Actual Losses and Paper Losses
18 November 2019
18 November 2019
PAL Holdings disclosed Thursday through regulatory filing that Philippine Airlines (PAL) losses widen at the end of the third quarter to to ₱8.5 billion from last year’s ₱3.92 billion, as interest expenses and financing charges increased.
PAL said losses came after adopting new accounting rules effective January 1, 2019 on leased planes previously not reflected on the balance sheet.
The new accounting rules is "The Philippine Financial Reporting Standard (PFRS)" 16, which requires lessees to recognize all leases, whether operating lease or a finance lease, on their balance sheet except for relatively small-value assets and leases with terms of 12 months or less.
The lessee is required to recognize a right-to-use asset and a lease liability, measured at the discounted value of the future lease payments in the balance sheet. A depreciation expense of the right-to-use asset and the interest charged on the outstanding lease liability are then recognized in the Income Statement. Any lease payment is treated as a reduction from the lease liability.
Unlike Cebu Pacific which leases all their planes under operating leases, Philippine Airlines has both finance leases and operating leases.
According to BIR in its new Revenue Regulations (RR) No. 19-86, Finance lease or full payout lease as “a contract involving payment over an obligatory period (also called primary or basic period) of specified rental amounts for the use of a lessor’s property, sufficient in total to amortize the capital outlay of the lessor and to provide for the lessor’s borrowing costs and profits.”
Operating lease on the other hand is “a contract under which the asset is not wholly amortized during the primary period of the lease, and where the lessor does not rely solely on the rentals during the primary period for his profits, but looks for the recovery of the balance of his costs and for the rest of his profits from the sale or re-lease of the returned asset of the [sic] primary lease period.”
To put it very simple, finance lease is like buying a new car on bank mortgage and operating lease is renting a car for a certain period of time.
To identify the characteristics that distinguished a capital lease from an operating lease, are the following four criteria under the generally accepted accounting principles (GAAP):
1. A lease that transfers ownership of the leased asset to the lessee at the end of the lease term
2. A lease containing an option allowing the lessee to purchase the leased asset at a bargain price at the end of lease term
3. A lease term greater than or equal to 75% of the asset’s economic life
4. A lease where the present value of the minimum lease payments (including any required lessee guarantee of residual value of the leased asset to the lessor at the end of the lease term) was greater than or equal to 90% of the fair value of the leased asset at the inception of the lease.
If any single criterion was met, a lease was deemed to be a capital lease for the lessee, requiring the leased asset and the related lease liability to be listed on the balance sheet. For the lessor, it was deemed either a sales-type lease or a direct financing lease, to be reflected on the balance sheet as a lease receivable. Leases not meeting any of the four criteria were considered operating leases for both lessees and lessors.
With PAL, most of their brand new fleet comprises operating leases. Meaning, the owners of the aircraft are aircraft lessors such as GE Capital Aviation Services (GECAS), a financial institutions whose rules are subject to regulations that allowed them to keep leased assets on their books only briefly, not long-term. They favored treatment as sales-type or direct financing leases.
This is the same reason GECAS created subsidiary PK AirFinance and Tamweel Aviation Finance to deal with lease payments roughly equivalent to 12 years typical for wide body planes or 75% of the assets economic life.
It doesn't mean operating lease payments wasn't paid before. Its just that its not reported in the balance sheet, for a reason. Operating leases are counted as off-balance sheet financing to keep the ratio of debt to equity low.
Historically, operating leases have enabled American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets which resulted to corporate fraud starting from ENRON accounting scandal 18 years ago prompting the United States to adopt the Sarbanes-Oxley (SOX) Act to protect investors from corporate fraud.
With the new financial system, it will provide investors with greater transparency and higher quality financial reports.And that also makes PAL non-operating expense huge.
For income tax purposes, as has been the longstanding tax treatment, only the periodic lease payments are treated as deductible expenses given that the substance of the transaction does not change but only the accounting disclosure, which in effect translate to mere paper losses and not actual losses of the airline.
As the famous Enron accountant and Finance Chief Andrew Fastow remarks,"Accounting isn't straightforward - 10% is black and white and 90% is in the grey area.
So, was there money losses or just paper losses? Lets check the financial report submitted to PSE.
The new accounting rules is "The Philippine Financial Reporting Standard (PFRS)" 16, which requires lessees to recognize all leases, whether operating lease or a finance lease, on their balance sheet except for relatively small-value assets and leases with terms of 12 months or less.
The lessee is required to recognize a right-to-use asset and a lease liability, measured at the discounted value of the future lease payments in the balance sheet. A depreciation expense of the right-to-use asset and the interest charged on the outstanding lease liability are then recognized in the Income Statement. Any lease payment is treated as a reduction from the lease liability.
Unlike Cebu Pacific which leases all their planes under operating leases, Philippine Airlines has both finance leases and operating leases.
According to BIR in its new Revenue Regulations (RR) No. 19-86, Finance lease or full payout lease as “a contract involving payment over an obligatory period (also called primary or basic period) of specified rental amounts for the use of a lessor’s property, sufficient in total to amortize the capital outlay of the lessor and to provide for the lessor’s borrowing costs and profits.”
Operating lease on the other hand is “a contract under which the asset is not wholly amortized during the primary period of the lease, and where the lessor does not rely solely on the rentals during the primary period for his profits, but looks for the recovery of the balance of his costs and for the rest of his profits from the sale or re-lease of the returned asset of the [sic] primary lease period.”
To put it very simple, finance lease is like buying a new car on bank mortgage and operating lease is renting a car for a certain period of time.
To identify the characteristics that distinguished a capital lease from an operating lease, are the following four criteria under the generally accepted accounting principles (GAAP):
1. A lease that transfers ownership of the leased asset to the lessee at the end of the lease term
2. A lease containing an option allowing the lessee to purchase the leased asset at a bargain price at the end of lease term
3. A lease term greater than or equal to 75% of the asset’s economic life
4. A lease where the present value of the minimum lease payments (including any required lessee guarantee of residual value of the leased asset to the lessor at the end of the lease term) was greater than or equal to 90% of the fair value of the leased asset at the inception of the lease.
If any single criterion was met, a lease was deemed to be a capital lease for the lessee, requiring the leased asset and the related lease liability to be listed on the balance sheet. For the lessor, it was deemed either a sales-type lease or a direct financing lease, to be reflected on the balance sheet as a lease receivable. Leases not meeting any of the four criteria were considered operating leases for both lessees and lessors.
With PAL, most of their brand new fleet comprises operating leases. Meaning, the owners of the aircraft are aircraft lessors such as GE Capital Aviation Services (GECAS), a financial institutions whose rules are subject to regulations that allowed them to keep leased assets on their books only briefly, not long-term. They favored treatment as sales-type or direct financing leases.
This is the same reason GECAS created subsidiary PK AirFinance and Tamweel Aviation Finance to deal with lease payments roughly equivalent to 12 years typical for wide body planes or 75% of the assets economic life.
It doesn't mean operating lease payments wasn't paid before. Its just that its not reported in the balance sheet, for a reason. Operating leases are counted as off-balance sheet financing to keep the ratio of debt to equity low.
Historically, operating leases have enabled American firms to keep billions of dollars of assets and liabilities from being recorded on their balance sheets which resulted to corporate fraud starting from ENRON accounting scandal 18 years ago prompting the United States to adopt the Sarbanes-Oxley (SOX) Act to protect investors from corporate fraud.
With the new financial system, it will provide investors with greater transparency and higher quality financial reports.And that also makes PAL non-operating expense huge.
For income tax purposes, as has been the longstanding tax treatment, only the periodic lease payments are treated as deductible expenses given that the substance of the transaction does not change but only the accounting disclosure, which in effect translate to mere paper losses and not actual losses of the airline.
As the famous Enron accountant and Finance Chief Andrew Fastow remarks,"Accounting isn't straightforward - 10% is black and white and 90% is in the grey area.
So, was there money losses or just paper losses? Lets check the financial report submitted to PSE.
This is not "Fair Use" and is most likely copyright infringement unless you have permission from Business World and the author.
ReplyDeletehttps://www.bworldonline.com/pal-operators-losses-widen/
Apologies for the comment above. I was mistaken.
ReplyDeleteSorry for grammatical error.
ReplyDeleteIf PAL wanted to earn a profit, push turnaround plan now for FY2020. Gilbert Santa Maria has been planning for this a month ago.
The disclosure states they are operating at a profit of 700 million. Of course that is offset by 9.8 billion representing the value of all aircraft on operating leases that is required to be reported. Because under the new accounting system operating leases required a lump-sum lease payment or rental expense on the books even though no lump sum payment has been made.
ReplyDeleteMeaning, if you rent a single A320 say for 5 years for $50 million then you must put the total value of the lease for 5 year instead of the yearly amortization payment. FASB’s ASU 2016-02 calls it present value of future lease payments. The new standard requires just one lease/rental expense reported. However, because assets are now recognized, impairments will also be recognized on the income statement, outside of this single lease cost. In other words, at the end of 5 years the value will be zero.
That's why non-operating income/expense is not recurring and is therefore excluded or considered separately when evaluating performance over a period of time. And that is the reason ANA is not alarmed at all.
Like to see cash flow for the quarter. Let see the cash coming in and going out for the quarter and the year.
ReplyDelete