’s assessment of an entity’s ability to continue as a going concern. Where previously, the auditor was required to conclude based on the evidence obtained, the auditor must now obtain sufficient audit evidence regarding an entity’s ability to continue as a going concern and to conclude on whether a material uncertainty exists.
This expanded requirement coupled with the Covid-19 pandemic is likely to increase the auditor’s focus and attention on the going concern assumption including increased scrutiny and challenge on the assessment made and assumptions included within. There are four possible outcomes along with each resulting audit opinion, as follows:
Aircraft are reviewed for impairment whenever events or changes in circumstance indicate that the carrying value may not be recoverable2. Covid-19 could be considered an example of such an indicator of impairment if market valuations indicate a decline in value greater than would be expected as a result of normal use. Additionally, internal information could suggest that certain aircraft could become idle or retired earlier than previously anticipated. An impairment review involves assessing the recoverability of the carrying value of each aircraft. If the carrying value is not recoverable an impairment arises equal to the difference between the carrying value and the higher of the asset’s value in use and its fair value less costs to sell.
The calculation of value in use incorporates an estimate of expected future contractual cash flows, residual values and in some instances future lease cash flows. All of these inputs including an appropriate discount rate should be reassessed and updated to capture the impact of Covid-19.
The discount rate should reflect the current market assessment of the risks specific to the aircraft for which the future cash flow estimates have not been adjusted. Determining an appropriate discount rate is subjective, involves judgement and is likely to present additional challenges in the current environment. Given the increase in credit risk generally in the market and the impact of the pandemic on the leasing industry in particular, it is likely that discount rates will have increased. This will reduce value in use estimates.
The fair value applied for each aircraft is typically the current market value (‘’CMV’’) derived from various third-party appraisers. Given the level of uncertainty currently in the aviation industry, the market for aircraft is likely to have been disrupted and as a result, there could be a significant level of variation in the third-party appraisal values. In the current environment, the latest valuations, overlaid if necessary, with other qualitative information (e.g. market transactions/liquidity), should be used to best capture any valuation adjustments. For example, a recently completed transaction by a lessor could be more indicative of current pricing in the market and required valuation adjustment.
Where lessors have granted lease rental payment deferrals to assist airlines in managing their current cashflows, the lease rental moratorium is likely to meet the definition of a lease modification (being a change that was not part of the original terms and conditions of the lease3).
In May 2020, the International Accounting Standards Board (“IASB“) issued an amendment to IFRS 16 Leases. This amendment permits lessees, as a practical expedient, not to assess whether rent moratoriums occurring as a direct consequence of the pandemic are lease modifications and instead to account for those deferrals as if they are not lease modifications. However, the amendment was not extended to lessors. The IASB staff paper in relation to the amendment indicated that such deferrals would be unlikely to change the classification of a lease for lessors.
However, lessors should carefully assess the details of the lease rent payment deferrals or concessions granted to their customers under both finance and operating leases.
For modifications to a finance lease, a lessor is firstly required to assess if the modification meets the requirements to be recognised as a separate lease or not.
The need for a separate lease would arise if the modification changes both the scope of the lease (by adding or terminating the right to use one or more underlying assets or amending the lease term) and the consideration received for the lease by an amount commensurate with the price for the change in scope.
When a separate lease is not required to be recognised, and the lease classification is unchanged, the lessor is required to adjust its measurement of the finance lease receivable asset to reflect any change in future contractual lease payments that has arisen from the lease modification. The corresponding adjustment to the finance lease receivable is required to be recognised as a modification gain or loss in the profit or loss. A rental holiday is unlikely to result in a significant gain or loss in the profit or loss.
Where a modification to a finance lease classifies the lease as an operating lease, had it been in place since inception, the lessor must measure the carrying amount of the underlying asset as the net investment in the lease immediately before the effective date of the lease modification.
Under IFRS 16 Leases, a lessor accounts for a lease modification as a new lease from the effective date of the modification, considering any prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease.
For operating leases, a lessor is required to recognise lease income on a systematic basis that represents the pattern in which benefits from the use of the underlying asset are diminished. This typically results in aircraft lessors recognising income on a straight-line basis over the life of the lease. Therefore, the lease modification as a result of the rent payment deferrals would require the straight-lining of the revised cashflows over the remaining term of the lease.
Maintenance and lease intangibles recognised for aircraft acquired with in-place leases are specific to aircraft and engine lessors. The accounting impact of a lease modification on these associated intangibles must also be considered. A rental holiday alone is not a change in the scope of a lease, as the airlines right to use the aircraft has not changed. In assessing whether there has been a change in the consideration for a lease, an entity considers the overall effect of any change in the lease payments. For example, if a lessee does not make lease payments for a three-month period, the lease payments for periods thereafter may be increased proportionally meaning the consideration is unchanged. However, if additional modifications are made to the original terms of the lease contract such as a change in lease term, maintenance return condition and or a reduction in future rentals, careful consideration would need to be given to the treatment of the associated intangibles.
Given the request for rental payment deferrals from airlines, as mentioned in 3 above, there is potentially an increased likelihood of default on lease receivables. IFRS 16 does not include explicit guidance for considering collectability of lease payments, meaning lessors are required to continue to recognising lease rental income over the lease term. Any collectability considerations are reflected in the expected credit loss impairment assessment and recorded in the profit and loss.
Lease receivables are typically assessed for expected credit losses using the simplified approach (“Lifetime ECL”). There are different approaches adopted by lessors to assess an ECL, for example, based on outstanding lease receivables less any security packages (e.g security deposit/Letter of Credit). All lease receivable amounts outstanding should be included in the ECL assessment at each reporting date. Lease receivable amounts which have been deferred continue to meet the definition of a financial asset and are hence required to be assessed for impairment. The ECL model and methodology should be applied consistently throughout each reporting period with inputs regularly updated, including the assigned internal credit rating to each lessee, assumptions and probability of default (“PD“) adjustments required.
A lessee’s credit rating might not be downgraded solely as a result of a lease deferral arrangement being in place or requested and other qualitative factors should also be considered. A number of other factors, such as Covid-19 related government assistance to airlines in certain jurisdictions, could be included in the internal credit rating assessment.
Additionally, in response to the current uncertainty, lessors could consider applying management overlays if management’s view is that, given uncertainties in relation to the lessee, the modelled ECL is insufficient. The basis for management overlays should be documented and based on supportable information.
The ECL impairment as calculated under IFRS 9 may contain an element of both a general and specific bad debt provision. Therefore, under previous tax rules it could mean that an element of the allowance may not be tax-deductible. The 2019 Finance Act was updated to clarify that expected credit losses as calculated under IFRS 9 are deductible for corporation tax purposes.
Where lessors need to amend the terms of existing debt agreements, management should carefully assess changes to determine if they represent a substantial modification or a contract extinguishment, which would have differing accounting implications in each case.
In summary, the debt should be derecognised if the cash flows are extinguished (i.e., when the obligation specified in the contract is discharged, cancelled or expires) or if the terms of the instrument have substantially changed.
IFRS 9 provides guidance for determining if a modification of a financial liability is substantial, which includes a comparison of the cash flows before and after the modification, discounted at the original effective interest rate (EIR), commonly referred to as ‘the 10% test’. If the difference between these discounted cash flows is at least 10%, the instrument is derecognised as the terms are deemed to be substantially different4.
However, other qualitative factors could lead to derecognition irrespective of the test (e.g., if a debt is restructured to include an embedded equity instrument).
Any debt modifications will require an adjustment to the amortised cost of the financial liability to reflect actual and revised estimated contractual cash flows. The amortised cost of the financial liability must be recalculated as the present value of the renegotiated or modified contractual cash flows discounted at the original effective interest rate or, when applicable, the revised effective interest rate. The adjustment is recognised in profit or loss as income or expense in that period.
Lessors may seek to hedge the interest rate exposure arising from floating-rate debt arrangements by entering into derivative contracts which swap floating interest rates for fixed interest rate. Where debt amendments are made, as mentioned in section 5 above, the impact of any associated hedged instrument(s) will also need to be assessed. For a hedge to continue, it would need to satisfy all the below:
When an entity discontinues hedge accounting for a cash flow hedge, it must account for the amount that has been accumulated in the cash flow hedge reserve in one of the following two ways:
i. the amount remains in accumulated OCI (until the cash flows occur) if the hedged future cash
flows are still expected to occur; or
ii. the amount is immediately reclassified to profit or loss as a reclassification adjustment if the
hedged future cash flows are no longer expected to occur.
Lessors could also seek to renegotiate with current swap counterparties (or break existing swaps and enter into new swaps) to align cash flows with the amended terms of the debt agreements.
The facts and circumstances for each transaction will differ and therefore should be carefully assessed on a case by case basis.
For debt facilities subject to covenant reporting, the impacts of Covid-19 could result in lessors being in breach of certain covenants (e.g. loan to value covenants due to a decline in aircraft valuations). When an entity breaches a provision of a long term loan arrangement on or before the end of the reporting period with the effect that the liability becomes payable on demand, it classifies the liability as current, even if the lenders agree, after the reporting period and before the authorisation of the financial statements for issue, not to demand payment as a consequence of the breach5.
In this scenario, the liability is classified as current because, at the end of the reporting period, the borrower does not have an unconditional right to defer the liability’s settlement for at least twelve months. The implications of such breach in provision of a debt agreement on the going concern assessment will also need to be considered.
IAS 10 Events after the Reporting Period provides that if the following events occur between the end of the reporting period and the date the financial statements are authorised for issue, those events are disclosed as non- adjusting subsequent events:
While these events would be disclosed as subsequent events, such negotiations could help to support the going concern assumption. The covenant requirements and implications of breaches should be assessed on a facility by facility basis.
It has been well publicised that a number of lessors have sought to restructure their orderbooks with OEMs in an effort to ease the short-term capital commitments and concurrently manage the asset risk being the risk of placing new aircraft and re-leasing their current portfolio. The restructures have taken the form of lessors cancelling certain orders or renegotiating the delivery dates of aircraft to later periods. OEMs have also sought to delay certain aircraft deliveries as the pandemic has impeded on their ability to deliver these aircraft orders as contractually agreed.
IFRS sets out guidance on capitalising borrowing costs that are directly attributable to the acquisition, construction or production of a “qualifying asset”. A qualifying asset is one that necessarily takes a substantial period of time to get ready for its intended use or sale. The orderbook of new aircraft are built over a number of months or years, therefore payments made during their production are typically deemed to be qualifying assets.
Lessors may seek to hedge the interest rate exposure arising from floating-rate debt arrangements by entering into derivative contracts which swap floating interest rates for fixed interest rate. Where debt amendments are made the impact of any associated hedged instrument(s) will also need to be assessed.
Lessors are required to make pre-delivery payments to OEMs in installments during the period when the aircraft is under construction. In accordance with IAS 23 Borrowing costs, the borrowing costs incurred relating to the pre-delivery payments are typically capitalised and included as part of the cost of the asset.
Interest is capitalised once the first installment is paid and is accrued monthly up until the delivery of the aircraft, at which point the interest amount is capitalised onto the aircraft book value.
The restructure of orderbooks should be assessed to determine if it is appropriate to continue to capitalise interest on such payments Typically, the nature of the restructure is such that the nature of the borrowing costs has not changed, viz a vis, funding a portfolio of aircraft under construction. Additionally, the accounting treatment for any cancellations needs to be assessed, including any compensation received from the OEM. The nature of the orderbook restructures will differ for each lessor meaning the accounting outcome is also likely to differ depending on the details of each.
In addition to the disclosure requirements for the preceding areas, IAS 1 requires disclosure of information about the assumptions concerning the future, and other major sources of estimation uncertainty at the end of the reporting period, that have a significant risk of resulting in a material adjustment to the carrying amounts of assets and liabilities, such as non-current assets subject to impairment, within the next financial year.
Examples of the types of disclosures that an entity is required to make include:
In accordance with IAS 34 Interim Financial Reporting, an entity is required to include in its interim financial report an explanation of events and transactions that are significant to an understanding of the changes in financial position and performance of the entity since the end of the last annual reporting period.
Information disclosed in relation to those events and transactions should also update the relevant information presented in the most recent annual financial report. IAS 34 includes a number of required disclosures as well as a non-exhaustive list of events and transactions for which disclosures would be required if they are significant. For example, where significant, an entity needs to disclose changes in the business or economic circumstances that affect the fair value of the entity’s financial assets and financial liabilities, whether those assets or liabilities are recognised at fair value or amortised cost. In addition, an entity is also required to disclose any loan default or breach of a loan agreement that has not been remedied on or before the end of the reporting period.
The standard presumes a user of an entity’s interim financial report will have access to the most recent annual financial report of that entity. Therefore, it is unnecessary for the notes to an interim financial report to provide relatively insignificant updates to the information that was reported in the notes in the most recent annual financial report. However, given in many cases the impact of the pandemic has arisen since the last annual report there may need to be a more comprehensive disclosure in the interim financial report.
The financial statement disclosure requirements for lessors will vary depending on the magnitude of the financial impact and the availability of information. Where such a decline in value, for example aircraft values, is determined to be non-adjusting the entity does not adjust the carrying amounts, but instead, discloses such a fact and its financial effect if it can be reasonably estimated.
The Covid-19 pandemic may also result in obligations or uncertainties that an entity may not have previously recognised or disclosed, an entity also needs to consider whether to disclose additional information in the financial statements to explain the impact of the pandemic on areas that might include provisions and contingent assets/liabilities.
In relation to the assumptions and estimation uncertainty associated with the measurement of various assets and liabilities in the financial statements, the occurrence of the pandemic has certainly added additional risks that the carrying amounts of assets and liabilities may require material adjustments within the next financial year. Therefore, management should carefully consider whether additional disclosures are necessary in order to help users of financial statements understand the judgement applied in the financial statements.
1 IAS 1.25
2 IAS 36.8
3 IFRS 16 Appendix A
4 IFRS 9 B3.3.6
5 IAS 1.74
This article was first published in the June 2020 issue of Aviation Finance. You may find it useful to review our latest insights and thinking to support you in leading through volatility; don’t hesitate to reach out if you have any questions.