Depreciation, residual values and useful economic lives · assets and depreciation rates adjusted...

1© 2017 KPMG, an Irish partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Ireland.

Depreciation, residual values and useful economic livesAccounting and commercial update

KPMG and IBA4 May 2017


Today’s agenda Introduction – Ian Nelson, Audit Partner KPMG

Accounting considerations – Niall Naughton, Audit Partner KPMG

Commercial developments – Stuart Hatcher, CIO IBA

Tax considerations – Gareth Bryan, Tax Partner KPMG

Wrap-up and Q&A – All

Expect to finish by 9.15 to allow some time for Q&A


Introduction


What’s the issue?

What are the trends in aircraft valuations, residual values and useful economic lives that could cause us to think differently about depreciaton?

How realistic is depreciation of an aircraft over a 20 or 25 year life to a % of original cost?


Recent commentaryAs more aircraft retire, useful lives and residual values continue to be a strong discussion point amongst industry participants

“…The economic life of commercial jet aircraft is an issue of great debate in the aviation industry today. In times of economic uncertainty or around the introduction of new technology, questions are raised around aircraft economic life assumptions made by investors and financiers and whether a permanent shift is taking place in the long-term values ascribed to commercial jets… …Whilst a small number of individual aircraft may suffer value impairment through early retirement, there is strong evidence that the broader patterns of fleet operation and ownership will continue to support current industry value retention assumptions and that that in-service life and average retirement ages continue to support the global aviation industry’s widely used 25 year depreciation assumption…“- Dick Forsberg, Avolon’s Head of Strategy.“…the conventional 25-year/15% residual value depreciation schedule exposes aircraft owners to more down-side risk than upside opportunity based on projected value ranges – particularly for mid-life and older assets. Ascend concluded that a 20-year useful-life assumption may be more appropriate…” - Liebo’s Leasing Letters, Gary S. Liebowitz, Wells Fargo Securities LLC.“…The curve suggests that a 15% residual is achieved within only 17 years for the A320ceo and only 19 years for the sharklet-equipped A320ceo – both well below the conventional 25-year accounting assumption…”- Liebo’s Leasing Letters, Gary S. Liebowitz, Wells Fargo Securities LLC.


One point to be clear on…

Accounting depreciation DOES NOT mean mark to market

IFRS• Depreciation is the systematic allocation of the depreciable

amount of an asset over its useful life.• Depreciable amount is further defined as the cost of an asset less

its residual value.

US GAAP• Depreciation is a system of accounting which aims to distribute

the cost of tangible capital assets less salvage over the estimated useful life of the unit in a systematic and rational manner.


FLIGHT TIME

Useful economic lives

IFRS US GAAP Question?

• Depreciate over life of asset, or life of asset to owner?

• The estimated useful life is the period over which the asset is expected to provide economic benefit or service potential to the holder of the asset after considering normal repairs and maintenance.

• The useful life of an asset is defined as the period over which an asset is expected to be available for use by the entity.

• The estimation of the useful life of the asset may be a matter of judgement based on the experience of the entity with similar assets.


FLIGHT TIME

Residual values


Include or exclude inflation?Residual value is the amount that an entity could receive for the asset at the end of the reporting period if the asset were already of the age and in the condition that it will be in when the entity expects to dispose of it. Residual value does not include expected future inflation. (KPMG Insights)

The salvage value is the estimated value expected to be recovered at the end of the estimated useful life of the asset

The residual value of an asset is the estimated amount that an entity would currently obtain from disposal of the asset, after deducting the estimated costs of disposal, if the asset were already of the age and in the condition expected at the end of its useful life.


FLIGHT TIME

Re-assessment


How is re-assessment accounted for?

While it would generally be expected that the appropriateness of significant assumptions within the financial statements would be reassessed each reporting period, there is no explicit requirement for an annual review of residual values.

The residual value and useful life of an asset shall be reviewed at least at each financial year-end and, if expectations differ from previous estimates, the changes shall be accounted for as a change in accounting estimate in accordance with IAS 8.


Discussion points

4

What are the key accounting developments in depreciation?

How can / should accounting for depreciation be aligned with theOwner’s commercial expectations?

What changes in RVs and UELs

are really being experienced?


Accounting considerations

12

Document Classification: KPMG Public

© 2017 KPMG, an Irish partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Ireland.

Agenda

Lessor analysis

Framework comparison

UEL / RV rules

Recent trends

Airline perspective

13© 2017 KPMG, an Irish partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Ireland. 13

Accounting rules

The same rules apply

More focus on useful life to owner

Key judgements

(UEL/RV)

Consistency of applicationImpairment approach

Transparent disclosure

Limited GAAP differences


Airline UEL / RV analysis

Airline Aircraft/Fleet type Useful life (UL) Residual Value (RV) Depreciation Rate (DR = (100%-RV)/UL)

Air Astana Flight equipmentRotable spare parts

10-20 years5-10 years

--

5%-10%10%-20%

Air China Core partsAirframe and cabin –

refurbishmentOverhaul of engine

Rotable parts



5%-

--

3%-6%8%-20%

7%-50%7%-33%

Air France-KLMGroup

Not specified 20-25 years - 4%-5%

Cathay Pacific PassengerFreighter

Aircraft productFreighters converted from

passengers

20 years20-27 years

5-10 years10 years

10%10%-20%

-

5%3%-5%

10%-20%10%

EasyJet AircraftAircraft spares

23 years14 years

- 4%7%

Emirates Group NewUsed

Engines and parts

15 years5 years

5-15 years

10%10%-20%0%-10%

6%16%-18%6%-20%

Kenya Airways Boeing 787, 777, 737-300, 737-700Boeing 767*

Simulator

17 years

3 years 20 years

-

--

6%

33%5%

Korean Airlines Aircraft fuselage Aircraft engines and parts

6-15 years 15 years

--

7%-17%7%


Airline UEL / RV analysis (continued)

Airline Aircraft/Fleet type Useful life (UL) Residual Value (RV) Depreciation Rate (DR = (100%-RV)/UL)

Lufthansa Group New commercial 20 years 5% 5%

Qatar Airways PassengerExecutive Freighter

12 years10 years

7 years

15%60%20%

7%4%

11%

Singapore Airlines PassengerFreighter

Used freighterTraining

Simulators

15-20 years 20 years

20 years less age of aircraft5-15 years5-10 years

5%-10%5%5%

10%-20%-

5%-6%5%5%

5%-18%10%-20%

South African Airways

Aircraft and simulators 5-20 years - 5%-20%

Turkish Airlines AircraftCargo aircraftComponents

20 years 20 years

7 years

10%-30%10%

-

4%-5%5%

14%

Residual values, where applicable, are reviewed annually against prevai l ing market rates at the balance sheet date for equivalenty aged assets and depreciat ion rates adjusted accordingly on a prospective basis.

Since 2013, new commercial aircraft and reserve engines have been depreciated over a period of 20 years to a residual value of 5 per cent.

Assets acquired second hand are depreciated over their expected remaining useful l i fe

Example d isc losures

Banks

A i r l i n e t r e n d s

UEL 15-25 yearsRV 0-20%

Impact of new technology

Factors affecting depreciation

ratesComponent accounting

UEL by component

Use of SL method


Lessor UEL / RV analysis

Lessor Type UL RV Depreciation rate

A Jets 25 years 15% 3.40%

B Jets 20 years Base value Varies

C Jets 25 years 15% 3.4%

D Jets 25 years 15% 3.4%

E Jets 25 years 15% 3.4%

F Jets 5 years Base value Varies

G Jets 18 years Base value c.4%

H Jets 25 years 15% 3.4%

I Jets 20 years 15% 5%

J Jets and Turboprops 25-30 years 15% Varies

K Jets EOL Base value Varies

L Jets 25 years 15% 3.4%

M Jets 25 years 5% 3.8%

N Jets 20 years 5% 4.80%

Presenter

Presentation Notes

Banks

L e s s o r t r e n d s

RV 5-15%

UEL 20-30 years Impact of new technology

Use of entity UEL

Limited use of component accounting

Use of SL method

www.iba.aero

Economic life and residual values

May 2017

Stuart Hatcher, CIO

Presenter

Presentation Notes

Aircraft economic lives have shifted over the last 35 years with the growth of leasing and competition. Whilst aircraft produced in the initial phase of a program tend to more closely follow the 25:15 rule in a half-life condition, trading evidence would suggest that accounting for intangible end of lease compensation and associated cash reserves should be considered. The last off the line effect will play a part that for some will be relatively minor compared to the effects seen for the more classic aircraft. Widebodies in general have exhibited a weaker value performance beyond 18-20 years which tends to fit well with their production cycle Going forward, we expect A320neo & 737Max aircraft to perform well, alongside other new types like the 787 and A350. We have more concerns over the 777-300ER and 777X, plus the market for the A330neo in the current fuel environment does not provide much confidence.

www.iba.aero

Last off the line effect

Traditional approach of depreciation worked

Based on trading data spanning 30+ years

Despite market swings in 1991, 2001, & 2008, the broad trend was consistent

0%

20%

40%

60%

80%

100%

120%

0 5 10 15 20 25

Valu

e %

Age (years)

Boeing 737-300

1984 1999 25y:100-15 Linear (1984) Linear (1999)

The same cannot be said about the last off the line!

@ 9/11, 925 NGs were in service (312 700s) v 1,988 classics (1,113 300s)

Never recovered from United & Continental fleet re-organisation

Source IBA.IQ

Presenter

Presentation Notes

Following the historical trading patterns of popular aircraft types we can see going back 30 years that 25 year depreciation to 15% value was a valid approach even with significant market swings in market value (1991, 2001, 2008), value performance followed the expected path. The same cannot be said for the last off the line 1999 build 737-300 that collapsed after 2001, showed some signs of recovery, then collapsed once United and Continental parked huge numbers as part of a cost cutting exercise. Economic life was effectively reduced to 14 years The aircraft lost position because the NG was a significant improvement and the market was moving towards the larger 800

www.iba.aero

Last off the line effect

The widebodies started off well too

The 747 was considered absolutely necessary for all international legacy carriers

8/10 of largest airlines by fleet size operated it (the other 2 were LCCs)

The last off line was hit hard.

In just 12 years, 89% of value has been lost

The replacement 747-8 is not the culprit – but the market has shifted to the “large twins”

Asian crisis, 9/11 & SARS didn’t help

0%

20%

40%

60%

80%

100%

120%

0 5 10 15 20 25

Valu

e %

Age (years)

Boeing 747-400

1989 2005 25y:100-15

Source IBA.IQ

Presenter

Presentation Notes

An even more pronounced effect can be seen for the 747-400 which was the main source of lift for most flag carriers until the 777 stole its market. Higher maintenance, fuel and reconfiguration were heavily to blame. Whilst not actively traded, the last off the line has failed to attract any takers for the ones parked up. The attraction of 4 engined high cost assets has well and truly collapsed unless there is something unique to offer. The 747 was matched by the 777 in the short term, but since then has spread across all manner of efficient twins and the A380

www.iba.aero

Today’s Technology

Applying to newer technology indicates a weaker trend in standard trading data

Not severe, but there is a gap

0%

20%

40%

60%

80%

100%

120%

0 5 10 15 20 25

Valu

e %

Age (years)

A320ceo first, middle & last off the line

1988 2003 25y:100-15 2017

Extrapolating that trend and excluding market shocks, the curve is weaker such that 15% is achieved after 21 years

This is softer than previously seen as neo v ceo is an engine upgrade solely – albeit a big one

The neo will suffer from higher maintenance cost, higher tech risk, and higher pricingSource IBA.IQ

Presenter

Presentation Notes

When looking at the A320ceo, it becomes more difficult as the neo is a performance upgrade rather than the end of an era. Whilst the first builds followed the 25 year expectation, 15 years on, all data would suggest a sub 25:15 performance. For 2017 builds, we expect economic life to reach 15 years after 21 years

www.iba.aero

Today’s Technology

This is backed up by unadjusted historical trading data

The deviation from expected depreciation is 15% in 15 years

This effect is reduced by factoring in the older aircraft beyond 15 years – but investors view that space

0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%40.0%45.0%50.0%55.0%60.0%65.0%70.0%75.0%80.0%85.0%90.0%95.0%

100.0%105.0%110.0%115.0%120.0%125.0%

0 2 4 6 8 10 12 14 16

Valu

e %

Age (years)

A320 trading data

A320 trading points 25 years 100% to 15%

Linear (A320 trading points) Linear (25 years 100% to 15%)

Is using trading data a valid approach?

Lessors don’t buy new aircraft and run them down to half-life without some level of compensation

Source IBA.IQ

Presenter

Presentation Notes

Looking at the trading data actuals for the entire market of A320s covering all maintenance conditions, we see that over the first 15 years that performance is 15% lower than the straight line approach - but this considers that maintenance is generally moving from new to half-life - because with a sawtooth graph, we can still show that the mean position is close to half-life With the leasing of aircraft (rather than trading of aircraft) in the vast majority of cases, cash is collected or expected to pay for the utilisation - so in essence full-life

www.iba.aero

A320ceo: 25 year principle valid?

By applying the full compensation and market effects together, we find that first/middle production aircraft performed very well

Even the last off the line aircraft with full compensation throughout its life satisfies the traditional view

0%

20%

40%

60%

80%

100%

120%

0 5 10 15 20 25

Valu

e %

Age (years)

Full-Life A320ceo first, middle & last off the line

1988 2003 25y:100-15 2017 2017 FL&HL

However…. Aircraft will at some point in their lives potentially become half-life once they have completed their maintenance cycle and first lease

Lessors will re-lease as-is, push the cash to their balance sheet, and structure an upsy-downsy lease

Source IBA.IQ

Presenter

Presentation Notes

By adding in the full-life element over the full life, even the latter build aircraft have the expectation that the ever increasing cost of maintenance can retain the 25 year principle - but that may not stack up considering that leased aircraft tend to be monitored in a half-life upsy/downsy way beyond a certain point in its life - coinciding with the re-leasing of the asset - traditionally at 12 years

www.iba.aero

777-300ER: Widebody Shorter economic life but less 777X pressure

The 777 has a bigger concern as widebodies in general show poorer performance and there is a replacement in the wings

Early builds are expected to perform in Full-Life condition, but Half-Life aircraft show strong deviation until year 25

High cost of configuration prevent significant lease turns

0%

20%

40%

60%

80%

100%

120%

0 5 10 15 20 25

Valu

e %

Age (years)

777-300ER last off the line concerns

2017 HLBV1.5% 2017 FLBV1.5% 2004 HLBV1.5% 2004 FLBV1.5% 25y:100-15

Source IBA.IQ

Current builds are more worrying as neither condition appears to stay close by shortening life by 5 years

Whilst 2004 builds will be ~20 years old by the time 777X deliveries escalate

Soaring LLP costs and possible freight conversion programs may help

Presenter

Presentation Notes

Widebodies in general show greater tendency towards shorter economic lives, particularly without a freight conversion route. The initial 777-300ER deliveries are likely to have a full life as they will be approaching 20 years old before the 777X fleet starts to impact the market in any sizeable numbers, whilst the last few deliveries will feel much greater pressure that even with soaring LLP costs, cannot bridge the gap

www.iba.aero

Regional Jets & Turboprops: Mix of factors influence value

The variance in the regional market is much larger

Good turboprops and large regional jets earlier in their cycle have performed reasonably well

Turboprops have longer technical lives and less susceptible to positive fuel shocks

Leases tend to be weaker credits for shorter terms

The 50-seater regional has not faired well and 15% at 15 years is not unusual

With so much new RJ competition coming to market, we expect to see weaker performance on all RJs

Young turboprops are currently in a weaker position, but we feel that is temporary

Specialist lessors like NAC or Elix will extract best value

0%

20%

40%

60%

80%

100%

120%

0 5 10 15 20 25

Valu

e %

Age (years)

RJ & TP Performance - CRJ200 v ATR72 v Ejet

2003 CRJ HLBV1.5% 2003 CRJ FLBV1.5% 2003 ATR HLBV1.5%

2003 ATR FLBV1.5% 25y:100-15 2005 E175 HLBV1.5%

2005 E175 FLBV1.5%

Source IBA.IQ

Presenter

Presentation Notes

Regional jets and Turboprops have different profiles. Higher utilisation and fuel performance tend to reduce the life of the RJs, whilst Turboprops are less susceptible to high fuel costs, but the market can easily dip in a low fuel cost environment or if there is less demand for short sector growth. For the most part, turboprops like the Dash 8 or ATR will undoubtedly have long lives possibly well beyond 25 years because of their robust utility, and economics, but short-term market volatility due to sharp swings in availability don't help. The larger generation of RJs differ greatly from the older 50-seater aircraft such that they perform closer to a Narrowbody, but their high utilisation still poses a problem These assets don't follow the same leasing trends as the bigger assets as leases can be shorter and too much weaker credits. They are better managed by lessors like NAC or Elix that specialise

www.iba.aero

Summary

Aircraft economic lives have shifted over the last 35 years with the growth of leasing and competition. Whilst aircraft produced in the initial phase of a program tend to more closely follow the 25:15 rule in a half-life condition, trading evidence would suggest that accounting for intangible end of lease compensation and associated cash reserves should be considered.

The last off the line effect will play a part that for some will be relatively minor compared to the effects seen for the more classic aircraft – particularly under current fuel cost rules. Widebodies in general have exhibited a weaker value performance beyond 18-20 years which tends to fit well with their production cycle

Going forward, we expect current generation narrowbodies will perform when associated with maintenance cash, but will not stand up to long-term half-life performance. Cant ignore the reserves or compensation

we expect A320neo & 737Max aircraft to perform well, alongside other new types like the 787 and A350 for the coming years. We have more concerns over the 777-300ER if configuration costs don’t come down, and Emirates re-fleet over a shorter period

Tax Considerations


Tax Profile – Full Life

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

$35,000,000

$40,000,000

$45,000,000

$50,000,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

ProfileCost Market Value Accounting NBV Tax Basis

Presenter

Presentation Notes


Tax Profile – Sale Mid Life (Traditional Model)

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

$35,000,000

$40,000,000

$45,000,000

$50,000,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

ProfileYear Cost Market Value Accounting NBV Tax Basis

Presenter

Presentation Notes


Tax Profile – Sale Mid Life (Traditional Model)

$0

$5,000,000

$10,000,000

$15,000,000

$20,000,000

$25,000,000

$30,000,000

$35,000,000

$40,000,000

$45,000,000

$50,000,000

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17

ProfileYear Cost Market Value Accounting NBV (New) Accounting NBV (Trad) Tax Basis

Presenter

Presentation Notes


Other thoughts

French restriction on deductions for head-lease payments:

Dividends & Distributable Reserves

RENT – > €3MACCOUNTINGDEPRECIATION

Parent

OpCo 1 OpCo 2


Wrap-up and Q&A


Wrap-up and concluding remarks There are a range of allowable approaches

The balance between simplicity and understanding of the depreciation policy by the users of the financial statements is important

If you cannot explain your depreciation policy in 30 seconds are you losing?

How best to reflect commercial changes outside of potentially lumpy impairments?

Interaction with ‘accelerated depreciation’?

Linkage to commercial strategy or not?

How long will the straight line to 20/25 years last…


Q&A?


KPMG is the only professional services firm identified in the ‘Airfinance Power 30’ list of companies that make an essential contribution to aviation finance.

To qualify, all companies had to meet one test: If they went out of business tomorrow, Would the market feel a significant loss?

KPMG Ireland - Credentials

“When you are advising practically every lessor in Ireland, you are a key player.”

“The most common link between the Dublin lessor community can be summed up in four letters – KPMG.”

“Its [KPMG’s] tax, listing, audit, financial modelling and due diligence experience gives the institution a unique position in the aviation finance centre of excellence that is Dublin.

“Without KPMG, the IPOs and securitisation of todays top lessors may not have happened.”

Source: Airfinance Journal


Thank you

Ian NelsonPartner, Aviation FinanceKPMG

t: +353 1 410 1989e: [email protected]

Niall Naughton Partner, Audit KPMG


Gareth BryanPartner, TaxKPMG


Stuart HatcherChief Intelligence Officer International Bureau of Aviation

t:e: [email protected]

kpmg.ie

© 2017 KPMG, an Irish partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Ireland.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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