Should operational leases be involved in the accounting statements or should they be excluded; case study of an airline industry.
Introduction to research topic and main research question
Significant restructuring of airline industries (such as Air China and Emirates) has brought along desirable increase in acquisition of aircrafts and other assets through leasing. The challenge at hand is whether the lease ought to be treated as an operating lease, a finance lease or should be excluded in the accounting all together. Throughout the airline industry internationally, the airlines comprehensively use operating leases for engines, aircraft, fly facilities and airport facilities.
Operating leases is a form of off-balance sheet financing because traditionally the accounting standards did not require entities to report operating leases. However, reporting entities had to disclose the use of operating lease. Recently, the significant impact of operating leases on the income in terms of debt and liability has prompted the bodies of standard to adopt an approach that all leases should be dealt with equally and consistently (Beattie, Goodacre & Thomson, 2006). Just recently, 2013, the International Accounting Standard Board (IASB) and Finance Accounting Standard Board (FASB) developed some changes in the accounting standards and proposed that operational leases, particularly for the Airline industry must be included in the balance sheets developed by the lessee.
As per the draft, the airline companies would have to include all leases in the balance sheet regardless of whether the lease is a finance or an operating lease (KPMG, 2013). The rationale is that the lessee is using the lease to finance capital assets. Therefore in order for the finacila statements to reflect a true and fair view of the airline, it is important to recognize the operating leases liabilities in the airlines’ financial statements (KPMG, 2013). The proposed research aims at studying the implications of the new lease accounting standard requiring airlines to report operating leases in the financial statements. In particular, the research will focus on Emirates and Air China that have high levels of debt.
Literature review and research question
The literature review will help to understand the background nature of the research problem as well as the existing views, results and statements about to brought operational leases in the statements of accounts. Therefore, I will conduct a review of the literature to evaluate the gap between the previous literature and the research topic.
The study primary focus is to research on the question whether operating leases should be included in the balance sheet of the airline companies or not. IFRS 9 Substance over form requires an entity to report the economic substance of a transaction rather than their legal form in order for the financial statements to reflect a true and fair view of the financial position of the reporting entity (Stolowy and Lebas, 2006). The IAS 17 lease applies the concept of substance over form and requires the reporting entity to consider the substance rather than the legal form of the transaction in determining what type of lease arrangement they have entered into.
The concept of operational lease has had various definitions from various researchers and scholars. Lipe (2001) define an operating lease as the agreement between the lessee and lessor for getting assets on short terms as compared to the actual life of that asset. Dhaliwal, Lee and Neamtiu (2011) define an operating lease as a contract for a shorter period than the complete financial life of the asset, and the ownership is not transferred to the lessee. Vasigh, Fleming and Mackay (2010) define operational lease as the agreement to finance an asset for a short duration of time, and the lessee can return the asset at the end of the contract. All the above definitions of operational lease are valid and bring out an overview of operational lease.
The use of operational leases in the airline industry has been on the rise since 1980’s (Vasigh, Fleming and Mackay, 2010). Ascend (2014) observes that the ownership of the global fleet has changed over the last years with leasing accounting for 36.9% of all aircrafts as at the end of 2013 as compared to 3.3% in 1981. Ascend (2014) notes that the aircraft rental is the most common operating lease in the airline. Airlines prefer operating lease because as compared to direct ownership, operating lease requires less capital investment, and provides more fleet planning flexibility. With the growth in operating leases, it is necessary that airlines report their operating lease obligations so that their financial statements provide a true and fair view of their financial position. Emirates and Air China prefer using operational leases to finance their aircrafts and facilities.
Leasing standard is under the broad umbrella of the international financial and accounting standards and prescribes the rules and guidelines in relation to accounting of operational and financial leases. The lease standards distinguish the operating lease from the financial lease by considering the risks and rewards as the primary factors of differentiation. Most of the airline industries (Air China and Emirates included) only mention their financial leases in their reports and operating leases are merely mentioned, and when mentioned they are under the category of expenses where, the footnotes sometimes only disclose the rental commitments (Beattie, Goodracre and Thomson, 2000).
KPMG (2013) reported on the consequences that would arise from the addition of operational lease in the accounting reports of the airline industries both in the side of the of lessee and lessor. Some of the major impacts are as outlined;
The airline industries would face foreign currency exchange rate risks, as the functional currency for most of the international airlines is USD (US dollar).
The process of coming up with the income statement will become complicated because there are high probabilities that the leases in the first half of the year would drastically change in the second half of the year.
The airlines would have to review and reconsider their standards for accounting to make changes with the new guidelines from the boards.
The differences in the operating leases in some cases, mainly for maintenance would make accounting for airlines a complex process. For instance, some operating lease may transfer the maintenance costs to the airline, while in other operating leases the maintenance cost would be incurred by the lessor.
The reporting format of cash flows would also have to be changed so as to be in line with the new standards of operational lease accounting.
KPMG also revealed that operational leases have a positive relationship with the risks adjustments in the organisations. However, the answers are not associated with the airline industry (Dhaliwal, Lee and Neamtiu, 2011). Separate reporting of capital and operating leases is very significant for the users of financial reports, as a clear distinction of the two types of leases is important (Caskey and Ozel, 2013). However, airlines have three major incentives not to report operating leases; lower tax burden, operational flexibility and reduction in financial risks (Caskey and Ozel, 2013).
KPMG reveals that many other studies from time to time have been done on the impacts of operating leases. The research found out that the change in the reporting standard by adding operational leases in the report would help in improving the process of financial reporting and increase the accountability of the airline industries (Beattie, Goodacre, and Thomson, 2006). The research also stated that the operating leases would directly impact on the debt, liabilities and assets of the company; therefore, it was important that they be recognised in the balance sheet as well as footnotes (Ely, 1995).
The study is mainly aimed to discuss the issue of operating leases whether to be added to the balance sheet of the airline companies or not. Based on the major objective and aim of the study, the research is going to answer the following research question:
Should the airline companies add operational leases in their account statements?
Methodology
The study I would like to conduct is focused on the subjectivity of operational leases in accounting. With this in this in mind, I will use an approach to primary data collection and analysis that will make use of both quantitative and qualitative data. Quantitative data is factual and thus more reliable. On the other hand, qualitative data will allow me to explore the research question more deeply.
I will use questionnaires to gather data from several managers and employees of Air China, Emirates, and KPMG. I will choose a sample of 800 respondents who will consist of managers and employees who are involved in the preparation of the financial statements. The questionnaires will help me to obtain detailed data, as well as maintain the confidentiality of the respondent. The use of the questionnaire will make my study economical considering that I need to gather data from respondents who are scattered across the globe. I would host the questionnaire online and then send invitations to the respondents to participate in the survey. Hosting the questionnaire online will save me time and cost of collecting the data.
I will undertake a mixed questionnaire that will allow questions to be both close and open ended. This type of questionnaire would allow respondents to freely express their views and ideas on subjectivity of operational leases in accounting should the nature of the question encourage it. In addition, the questions used in the survey would be structured. This would ensure that they are well-prepared and concrete before the questionnaires are conducted to help prevent any potential complications.
For conducting the survey, it is very important to decide the population and design the sample in terms of the sampling technique, the size of the sample, etc.
The airlines companies (Air China and Emirates) will be the major population for the study.
The major reason for selecting these two airlines is that both of these airlines have many debts in regards to operational leases that are never reported in the annual financial reports.
The invitations to the survey will be sent to more than 800 respondents, expecting that 50% of the respondents will accurately and completely respond to the questionnaire.
The sample will be designed based on the purposive sampling technique as the focus of the study is lease accounting, therefore, the participants must have a role in the preparation and reporting of the airlines financial statements.
The survey will be conducted using questionnaire.
The researchers will conduct a survey online and will send the link to the email addresses of the respondents.
For the sake of confirmation of receiving the link to the survey, the researcher will also send the link to the respondents via direct mail.
The reason for online survey is that the researcher has limited time and budget to conduct the study and it will very costly to go to each respondent individually.
I will first review previous studies in order to develop a rough copy of the questionnaire for a pilot survey. The pilot test is important in order to test the validity and reliability of the data collected. In addition, the pilot test will identify any potential problems before embarking on a full scale survey. The rough questionnaire will be sent to 10 respondents with a prior letter confirming about the pilot testing for conducting the research. Once, the pilot testing is done, the modified (if required) questionnaire will be distributed to the sample.
The questionnaire will ask few questions to get the background information of the respondents such as age, education, gender, etc. as these factors can impact their answers or responses. The questionnaire will mainly use Likert Scale that is the most appropriate to use in measuring the responses for the close ended questions.
Analysis of data
Once the data has been collected using the questionnaire, I will analyse the data to next phase of data analysis and explanation to reach to the significant results. The statistical data will be used to understand the impacts of operational leases for adding in the account reports on the airline companies and their financial statements.
Based on the responses of the research participants, I (the researcher) will find the answer as to whether the addition of operational leases in accounting is required and whether the airline companies should add them in their statements of account or not. For this purpose, the researcher will use the statistical tools to analyse the data collected from the survey.
The researcher will use SPSS tool for conducting the data analysis and interpretation. The analysis will begin with the description of the characteristics of the respondents based on the demographic questions. Then, the researcher will analyse the psychographic questions to lead the analysis to find the answers to the research questions. For the accurate and proper data representation in the analysis, the charts and tables will be used.
Ethical considerations
My study is likely to elicit strong opinions from various stakeholders. The move to include operational leases in the airlines financial statements may expose some of the liabilities the airlines had long been able to conceal. Consequently, I will have to bear in mind some of the ethical issues that may arise in the course of the study. As a researcher I must pay close attention to the ethics, norms, values and code of conduct to consider all these factors in the course of my study (Creswell, 2013). For the following research, the researcher will be guided by the following ethical considerations:
People are hesistant to share financial information abouth themselves or their companies, therefore, it is important I reassure the respondents in written form that the information collected from them will not be used for other purposes other than the research. Further, the researcher will not collect any confidential information that may harm the companies involved or the participants.
The researcher will first inform the participants about the research objectives and purposes before commencing the research and then would ask them to sign the consent form before filling the questionnaire. This means that the respondents will not be deceived or manipulated to provide data that they would not provide if they had been informed of the purpose of the data. Furthermore, the respondents will be provided with the findings of the research before I publish the research.
Since the study is likely to elicit strong opinions, it is important that I reassure the respondents that the information provided will be kept private and confidential and not be disclosed to any third party. The questionnaires will not have any feature that can identify any particluar response to any respondent.
References
Caskey, J., & Ozel, B. (2013). The role of economic and reporting incentives in operating lease use: Evidence from the airline industry. Working paper, University of Texas and University of California (UCLA).
Dhaliwal, D., Lee, H. S. G., & Neamtiu, M. (2011). The impact of operating leases on firm financial and operating risk. Journal of Accounting, Auditing & Finance, Vol. 26, No. 2, pp. 151-197.
Ely, K. M. (1995). Operating lease accounting and the market's assessment of equity risk. Journal of Accounting Research, Vol. 33, No. 2, pp. 397-415.
KPMG. (2013). Leases: Final Approach or Go-around? Another US$100 billion of debt for the top global airlines. Available from https://www.kpmg.com/Global/en/IssuesAndInsights/ArticlesPublications/Documents/leases-final-approach-or-go-around.pdf [Accessed 24 February 2016]
Kumar, S., &Phrommathed, P. (2005).Research methodology (pp. 43-50).Springer US.
Lipe, R. C. (2001). Lease accounting research and the G4+ 1 proposal. Accounting Horizons, Vol. 15, No. 3, pp. 299-310.
Saunders, M.N., Saunders, M., Lewis, P. and Thornhill, A., (2011).Research methods for business students, 5/e. Pearson Education.
Beattie, V., Goodacre, A., & Thomson, S. (2000). Operating leases and the assessment of lease–debt substitutability. Journal of Banking & Finance, Vol. 24, No. 3, pp. 427-470.
