With airlines continuing to seek rental payment deferrals, lessors need to be clear and consistent in how collectability considerations are reflected in their expected credit loss (ECL) impairment assessment and recorded in the profit and loss account, writes EY’s Niamh Tobin for the latest edition of Aviation Finance.
Covid-19 is the biggest shock to hit aviation in generations. While the rollout of the vaccine is positive news, the emergence of new variants is a cause for concern and it is clear that the recovery of the airline industry will still take some time. Lessors are continuing to receive requests for rental payment deferrals to assist airlines in managing their current cashflows meaning there is an increased likelihood of default on lease receivables.
IFRS 16 Leases does not include explicit guidance for considering collectability of lease payments. Lessors are required to continue to recognise lease rental income over the lease term. Any collectability considerations are reflected in the expected credit loss (ECL) impairment assessment and recorded in the profit and loss.
Lease receivables are typically assessed for ECL using the simplified approach (Lifetime ECL). There are different approaches adopted by lessors to assess an ECL, including a matrix approach based on aging of the lease receivables. All lease receivables amounts outstanding less any security packages (e.g. security deposit/Letter of Credit) should be included in the ECL assessment at each reporting date.
Lease receivable amounts which have been deferred, and are not therefore due, continue to meet the definition of a financial asset and are 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 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 if this has been offered to all lessees. A number of qualitative factors, such as Covid-19 related government assistance to airlines in certain jurisdictions, should be considered when assigning an appropriate credit rating.
The assessment of the impact of the coronavirus pandemic on ECL will require significant judgement, especially as it is not directly comparable with any recent similar events. The IASB acknowledges that it is likely to be difficult to incorporate the specific effects of the pandemic and government support measures on a reasonable and supportable basis. When it is not possible to reflect such information in models, the IASB expects management overlays or adjustments to be considered. The basis for management overlays should be documented and based on supportable information.
From a tax perspective, the ECL as calculated under IFRS 9 may have been deemed to contain an element of both a general and specific bad debt provision. Under previous tax rules, this could mean that the general element of the ECL may not be tax-deductible. The 2019 Finance Act was updated to clarify that IFRS 9 ECLs are deductible for corporation tax purposes.
Given the inherent level of uncertainty in estimating ECLs, the disclosure of key assumptions and related sensitivities is particularly important. This is the case both for annual reporters and for entities that will prepare interim financial statements under IAS 34, as the inputs into the ECL measurement may have significantly changed compared to their most recent annual or interim financial report.
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