homework:
week 2: Accounting for Leases at American Airlines
week 3: Fair value accounting at Berkshire Hathaway
week 4: Ratio Analysis & Valuation
week 5: Ratio Analysis & Valuation
week 6: Ratio Analysis & Valuation
Financial Statement Analysis & Valuation
MSc Accountancy & Control 2020-2021
Accounting for Leases at American Airlines homework week 2
Student #1: Cato Carlier (12756164) [Tutorial group 1]
Student #2: Larissa de Wit (12830453) [Tutorial group 1]
Assignment solutions:
1. Do you think the new lease standard better reflects the economic reality of American
Airlines? Why, or why not?
You would say yes, because the new standards should help increase transparency and
comparability among organizations by recognizing all leases as assets on the balance sheet.
However airline companies have a lot of variable leases, which are an exception for the
balance sheet if the index rate is not easily measurable. Airline companies make sure these
rates aren’t easy to measure, and for this reason the variable leases of airplane companies stay
off-balance. For American Airlines 54% of its total operating leases in 2018 exist of variable
leases, and since these leases don’t have to be recognized on the balance sheet, I would say
that even with the new standards it doesn’t reflect the economic reality of American Airlines
well.
2. How does the new lease accounting standard affect American Airlines’ assets, debt,
and debt‐to‐equity ratio in 2018? As an analyst, how does the new standard affect your
evaluation of American Airlines’ performance and financial position?
The new lease standards affect American Airlines assets for the operational leases they had.
With the new standards they have to recognize the operational leases as assets on the balance
sheet, so as an effect it will increase the total assets on the balance sheet. As a consequence
this will also increase American Airlines debt since they have to take a liability to pay off the
assets.
The increase in debt will have a negative influence of the debt-to-equity ratio. Since the sales
stays the same and just the costs are shifted from the income statement to the balance sheet
the outcome of the debt-to-equity ratio will be lower, because the same amount of sales will
be divided by more debt. Furthermore is the equity understated with the old standards when
the assets weren’t recognized on the balance sheet, which also influences a lower outcome of
the equity ratio. However the article states that when the operating leases would not be
counted as debt for covenant purposes the debt-to-equity ratio wouldn’t be significantly
affected.
The new standards affect the evaluation of American Airlines financial position in a positive
way since when the leases are recognized as assets on the balance sheet, this will give a better
understanding of the company’s performance, because it increases the transparency and
comparability. However the off-balance sheet variable leases are often not included in the
lease obligations, and therefore do not give an accurate rating and give difficulties with
calculating and comparing companies leverage.
,3. Based on the variable lease payments for 2018, compute the effect on American
Airlines’ leverage ratio (total liabilities to total assets) assuming that variable leases
would be capitalized on the 2018 balance sheet. Also assume that annual variable lease
spending remains constant at the 2018 level and that the contracts have the same
weighted average remaining lease term and discount rate as operating leases.
When there is a high demand, it is more profitable to have more assets compared to variable
costs, because this highers your revenue. However having more assets compared to variable
costs is also riskier, because when the demand decreases you will also make a higher loss. For
airplane companies it is common to have high fixed costs, however what is written in the case
it is also quite normal to lease assets to divide the costs. Given the corona pandemic there is a
low demand, so we would expect companies to make more use of leasing. American Airlines
indeed has a lot of lease contracts so from first sight we would say that the leverage ratio
would be low. However given the new regulations and as mentioned that the leases are
capitalized and the annual variable lease spending remains constant we expect the leverage
ratio to be higher.
Using the given information from 2018 balance sheet the leverage ratio of American Airlines
is calculated as followed:
Total assets: $70.878
Total liabilities: $41.987 + $17.121 = $59.108
Leverage ratio: $59.108 / $70.878 = 0,833
4. Would you recommend that accounting standard setters require firms to capitalize
variable leases? Why, or why not? In answering this question, use the effects of the
COVID‐19 crisis on the business of American Airlines as an “experiment”. Specifically,
you can use the following information obtained from the quarterly reports of American
Airlines before and after the start of the crisis to determine how variable the lease
expenses truly are:
Note that American Airlines does not disclose the variable lease expenses as a separate
line item. Therefore, assume that all variable leases are included as part of “regional
expenses” and “other rent and landing fees”.
The standards setters of the FASB proposed to use an index or rate for estimating the
upcoming variable payments, while recognizing variable leases as assets and liabilities on the
balance-sheet. In the experiment of American Airlines, they use the Consumer Price Index
, (CPI). In this case the baskets for each quarter and year are shown in the table below, where
2019Q1 is base. The numbers from the selected expenses are used.
2019Q1: (2,294/2,292) x 100 = 100 2020Q1: (2,359/2,292) x 100 = 102,92
2019Q2: (2,421/2,292) x 100 = 105,63 2020Q2: ( 1,116/2,292) x 100 = 50,65
2019Q3: (2,443/2,292) x 100 = 106,59 2020Q3: (1,281/2,292) x 100 = 55,89
2019Q4: (2,389/2,292) x 100 = 104,23 2020Q4: (1,640/2,292) x 100 = 71,55
The results show for 2019, the year before COVID, a constant growth relative to the base
year. Which indicates the expenses are variable. But from the moment COVID pandemic
started you see a significant decrease. In 2020Q2, the CPI index dropped from 2,92% to
0,507% which means that the costs decreased by more than 50%. This indicates that variable
leases can be very variable in a time of a pandemic. The advantage is that since revenues are
low, the costs are low as well. But there are a few big disadvantages; due to the reported lease
on the balance sheet, the company has a lot of debt on her balance sheet. This was no problem
before COVID, when the costs were stable/variable. But now when the lease expenses have
decreased, the company will have to compensate these costs later to make sure they pay 75%
of the lease amount within the lease term. And because COVID caused an emotionally driven
decrease in revenues, this cannot be solely solved with fare-price reductions. An disadvantage
of high debt is it can influence the debt-to-equity ratio. The higher this ratio, the more less
interested are investors. Our conclusion is that in times of stability, we would recommend
standard setters to require firms to capitalize variable leases, but they must warn companies
that it can be risky in times of a pandemic or other factors who create an unstable economy.
5. Explain the primary difference between IFRS and US GAAP in the treatment of
leases that were previously classified as off‐balance sheet operating leases.
To understand the main differences between IFRS and USGAAP in their treatment of leases,
you have to know that IFRS 16 and ASC 842 (US GAAP) use different methods in
classifying operating leases. A big difference between the two is that for lessees, IFRS uses a
single-on-balance sheet lease accounting model, operating leases and finance leases are
treated the same. US GAAP uses a dual classification lease model, this means that there is a
separation of leases, finance leases and/or operating leases. Previously, before the
introduction of the new lease standards (ASU 2016-02) only finance leases were reported on
the balance sheet and operating leases were only reported on the income statement as a
period expense. Furthermore, before ASU 2016-02) variable leases were not included on the
balance sheet, now they are recognized on the balance sheet, but only if they are measurable
with an index or rate. Otherwise they are not recognized on the balance sheet.
This brings us to the primary difference between the leases (finance + operating) under
IFRS and the operating leases under US GAAP. Operating leases under US GAAP are now
recognized on the balance sheet (if criteria are met) as a liability and are amortized with the
straight-line expense method over the length of lease term, while under operating leases under
IFRS are depreciated with interest expense.
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