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Journal of Transportation Management

Volume 28 | Issue 1 Article 4

7-1-2018

The impact of lease accounting standards onairlines with operating leases: Implications forbenchmarking and financial analysisPaul CasterFairfield University, pcaster@fairfield.edu

Carl A. ScheragaFairfield University, cscheraga@fairfield.edu

Michael J. OlynickDeloitte, Michael.Olynick@student.fairfield.edu

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Recommended CitationCaster, Paul, Scheraga, Carl A., and Olynick, Michael J. (2018). The impact of lease accounting standards on airlines with operatingleases: Implications for benchmarking and financial analysis. Journal of Transportation Management, 28(1), 15-23. doi: 10.22237/jotm/1530403380

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THE IMPACT OF LEASE ACCOUNTING STANDARDS ON AIRLINES WITH OPERATINGLEASES: IMPLICATIONS FOR BENCHMARKING AND FINANCIAL ANALYSIS

Paul CasterCarl A. Scheraga

Fairfield University

Michael J. OlynickDeloitte

ABSTRACT

In 2016, the Financial Accounting Standards Board (FASB) has issued a new standard for leaseaccounting. The standard requires capitalization by lessees of most leases currently treated as rentals, i.e.,those currently classified as operating leases under the existing standard for lease accounting. We examinethe impact on airlines that currently make use of operating leases. Several key financial ratios are examinedbefore capitalization and then after capitalization on a pro forma basis. The results indicate that workingcapital, leverage, and solvency change dramatically in a negative direction, and airline rankings based onthose ratios also change, which has implications for benchmarking performance.

INTRODUCTION

Benchmarking is a widely used management tool. Itcan be performed in any type of organization, aslong as data are available for peer organizations. Itmay involve financial and also nonfinancialmeasures. For example, a public company maywant to compare its efficiency in the use of assets toother, similar companies. It may calculate the assetturnover ratio using readily available financial datafor a peer group of companies. It would then rankthe companies to see where it ranks relative to thepeer group.

Using published financial statement data forbenchmarking may be problematic, particularlywhere generally accepted accounting principles havefallen behind economic reality. Just how far behind issubject to speculation, but Standard & Poor’s, thelarge credit-rating agency, makes adjustments foralmost twenty financial statement items, includingaccrued interest, capitalized interest, postretirementemployee benefits, and operating leases, to name afew (Standard & Poor’s, 2013). One adjustmentthat has received a great deal of attention is theadjustment for operating leases.

Accounting for leases has been a vexing problem forstandard setters for almost three quarters of acentury. According to Myers (1962, 1-2), in 1949,the Committee on Accounting Procedure issuedAccounting Research Bulletin (ARB) No. 38 inresponse to the increased use of leasing as a meansof financing the purchase of assets with little to nodisclosure of the existence of such leases. ARB No.38 took a principles-based approach to leaseaccounting, calling for capitalization of futurepayments under a lease that in essence finances thepurchase of an asset, with an entry on the balancesheet for the leased asset and corresponding leasepayments liability.

In the years following the issuance of ARB No. 38,the use of leasing continued to grow, capitalizationto the balance sheet was nearly non-existent, anddisclosure was less than that called for by ARB No.38. Given this, financial analysts wanted moredisclosure (Myers, 1962, 2-3). These same issuespersisted to some degree for the next six decades,despite repeated efforts by accounting standardsetters to change the behavior of lessees andlessors. It is noteworthy that four of the AccountingPrinciples Board’s (APB) 31 official opinionsinvolved lease accounting. The Financial AccountingStandards Board (FASB) issued Statement Number

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13 on lease accounting in November 1976.Following that, the FASB issued a significantnumber of additional statements to amend leaseaccounting, as well as a number of officialinterpretations and technical bulletins involving theaccounting for and reporting of leases.

At least two major problems cause concern forregulators. One is the persistence of the use ofoperating leases by lessees to achieve off-balancesheet financing for the acquisition of long-termassets. The second is the lack of symmetry that mayresult in a “missing asset” problem. Imagine that anairline is leasing a fleet of aircraft from amanufacturer and desires off-balance sheetfinancing. Using the FASB Statement Number 13rules-based approach, the airline is able to write alease contract in such a way that it qualifies as anoperating lease. Thus, the fleet of aircraft (and therelated liability) is not recorded on the books of theairline. However, the aircraft manufacturer has nodesire to keep the aircraft on its books once itdelivers the fleet. Thus, the lessor finds a way torecord the same lease as a sales-type lease. Theability for each of the parties to take its preferredaccounting is at the heart of this problem.

One method of classifying the same lease as anoperating lease by the lessee and yet as a sales-typelease by the lessor is for the lessor to hire a thirdparty to guarantee the residual value of the leasedasset. One criterion for treating a lease as a capital-type lease is if the present value of the minimumlease payments is 90% or more of the fair value ofthe asset. In the airline example, since the lessee isnot guaranteeing the residual value, it excludes theresidual value from its present value calculation,thereby falling below the 90% threshold. In contrast,the aircraft manufacturer includes the residual valuein its present value calculation, thereby exceedingthe 90% threshold. It then records the lease as asales-type lease and removes the leased aircraftfrom its inventory. The airline simply records rentexpense as lease payments are made. In thismanner, the entire fleet of aircraft simply“disappears.” That is, the fleet is not recorded oneither company’s books. These “phantom assets”

become a problem for those evaluating eithercompany’s financial statements.

After a long history of unsuccessful attempts atregulating the accounting for leases to avoid theabove mentioned problems, the FASB and theInternational Accounting Standards Board (IASB)embarked on a joint project to develop new ruleson leasing. And in 2016, each board issued newstandards. The new standards are similar, and thedifferences between them are not relevant to thecurrent research. The main feature of the new rulesis that capitalization will be required for virtually allleases, which should, in theory, put an end to off-balance sheet financing. According to an article inThe Wall Street Journal (2012), the new leaseaccounting rules may result in as much as two trilliondollars of additional debt added to corporatebalance sheets. For public companies following theFASB’s rules, the new lease accounting standardgoes into effect for fiscal years beginning afterDecember 15, 2018.

We investigate the impact of capitalization bylessees in the U.S. airline industry, building upon thepioneering work of Gritta (1974a, 1974b). Airlinesmake heavy use of leases, both for aircraft and alsofor ground operations. Gritta (1974a) first examinedhow capitalization of operating leases would impactcertain measures of leverage in the U.S. domesticairline industry. He updated the original study twentyyears later to see if the use of leases had changed(Gritta, Lippman, and Chow, 1994). The currentresearch expands upon this line of research by usinga more refined method to capitalize operatingleases, and tailoring it to each individual airline’sfinancial structure. We use a capitalization methodsimilar to that used by Standard & Poor’s RatingsServices, as discussed in Berman and LaSalle(2007). We also examine the impact on measures ofliquidity and profitability in addition to leverage.

LITERATURE REVIEW

Thousands of journal articles have been written onthe topic of lease accounting. We limit our literaturereview primarily to articles that examine the impactof capitalizing operating leases by lessees in the U.S.airline industry.

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Gritta (1974a) laid the foundation for much of theresearch in this area. He examined the impact ofcapitalization on ten U.S. airlines and calculatedbefore and after figures for two commonly usedratios to measure financial leverage. As one wouldexpect, Gritta found that those airlines alreadymaking the greatest use of leverage were the onesmost impacted by capitalizing their leases. In asecond paper published the same year, Gritta(1974b) focused on the four largest U.S. airlinesand included leases of ground equipment in additionto aircraft. He found significant changes in twomeasures of financial leverage when leases werecapitalized, and he speculated that the impact wouldbe greater when making intra-firm comparisonswithin the airline industry, since several othercompanies at that time did not make great use ofleasing.

Gritta, Lippman and Chow (1994) report that theuse of leases by airlines grew significantly in thetwenty years since Gritta’s original research (1974a,1974b). In addition, accounting for leases hadchanged since the prior studies, with the issue ofStatement of Financial Accounting StandardsNumber 13: Accounting for Leases (FASB, 1976),necessitating a fresh look at this persistent problem.Using airline data from 1991 financial statements,they found results similar to the earlier studies, butthe impact on leverage was even more pronounced.They conclude that despite the FASB’s leaseaccounting rules, “air carriers can structure leases toavoid capitalization of lease payments (1994, 199).

Gritta and Lippman (2010) examined the extent towhich airlines changed their use of operating leasessince the original two studies in 1994 and 1974.They reported that “Alaska, Continental, and USAirstructure all of their leases as operating leases”(2010), an increase from the prior studies. Theycapitalized the operating leases using the samemethodology as in the prior studies, with a 10%discount rate for all airlines in the sample. Theyreport the impact on two leverage ratios. Also, forthe first time, they rank the airlines based on eachleverage ratio and show before and after ranks.Although no test of significance was reported, theyconcluded that the relative riskiness, as measured by

the rankings of the debt ratio, remained unchangedby capitalizing the operating leases.

Scheraga and Caster (2014) examined the impactof ignoring capital leases in the airline industry whenbenchmarking the strategic management of financialleverage. They found that capitalizing operatingleases led to statistically significant declines inmeasures of operating efficiency, using dataenvelopment analysis. They conclude that “notcapitalizing operating leases to the balance sheetcreates significant distortions in the perceptions andassessment of the abilities of managers to utilizefinancial leverage to make investments that enhancefirm profitability” (2014).

Furthermore, Scheraga and Caster demonstratedwhat Gritta (1974a) had observed earlier. Grittasaid “the effect of capitalization on these ratios issignificant, especially in an intra-industrycomparison.” It is interesting because some havesuggested that capitalizing the operating leases mayhave no effect. For example, Boatsman and Dongconclude that “lease accounting is often not a matterof consequence in the context of estimating equityvalue” (2011, 1). However, they do indicate that itmay have indirect effects, such as managementcompensation effects and the effects on lenderbehavior.

Lipe (2001) reviewed the lease accounting literatureand organized results around three decisioncontexts. In terms of financial statement analysis ofequity risk, he reported that most of the studiesfound that capitalization of operating leases resultedin better measures of shareholder risk. At the sametime, the impact on equity value showedinconclusive results. However, sophisticatedinvestors already adjust for operating leases, thusthe impact on equity values may be minimal. Lipe’sthird category was management decision-making.He reported evidence that management makes useof the FASB Statement Number 13 rules toconstruct lease contracts that circumventcapitalization of leases when that is their intent.

Grossman and Grossman (2010) examined theimpact of capitalization on 91 of 200 companies in

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the Fortune 500. They were among the few thatdiscussed and examined the impact on the currentratio. Not surprisingly, they found that currentliabilities increased, in some cases more than 10%,with one company experiencing an almost 50%increase in current liabilities. They reported that thecurrent ratio declined by significant amounts in somecases. In addition, they calculated the impact on thedebt ratio and reported the impact for 8 companiesin their sample. One implication they drew from theirresults is that capitalization of operating leases maycause many companies to be in violation ofrestrictive covenants in debt agreements.

From Lipe’s (2001) review and categorization ofthe lease accounting literature, and from the airlinestudies conducted to date, the empirical resultsdemonstrate that if the concern is with equityvaluation, capitalizing the operating leases may notmake a difference. But for most other types ofdecisions, including lending, credit ratings, andbenchmarking, capitalization of operating leasesresults in significant changes in the relative financialposition of various airlines.

METHODOLOGY AND DATA SET

Berman and Lasalle (2007) review the methodsused by three credit rating agencies to capitalizeoperating leases. They reported that Standard &Poor’s uses lease footnote information to calculatethe present value of minimum lease commitments.They use an interest rate that reflects the actualborrowing costs as the discount rate for the presentvalue calculation. Moody’s simply multipliesreported rent expense by a factor of 5, 6, or 8,depending on the industry segment involved. Forairlines, the factor is 8. They believe the resultapproximates the present value of the futureminimum lease payments. Fitch uses both methods.If data permits, they calculate the present value,otherwise, they multiply rent expense by a factor of8 to approximate the capitalized amount.

The factor method seems too simplistic and ad hoc.Instead, we followed the capitalization method usedby Standard & Poor’s (2013). Damodaran (2016)provides an Excel template for converting operating

leases to capital leases. His methodology is verysimilar to that used by Standard & Poor’s.However, determining the appropriate discount rateto use for the present value calculations isproblematic. With more airlines making greater useof variable interest rate debt agreements, mostairlines no longer disclose in financial statementfootnotes a weighted average interest rate on theiroutstanding debt. Some disclose separate rates forfixed-rate debt and variable-rate debt, while othersdo not disclose any weighted average rate. Wefollowed a suggestion in Imhoff, Lipe, and Wright(1997) to calculate an implied interest rate bydividing interest expense by outstanding long-termdebt. We then compared the resulting interest rateto individual rates disclosed in the long-term debtfootnote to ensure that the rate used forcapitalization was reasonable, that is, within therange bounded by the lowest to highest interest rateon any given debt agreement.

The data set used in the study reported on here wasdrawn from the Department of Transportation’sResearch and Innovative Technology Administration(RITA) Bureau of Transportation Statistics, FormB-43, inventory of aircraft. The inventory was forcalendar year 2015. Each airplane is identified byRITA as being owned, leased as a capitalized lease,or leased as an operating lease. We deleted allairlines that had no operating leases and confinedour sample to U.S. passenger airlines. Also, eachairline had to be publicly traded with a Form 10-Kannual report available for 2015. Finally, we deletedone airline that was in Chapter 11 bankruptcyproceedings. The result was a sample of 10 airlines,including some of the largest U.S. airlines, i.e.American, Delta, and United.

RESULTS

We chose one measure of short-term liquidity; thecurrent ratio, two measures of long-term solvency;the debt ratio and times interest earned, and twomeasures of profitability/efficiency; return on assetsand asset turnover, for the purpose of benchmarkingfinancial performance within the sample of airlines.

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Table 1 provides the formulas used to calculatethese ratios.

Table 2 shows each airline, its ratio, and its rankingwithin the group both before and after capitalizationof operating leases.

Some airlines saw dramatic changes in ratios. Forexample, Spirit Airlines had a current ratio of 2.20:1before capitalization. It fell to 1.48:1, a decline ofabout one third. In contrast, Southwest and Deltahad very low current ratios before capitalization,and their ratios declined by only eight percent aftercapitalization. The most dramatic change occurredin the asset turnover calculations, where VirginAmerica fell from first in the rankings, with aturnover of 0.98 times, to last, with a turnover of0.48 times, a decline of about 50 percent. VirginAmerica also dropped from first place to sixth placein the debt ratio after capitalization of its operatingleases.

Table 3 shows the results of the non-parametric t-test for differences in means before and afteradjustment for operating leases. The current ratiofell significantly (t = 2.81, p = .01), which is notsurprising given that capitalization of operatingleases only adds amounts to the current liabilities(due to the current portion of long-term debt) withno addition to current assets. Because the currentratio has to fall in value after capitalization, we usedthe one-tailed test. Similarly, asset turnover declinedsignificantly (t = 4.87, p < .01). The numerator isunchanged by capitalization, but the denominatorincreases when the right-to-use asset is recognizedand added to total assets. The change in return onassets was not statistically significant (t = 2.20, p =.06). We used the two-tailed test because both the

numerator and denominator change withcapitalization of operating leases, so we could notpredict the direction of the change in the ratio.Finally, both measures of solvency changedsignificantly. The change in “times interest earned”has a t value of 3.59 (p < .01) and the change in thedebt ratio has a t value of 3.25 (p < .01).

Since airlines often benchmark their performanceagainst other airlines, we also ranked the airlines oneach ratio. We performed the Friedman (1937) testfor a significant change in ranks before and aftercapitalization of operating leases. The Friedman testwas developed by economist Milton Friedman as away of examining ranked data to determine if asignificant change in ranks occurs. Table 4 showsthe results of the Friedman tests. Ranks changedsignificantly for all of the ratios except return onassets.1

SUMMARY AND CONCLUSIONS

This research demonstrates that companies makinguse of operating leases, that is, off-balance sheetfinancing, will be heavily impacted by new leaseaccounting standards requiring capitalization of mostoperating leases. This treatment will be required forfiscal years beginning after December 15, 2018. Byexamining five widely used financial ratios thatcapture measures of liquidity, long-term solvency,and profitability, we found that statistically significantchanges occurred in the means for all but one ratio,and in the rankings within the group, again for all butone ratio.

One limiting aspect of this research is that all of thecompanies examined came from one industry, U.S.airlines. It is an industry where some participants

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Vol. 28 No. 1 21

make heavy use of operating leases. We have noreason to believe the results would not generalize toother industries where the use of operating leases isprevalent.

Since companies and financial analysts make use ofbenchmarking and other comparisons within anindustry, the results demonstrate that it is necessaryto make adjustments for operating leases before anymeaningful comparisons can be made. As suggestedby Gritta (1974b), the results would be even moredramatic if comparisons were made to all of thecompanies in an industry, including those that do notmake use of operating leases. Finally, it is interestingto note that long before the FASB proposed newlease accounting standards requiring capitalization ofoperating leases, credit rating agencies such asStandard & Poor’s, Moody’s, and Fitch made suchadjustments. However, this is not an ideal way ofaddressing the issue, and full capitalization of leaseswill provide for more transparency in actualreported data.

ENDNOTES1. We also calculated the Wilcoxon signed-ranks test because we only had two panels of data for each

ratio, before and after capitalization of operating leases. The same four ratios showed statisticallysignificant differences in ranks after capitalization of operating leases, similar to the Friedman test.

REFERENCES

Berman, M., and LaSalle, J. L. (2007),“Capitalization of Operating Leases by CreditRating Agencies,” Equipment Leasing & FinanceMagazine (formerly ELT) (February): 12-18.

Boatsman, J. and Dong, X. (2011), “Equity ValueImplications of Lease Accounting,” AccountingHorizons 25 (1): 1 – 16.

Damodaran, A. (2016), “Damodaran OnlineSpreadsheets,” Pages.Stern.NYU.edu/~adamodaran/New_Home_Page/spreadsh.htmAccessed August 2016.

FASB. (1976), “Statement of Financial AccountingStandards No. 13: Accounting for Leases,”Financial Accounting Standards Board(November).

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Friedman, M. (1937), “The Use of Ranks To Avoidthe Assumption of Normality Implicit in the Analysisof Variance,” Journal of the American StatisticalAssociation 32 (December): 675 - 701.

Gritta, R. D. (1974a), “The Impact of theCapitalization of Leases on Financial Analysis: aCase Study in Air Transport,” Financial AnalystsJournal (March-April): 47 - 52.

Gritta, R. D. (1974b), “Capitalizing Net LeaseRentals: a Comment,” Management Accounting56 (5) (November): 37 - 39.

Gritta, R. D. and Lippman, E. (2010), “AircraftLeasing,” Journal of the Transportation ResearchForum 49 (3) (Fall): 101 - 110.

Gritta, R. D., Lippman, E., and Chow, G. (1994),“The Impact of the Capitalization of Leases onAirline Financial Analysis: an Issue Revisited,”Logistics and Transportation Review 30 (2)(June): 189 - 202.

Grossman, A. M., and Grossman, S. D. (2010),“Capitalizing Lease Payments,” The CPA Journal80 (5) (May): 6, 8 - 11.

Imhoff, E. A., Jr., Lipe, R. C., and Wright, D. W.(1997), “Operating Leases: Income Effects ofConstructive Capitalization,” Accounting Horizons11 (2) (June): 12 - 32.

Lipe, R. C. (2001), “Lease Accounting Researchand the G4+1 Proposal,” Accounting Horizons 15(3) (September): 299 - 310.

Myers, J. H. (1962), “Reporting of Leases inFinancial Statements,” Accounting Research StudyNo. 4 American Institute of Certified PublicAccountants: 1 – 143.

Scheraga, C. A., and Caster, P. (2014), “Distortionsin the Measurement of the Efficiency of FinancialLeverage Strategies in the Airline Industry WhenOperating Leases Are Ignored,” Journal ofTransportation Management 25 (1) (Spring/Summer): 21 - 36.

Standard & Poor’s. (2013), “CorporateMethodology: Ratios and Adjustments,” Standard& Poor’s Global Ratings. November 19, 2013.

The Wall Street Journal. (2012), “Leases SufferIdentity Crisis,” The Wall Street Journal. SectionB, CFO Journal. Tuesday, May 22, 2012: B7.

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BIOGRAPHIES

Paul Caster is Professor of Accounting in the Dolan School of Business at Fairfield University. His primaryresearch interests include audit evidence and audit decision-making, the financial impact of accountingprinciples, and analysis of business strategy using strategic variance analysis. Caster has published articles inAuditing: A Journal of Practice and Theory, Issues in Accounting Education, Journal of AccountingLiterature, Journal of Forensic Accounting, Journal of Transportation Management, Journal of theTransportation Research Forum, Research in Accounting Regulation, The Quarterly Review ofEconomics and Business, The Journal of Accountancy, The CPA Journal, The EDP Auditor Journal,and the Financial Analysts Journal. Caster received his Ph.D., in accounting, from the University of NorthTexas, an MBA degree from the University of Chicago, and a B.S., in business and economics, from LehighUniversity. E-Mail: pcaster@fairfield.edu

Carl A. Scheraga is Professor of Business Strategy and Technology Management. His fields of researchand teaching include transportation and international logistics, global strategic management, cross-culturalmanagement, and the management of technology and innovation. Scheraga has published numerous articlesin Transportation Research Series A, Transportation Research E, Journal of TransportationManagement, Transportation Journal, Journal of the Transportation Research Forum, Journal ofPublic Policy and Marketing, Technology in Society: An International Journal, Journal of Bankingand Finance, Global Business and Finance Review, Journal of Investing, Management InternationalReview, International Journal of Advertising, International Review of Economics and Finance, andBusiness Education Innovation Journal. He also has published chapters in such volumes as JapaneseDirect Investment in the United States: Trends, Developments and Issues, International FinancialMarket Integration, and Neuroeconomics and the Firm. As a co-author, he has received theTransportation Research Forum Outstanding Research Paper Award in 1998 and the Aviation ResearchPaper Award in 1999. Scheraga received his Ph.D. in Economics from the University of Connecticut, anM.A. in Economics, and a Sc.B. in Mathematics from Brown University. E-Mail: cscheraga@fairfield.edu

Michael J. Olynick is a tax consultant with Deloitte. He received his MS degree, in accounting, and hisBS degree, in Business Administration, from Fairfield University. E-Mail:Michael.Olynick@student.fairfield.edu