Cathay Pacific is identified among the largest airlines in Hong Kong. The new accounting standard, IFRS 16, requires recognition of lease transactions as right-to-use assets and lease liabilities by lessees; hence they should be included in the financial statements. Adopting the standard is identified to impact businesses significantly through increasing their debts and EBITDA, reducing profits or increasing losses, and increasing expenses such as impairment and depreciation.
Implementing the new accounting standards for lease will affect Cathay Pacific significantly. For example, research by PwC in 2016 indicated that the airline industry is among the most affected by the new standard, with an estimated increase in debt of 47% (Leung & Wan, 2020). This is because leasing is a common practice for airlines. Airlines often lease airport facilities, aircraft, and aircraft equipment. For example, most airlines in Hong Kong operate aircraft which are, on average, 32% operating leased and 30% finance-leased compared to 38% owned aircraft.
The airline’s indebtedness will be affected due to the standard’s effect on its liabilities and assets. By classifying its previous operating leases into right-to-use assets and leasing liabilities, it can be identified that the airline’s gearing ratio increased by 36.5% from 0.96 when hypothetically using HKAS 17, the old standard, to 1.31 when using the new standard HKFRS 16 (Leung & Wan, 2020). When the gearing ratio is high, the airline’s debt proportion is higher than its equity. An increase, in this case, indicates that adopting the new standard would expose the airline to financial risk because excessive risks can result in financial difficulties.
It is evident that adopting HKFRS 16 affects a company’s profits. In 2019, Cathay Pacific’s net profits were HKD1.7bn, a 39% decline from HKD2.8bn in 2018. HKD26 million of the decrease was attributed to the implementation of the HKFRS 16. Despite assets such as equipment, plant, and property increasing with the adoption of the standard, profits will worsen. According to Cathay Pacific’s financial position as of the end of 2019, profits worsened due to the increase in finance charges by HKD0.744bn and depression expense by HKD3.849bn (finance charges and depreciation expense in total is HKD4.593bn) (Leung & Wan, 2020). The total finance and depreciation charges outweighed the savings obtained in operating lease rentals of HKD4.507bn by HKD86 million, worsening profits. However, the operating cash flow of the airline increased by HKD3701mn as a result of the adoption of the new standard, even though its net cash flow position did not change.
By adopting HKFRS 16, Cathay Pacific would also face impairment expenses due to the risk of the increased write-down of property, equipment, and plant assets, which had increased to HKD2Obn (Leung & Wan, 2020). The residual risks will therefore affect the airline’s net profits by reducing them and making them more volatile.
Leasing is a flexible financing form that most companies use to finance their fixed assets. Companies tailor lease rentals to match income generated by the use of the asset, making it self-funding. The lease asset’s payment period often matches its economic life. Based on the case study, IFRS 16 proves to reduce leasing’s attractiveness prompting companies that depend on leasing, such as Cathay Pacific, to act in response to its negative impacts. Cathay Pacific should take some action.
One of the actions is to shift to the purchase option. IFRS 16 requirements provide significant comparability between those who borrow to buy assets and those who lease the assets. The risks that come with leasing due to the standard can lead to Cathay Pacific deciding to buy the assets rather than lease them (Leung & Wan, 2020). The airline will minimize the negative impacts of increased debts, worsening losses and profits, and gearing by taking this action. However, the airline will not enjoy the benefits that are associated with leasing. Buying may be costly, especially when assets often require renewing as technology advances, an advantage that comes with leasing. Buying also means that the airline loses the ability to use the asset for only the needed portion of its economic life. They get stuck with the asset after its use. Borrowing to buy may require supplementary guarantees not needed in leasing. I recommend that the airline determines the assets they can purchase and those that it is only possible to lease. Cathay Pacific should enter into fewer leases hence reducing the negative impact of shifting to the model of right-to-use.
Cathay Pacific can also negotiate lease rental agreements that are flexible such that they would pay for the leased asset based on the hours of flying (Leung & Wan, 2020). This would be advantageous because the leased assets would not be included in the financial statements hence no lease liabilities. However, the disadvantage of this option is that there would be a risk of increased rent. The lessor may want to charge higher rent to compensate for the risks associated with lease agreements that are short-term. With flexibility per hour, there is the risk of the lessee terminating the contract, which can only be compensated by the lessor charging higher. The lessor may also decide to increase rent (payments) during every renewal, which can be costly. To minimize the disadvantage of this option, the airline can negotiate a leasing rate with the lessor that would last for a given agreed time, after which the lessee would be aware of the expected changes they would be ready for. This way, the option of a flexible lease arrangement would work.
References
Leung, W. S., & Wan, T. (2020). Cathay Pacific: Financial Impact and Challenges in Adopting the New Lease Accounting Standard. ACRC – Asia Case Research Centre – Devoted to advancing business education through the development of Asian case studies. https://www.acrc.hku.hk/Case/Detail/1050
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