The chairman of a leading private airline highlighted in a recent news report a key development in the running of the airline industry — entry into sale and leaseback arrangements, and booking higher profits. The national carrier, which until now owned most of its fleet, plans to enter into sale and leaseback of its aircraft to address a temporary liquidity crisis. The move could be related to financing or alternative accounting treatment available under existing accounting standards.

Financing rational

Sale and leaseback is a financing arrangement through which an airline sells an aircraft and leases it back. It is generally used by airlines that have a leveraged balance sheet or when no further sources of funding are available to bring in new capacities. Sale price under a sale and leaseback arrangement is interdependent on future lease payments — that is, higher the sale price agreed at the start, higher the future lease payment.

Proper negotiations may allow the airline to sell the aircraft above the existing book value or price paid.

How does it work?

Generally, an airline negotiates a discount (10-40 per cent over the listed price) from aircraft manufacturers against large order-booking. Funding through a normal bank financing arrangement might be limited to 80-90 per cent of the actual cost. However, under a sale and leaseback arrangement the sale can happen at the market value (list price) of the aircraft, thus allowing higher funding. For example, if the airline gets a 25 per cent discount on the aircraft’s list price of $100 million (actual purchase price is $75 million) and the bank allows 80 per cent financing facility, then nearly $80 million can be financed under a sale and leaseback transaction for a new aircraft against just $60 million under normal bank financing. The example is only representative and need not apply in all cases.

Accounting implications

If the airline goes for normal funding, there are two types of cost — interest cost and depreciation of assets. The accounting under sale and leaseback would depend on whether it is a finance lease or an operating lease.

Under a finance lease, the airline would typically retain all the risks and rewards of the aircraft by using it for the entire life of the aircraft. In which case, the gain and loss on the sale of the aircraft would be amortised over the lease term in proportion to the depreciation. Further, they would be recapitalised in the books at the future minimum lease payment.

Under an operating lease, the loan liability is off the books permanently. The gain/ loss of aircraft sale is recorded upfront in the airline’s books, unless it resulted in reduction of lease rent that would otherwise have to be paid in an arm’s-length transaction. As in the above example the arm’s-length price for a new aircraft can be argued to be $100 million, thereby allowing airlines to book artificial profits ($25 million) on day one.

Global standards

With FDI in airlines, the time is not far when domestic players would need to align Indian accounting requirements with those of IFRS and US GAAP. Current requirements are more or less similar between them.

However, as part of the convergence project between IFRS and US GAAP, the IASB (the accounting body that publishes IFRS) issued new draft leasing standard in 2010.

The key consideration for airlines under the revised draft is the accounting for operating leases. The existing proposals suggest that entities should recognise an asset and liability at the start of the lease, irrespective of whether it is finance or operating. As the proposals are still under consideration, there is some grey area over how the sales and leaseback transaction accounting would be impacted once the classification of operating lease and finance lease is abolished.

But it is certain that the change would have greater impact on the balance sheet as well as profitability.

As there are choices for structuring, it is important that investors distinguish between real gains and accounting gains. Also, as the accounting standards are evolving, airlines planning to go global should evaluate the implication of the new proposals.

Shrenik Baid is Executive Director, PwC India

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