Untangling New Lease Accounting Rules; To get around this complexity and burden, companies might try to stop doing leases and start structuring them as service contracts

http://blogs.wsj.com/cfo/2015/03/13/avolon-cfo-untangling-new-lease-accounting-rules/

March 13, 2015, 2:44 AM ET

Avolon CFO: Untangling New Lease Accounting Rules

NOELLE KNOX

Editor, CFO Journal

Avolon Holdings Ltd.AVOL +0.42%, a global aircraft-leasing company based in Ireland, went public in December on the New York Stock Exchange and had its first quarterly conference call last week. U.S. accounting regulators are debating sweeping changes for long-term capital leases, and CFO Journal Editor Noelle Knox spoke at length about the ramifications with Avolon Chief Financial Officer Andy Cronin. Here is an edited excerpt:

The Financial Accounting Standards Board is evaluating how to change standards for lease accounting. Will the variations between U.S. and international standards be a challenge to manage?

AC: That’s the issue — U.S. [General Accepted Accounting Principles] and [International Financial Reporting Standards] are diverging rather than converging (on leases). That is an issue or cause for concern. We look at lessees around the world and airlines around, there are wildly different conventions. It makes it more difficult, and it makes it harder to get a like-to-like comparison. As well as that, it introduces a lot of complexity onto the airlines’ accounting teams, and some quite subjective assessments.

On one hand it does add complexity, on the other hand in terms of commercial substance I think analysts and we are doing our own assessments of airlines’ balance sheets, we already add up the off-balance sheet leasing liabilities. So on commercial substance I think that is already happening. So when you look at the credit analysts in the airline space they’re already doing the analysis of what are the lease obligations and what’s the adjusted debt position. So I think the commercial impact of all this is going to be minimal because people are going to look through the account change to the commercial substance. The question is: will they actually be able to? And the level of complexity going onto the balance sheet and will they be able to pick it back to the starting place

If your clients have to bring a multi-year lease onto their books as debt, they will have to have an equivalent value under “property, plants and equipment” on their books as an asset.

AC: Right, the use of the aircraft.

That’s rather intangible; not like there are not a lot of intangible assets on balance sheets.

AC: I completely agree. And the assumptions around that are about the discount rate and the value of the utility. Is that straight line or is that not straight line? As you bring all these measurements onto balance sheet how do you know – whether it’s a truck leasing company or whatever – how do you get to the bottom line use of what assumptions are being used by each lessee? Because they could each come up with a wildly different answer.

To get around this complexity and burden, companies might try to stop doing leases and start structuring them as service contracts.

AC: That’s currently an open question, service contracts, how do they actually get incorporated into the [FASB] standard. Certainly in our industry it’s quite difficult to work it into a service contract, in part because we go to great lengths to separate that out as a dry operating lease and we don’t want to have any operational responsibility for the asset. The airline is responsible for everything that’s in the aircraft, the airline is responsible for maintaining the aircraft. Our business model is such that we’d be very cautious to adopt any operational risk even if it is indirect. I’d imagine that’s true for most lessors but probably the lessors of big-ticket items are more conscious of that risk. There would always be a clear separation between utilization of the asset and responsibility, compared to other assets where it’s easier to have a combination of utility and service.

How are lower rates in India and China vis-à-vis the U.S. and the potential to raise rates affecting your strategy for debt raising?

AC: We’re exclusively a dollar business, all aircraft is in dollars, we borrow money in dollars. We don’t borrow in local currency.

All of those lease payments are in dollars.

AC: They are in dollars, but indirectly the credit profile of our lessees could be affected if there is a large currency swing. A lot of their currency outflows are in dollars, while a lot of their revenues are in local currency. However, the currency movement also tends to be closely correlated with the price of oil. So they are effectively not getting the benefit of lower oil, because of the currency movement they’re only getting some of that.

So how will the potentially higher U.S. interest rates impact your borrowing strategy?

AC: We’re a spread business, our average-lease term is seven years, we’re very mindful that our objective is to maximize that spread and minimize the risk to that spread. That’s what we’re paid to do. So 71% of our debt is fixed-rate, 19% of our debt is tied to leases – floating-rate leases – and we’ve balanced the remaining 11% with interest rate caps…Because when rates go up, they tend to go up very quickly, and when you’ve got variable-cost funding, you’re going to get spread compression… In general, higher rates are generally good for the leasing community in our sector because it tends to reduce spread to debt. Fixed-income investors tend to look for a coupon, so as rate goes up it’s the same coupon. Rental yields expand because they’re priced over the risk-free rate. And then secondly, what you tend to get is that interest rates are highly correlated with inflation, and inflation is great for a company that owns assets. Inflation is a very good thing for us because aircraft is a 25-year asset.

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