'Leases' and its impact on the financial position and performance of companies - Essay Example

?Exposure Draft ED 6 'Leases' and its impact on the financial position and performance of companies Executive Summary The revised exposure drafthas made some radical changes in the accounting rules related to lease. This has created mass criticism among many experts. This study highlights on the changes that will be incorporated in the income statement and the balance sheet of the lessee. This impact will also affect the financial position of the organization. In this study, the analysis has been done on Delta Airline, which has a major presence in the airlines industry of USA. They are highly dependent on lease. The revised Exposure Draft will increase the income expense of the organization, which in turn will lead to an increase in the debt. As the total lease expense will increase, so the organization has been recommended to reconsider any plans related to entering into new lease areas. Apart from this, the future cash flows are also required to be reassessed. Table of Contents Introduction 4 Lease Contacts by Delta Airlines 5 The revised Exposure Draft 6 The Implications 8 Conclusion 9 Reference List 11 Appendix 12 Introduction Financial accounting Standards Board (FASB) and International Accounting Standards Board (IASB) has revised the Exposure Draft that outlined some proposed changes in the accounting rules for leases. The reason behind such a proposal is just to improve the comparability and quality of financial reporting, by increasing the transparency related to leverage. This signifies the use of assets in the organization in its day to day operations and the exposure to risk by entering into a lease contact. The Exposure Draft has proposed a dual approach through which identification, measurement and presentation of the cash flows and the expenses related to lease can be made. Apart from this, the board has proposed some disclosure that would facilitate the investors and other users of the financial information to understand the uncertainty of cash flow, amount and timing arising from leasing (IFRS Foundation, 2013a). This study focuses on the impact of new revised accounting standards that are framed for leases, on the financial performance and position of the organization. Delta Airlines is a major airline, which is operating in America. It is headquartered at Atlanta, Georgia. It has an extensive network serving both domestic and international location in almost every continent except Antarctica. The organization along with its subsidiaries is operating with more than 5000 flights everyday and has approximate employee strength of about 80,000. Many of its aircrafts along with some ground facilities are taken on lease (Delta Air Lines, 2013; Delta Air Lines, Inc. 2013a). Thus, following section of the reports deals with how the revised accounting standard is going to affect the company. Lease Contacts by Delta Airlines Operating lease may act as an attractive option for the airlines industry as it increases the flexibility of the fleet, reduces the residual risk related to the aircraft for the aircraft industry and requires lower amount of capital commitment for the airline company. During the year 2012, Delta Air lines have entered into contact with The Boeing Company and Southwest Airlines, to lease eighty eight B-717-200 aircraft. In the later part of 2012, these aircrafts were delivered. In the first fleet, 16 aircrafts were delivered and thirty six aircrafts will be delivered in 2014 and 2015 respectively. The B-717-200 aircraft that has been leased by the company will have advanced features like new and fully upgraded interiors, total seats of 110 that comprises of 15 Economy Comfort seat and 12 First Class seat, along with in-flight Wi-Fi (Delta Air Lines, Inc. 2013b). Thus, it can be expected to generate more income. Apart from this, most of the ground facilities of Delta are also on lease. Most of the lands and building that are occupied by the organization are on lease. The largest base for aircraft maintenance, principal offices, training facilities, kitchens, cargo and various computers that are located at or near the Atlanta Airport are all taken on land lease from the City of Atlanta. The air cargo facilities, operating area, terminal space and ticket counters, all are taken through lease in most of the airports in which the organization serves. In most of the airport, the organization has entered into use agreement that allows them to non-exclusively use the taxiway, runways and other facilities and improvements. Under these agreements, the landing fees are dependent on the weight of the aircraft and the number of landings occurred. The use agreement and the leases taken by Delta Air Lines generally lasts for a period of lesser than 1 to 30 years and often attached with provisions that allow adjustments related to landing fees, lease rates and other charges on periodic basis, which is applicable in case of this type of agreements. Apart from these, the air cargo facilities and the aircraft maintenance facilities of certain airports such as the air cargo facilities and hangar at “the Cincinnati/Northern Kentucky International Airport, Salt Lake City International Airport, Detroit Metropolitan International Airport, Minneapolis-St. Paul International Airport and Seattle-Tacoma International Airport” (Delta Air Lines, Inc. 2012, p. 22), the Atlanta air cargo facilities and the main maintenance base are also on lease. Leasing the aircraft maintenance facilities allows the company to pay the cost for maintaining, operating and providing the facilities like the amounts necessary to disburse the debt services on special facility bonds that are issued for the purpose of raising finance required for construction purpose. On the basis of various time durations, the offices of reservation, ticketing and marketing of certain location are accessed via lease. The revised Exposure Draft According to the new approach of lease accounting developed by the board, the lessee needs to recognise the liabilities and the assets based on the rights and the obligation created by the lease. The model states that at the beginning of the lease agreement, the lessee gains the right to use the assets for a stipulated period of time. On the other hand, this right is delivered by the lessor. Therefore, the board has referred this model as the ‘right-of-use’ model (IFRS Foundation, 2013b). In this proposed model, the lessee is needed to identify the lease liability and right-of-use assets for all the leases that are for a period of more than 12 months. However, they are not required to recognise the same for the lease that is less than or equal to 12 months. By doing this, the concern about complexity and cost are addressed without creating any material changes in the information that are provided to the financial statement users (International Accounting Standards Board, 2013). At the very first stage, the liability and the asset is to be measured at the present value of the lease payment. The right-of-use asset includes the cost incurred directly as a result of entering into the lease agreement. On the other hand, the lease liability is also measured using the same approach regardless of considering the nature of the underlying assets. Excluding the payments in optional periods and variable payments from the calculation of lease liabilities and assets, is seen to address the concern that was raised regarding the complexity and cost (IFRS Foundation, 2013b). A variety of lease transactions are there that are different in different economics. The dual approach that is proposed in the Exposure Draft is related to the presentation, measurement and recognition of the cash flows and expenses that arise from the lease are seen to better reflect these differences. The board has introduced the dual approach for lease expenses as single lease accounting model fails to reflect the difference in economies in case of a wide range of lease contracts. The most appropriate approach to be followed is based on the amount of consumption of the underlying assets. This reflects that there is significant difference between the type of lease in which the lessee pays for consuming a part of the underlying assets and the lease in which the lessee is paying for merely using the asset. A lessee is a consumer who consumes only a part of the vehicle or equipment that is given on lease. This is due to the fact that value of the vehicles or the equipments are depreciating in nature. The value of these assets tends to decline over their economic lives. This decline is more in the early years of their life as compared to the later years. In such cases the lessor is seen to charge the lease price on the basis of recovering the value of the part of asset that is being consumed as well as to get the return on the amount invested on this asset (IFRS Foundation, 2013b; International Accounting Standards Board, 2013). In other case, the lessee is merely the user of the underlying asset and does consume more than an insignificant part of it. This case is especially in those situations where lands and buildings are given on lease. These properties are seen to have much longer life as compared to the previous items. For example, the value of the land is neither expected to depreciate that much nor the lessee consumes a significant amount. In such cases the lessor only looks for obtaining the return on the investment from the lessee. Therefore, the lease of equipments and vehicles is referred to as Type A lessee and the lessee of the property is referred to as type B (International Accounting Standards Board, 2013). While entering into type A lease the lessee should present an amortisation of the right-to-use assets in the same way as they do for other expenses and the interest on the lease liability is also calculated in the same way as for financial liabilities. On the other hand, in case of type B lease, the amount paid should signify the return on investment of the lessor. The payment that the lessee makes for using the property should be reported as one amount in the income statement and has to be recognised on a straight line basis (IFRS Foundation, 2013b). The presentation in the cash flow statement is kept consistent as made for other expenses made in the income statement. For type A lease the principal amount of the cash payment has to go under the financing activity and the interest has to go under the financing or operating activities. The cash payment is made under operating activities in case of type B (IFRS Foundation, 2013b). The Implications FASB and IASB have jointly released the exposure draft on lease accounting in August 2010. The board has made many significant changes in the draft after that. In the year 2013, the draft was revised and some more changes were made (Financial Accounting Standards Board, 2013). According to the proposal operating lease agreement found its place in the balance sheet of the lessee, as a result of which new liabilities will be identified that will attached to the right-to-use assets and subsequently depreciation will occur over the period of lease. Operating lease of the aircrafts is a very important practice in the airlines industry and capitalising on these leases will bring significant changes in the balance sheet of many airlines. Apart from affecting the balance sheet, the changes that have been made will also affect the income statement by accelerating the expenses as compared to the current treatment of operating lease (KPMG International Cooperative, 2013a). Most of the airlines have the functional currency other than USD, whereas most of the party providing leases are in USD. The current proposal has lead to adjustment in the liability, but not in the assets as the change in the exchange rates. This is expected to result into significant volatility in the income statement. Again, the classification of the lease items as type A and B will lead to some more changes in the financial statement of the company like both type A and B will find its place in the balance sheet and the lease expense will be front loading the income statement. The income statement will reflect greater amount of income charges for the first half of the lease as compared to the second half. Thus, the income expense of the organization will increase. Therefore, if the company has any plans for entering into new areas then the total lease expense will be accelerating (KPMG International Cooperative, 2013b). Conclusion The revised exposure draft is a major shake up for the aviation industry. The proposal has bought most of the leases to the balance sheet of the lessee, which will be resulting into an increase in debt of the Delta Airlines, in their balance sheet. Apart from this, the lease expense has been also accelerated. Therefore, if Delta is planning to enter into some more lease areas then they should give it a second though before reaching to any concrete decision. If the organization is into sale or leaseback transactions, then they need to reconsider the accounting. Apart from this, the future cash flows need to reassessed and adjusted as per the right-of-use assets. Since, this proposal makes the balance sheet volatile, so it is difficult for the lessee to forecast the future. Reference List Delta Air Lines, 2013. Stats & Facts. Available at [Accessed 17 September 2013]. Delta Air Lines, Inc. 2012. Annual Report Pursuant To Section 13 or 15(D) of the Securities Exchange Act of 1934 [pdf] Available at < http://www.delta.com/content/dam/delta-www/pdfs/about-financial/DeltaAirLines_10K_2012.pdf> [Accessed 17 September 2013]. Delta Air Lines, Inc. 2013a. About Delta [online] Available at < http://www.delta.com/content/www/en_US/about-delta.html> [Accessed 17 September 2013]. Delta Air Lines, Inc. 2013b. Annual Reports & Financial Information [online] Available at < http://www.delta.com/content/www/en_US/about-delta/investor-relations/annual-reports-and-financial-information.html> [Accessed 17 September 2013]. Financial Accounting Standards Board, 2013. FASB and IASB to Hold Joint Roundtable Meetings on Revised Leases Proposals [online] Available at < http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB/FASBContent_C/NewsPage&cid=1176163075421> [Accessed 17 September 2013]. IFRS Foundation, 2013a. IASB and FASB Propose Changes to Lease Accounting [online] Available at < http://www.ifrs.org/Alerts/ProjectUpdate/Pages/IASB-and-FASB-propose-changes-to-lease-accounting-May-2013.aspx> [Accessed 17 September 2013]. IFRS Foundation, 2013b. Snapshot: Leases [pdf] Available at < http://www.ifrs.org/Current-Projects/IASB-Projects/Leases/Exposure-Draft-May-2013/Documents/Snapshot-Leases-May-2013.pdf> [Accessed 17 September 2013]. International Accounting Standards Board, 2013. IASB Exposure Draft ED/2013/6 Leases [pdf] Available at [Accessed 17 September 2013]. KPMG International Cooperative, 2013a. 2013 Airline Disclosures Handbook [pdf] Available at < http://www.kpmg.com/Ca/en/IssuesAndInsights/ArticlesPublications/Documents/2013-airline-disclosures-handbook.pdf> [Accessed 17 September 2013]. KPMG International Cooperative, 2013b. Leases: Final Approach or Go-around? [pdf] Available at < http://www.kpmg.com/BE/en/IssuesAndInsights/ArticlesPublications/Documents/leases-final-approach-or-go-around.pdf> [Accessed 17 September 2013]. Appendix I: Lease of Delta Airlines Read More