Financial Services Ireland

AVIATION FINANCE ARTICLE

Covid-19 impairment considerations for lessors

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The Covid-19 pandemic has forced commercial airlines worldwide to ground their fleets and has brought with it what some consider to be the greatest challenges to ever face the aircraft and engine leasing industry. Against this background lessors need to carefully consider the impact of the pandemic on aircraft and engine impairments, writes EY’s Niamh Tobin for Aviation Finance.

Aircraft are reviewed for impairment whenever events or changes in circumstance indicate that the carrying value may not be recoverable1. If reductions in market values, driven for example by Covid-19, indicate a decline in value greater than would be expected as a result of normal use this would be an indicator of impairment. Additionally, internal information could indicate that certain aircraft have become idle or have retired earlier than previously anticipated. Due to the evolving situation and continued volatility in the current market, an impairment assessment is likely to be required at each reporting period.

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 fair value less costs to sell and value in use (“VIU”). Due to the current environment, certain assumptions used in both the fair value less cost of disposal and the VIU calculation will need to be reconsidered.

Due to the evolving situation and continued volatility in the current market, an impairment assessment is likely to be required at each reporting period.

Fair value less cost of disposal (FVLCD)
Within the aircraft lessor industry, the FVLCD is typically estimated as the current market value (CMV) obtained from third party appraisers. Current market value assumes an aircraft’s maintenance status is at half-life or benefitting from an above-average maintenance status if it is new. The CMV applied is maintenance adjusted based on the contractually agreed return condition of the aircraft at the end of the lease. Current market values also consider the perceived demand for the aircraft or engine type, its availability on the market, and, further, takes account of the expressed views of informed industry sources.

The CMV derived from the third party appraisers has been defined by the International Society of Transport Aircraft Trading (ISTAT) as the appraiser’s opinion of the most likely trading price that may be generated for an asset under the market conditions that are perceived to exist at the time in question. Market values are often value opinions based on each appraiser’s careful analysis of information about recent transactions.

Given the current level of uncertainty in the aviation industry and reduction in market transactions, there could be a significant level of variation in the third-party appraisal values meaning obtaining more than one appraisal value should be considered.

In the current environment, the latest valuations could be overlaid with other qualitative information. For example, a sale recently completed by a lessor could be more indicative of current pricing in the market and any required valuation adjustment.

Value in Use
The calculation of VIU incorporates an estimate of contractual cash flows, discount rate, residual values and in some instances expected future lease cash flows. Each of these inputs should be reassessed and updated, where necessary, to capture the impact of Covid-19.

Discount rate
The discount rate should be a pre-tax rate that reflects the current market assessment of the risks specific to the aircraft. Where future cash flow estimates have been adjusted to reflect revised expectations, it is important to ensure that there is no double count with the risks captured in the discount rate. The discount rate should reflect an investor’s required rate of a return in the current market. This rate is estimated from either the rate implicit in current market transactions or from the weighted average cost of capital (“WACC”) of a listed lessor that has a portfolio of aircraft similar in terms of service potential and risks.

Lessors that are not directly comparable to their listed peers (for example due to size, portfolio mix or risk) should consider their own WACC, incremental borrowing rate and other market borrowing rates when estimating an appropriate discount rate. The discount rate used should be independent of the lessor’s own capital structure and the way it financed the purchase of the aircraft or aircraft portfolio.

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, we are seeing increases in discount rates and, therefore, reducing VIU estimates.

Given the current level of uncertainty in the aviation industry and reduction in market transactions, there could be a significant level of variation in the third-party appraisal values meaning obtaining more than one appraisal value should be considered.

Contractual cashflows
Prior to the Covid-19 pandemic and in a stable environment, the contractual cashflows applied in the VIU were as per the lease agreement. In the current environment, these cashflows might need to be adjusted to reflect the estimated unreliability of such cashflows. For example, if an airline has filed for bankruptcy or a lease restructure is ongoing, such factors should be considered in the VIU calculation, if that risk has not already been captured in the discount rate. Additionally, the inclusion of any deferred lease payments within the VIU calculation should be carefully considered.

Future lease cashflows
Some lessors include future estimated lease cashflows in their VIU estimate when their strategy is to hold the aircraft beyond the current lease. The estimated future lease rates are typically obtained from third party appraisers. Similar to the CMVs, there could be a significant variation in lease rates from the third-party appraisers meaning more than one appraiser is recommended. Recent transactions for similar aircraft types could be more indicative of future lease rates in particular in the short term and could be used to overlay any third-party estimates.

Re-lease terms and downtime assumptions may also need to be adjusted for leases expiring in the short term. Downtime is likely to be extended and release terms reduced resulting in a lower VIU.

Disclosures
The financial statement disclosure requirements for lessors will vary depending on the magnitude of any impairment identified and the availability of information. Enhanced disclosures might be required to assist the users of the financial statements in understanding any changes in assumptions used in the impairment assessment and the key drivers behind any impairments recorded.

1 IAS36.56

This article was first published in the November 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.

Niamh Tobin

Aviation Finance Sector Leader
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