Emerging Accounting & Valuation Challenges

KPMG & IBA Breakfast Briefing 10 November 2016

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Today’s agenda Topic

Presenter

■ Accounting issues

Ian Nelson

■ Key valuation considerations

Phil Seymour

■ Tax considerations

Gareth Bryan

■ Other valuation hot topics

Phil Seymour

■ Other accounting hot topics

Ian Nelson

■ Wrap-up and Q&A

All

© 2016 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.

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Today’s speakers Ian Nelson Partner, Financial Services KPMG Ian is a Partner in our aviation practice specialising in audit and assurance. Ian is an IFRS 9 and US GAAP specialist.

Gareth Bryan Partner, Tax KPMG Gareth is a Partner in the financial services taxation practice specialising in both domestic and international corporate tax. Gareth advises a range of domestic and international clients.

Phil Seymour President and CEO International Bureau of Aviation Phil is the CEO of IBA, a leading aviation consultancy where he specialises in strategic projects for lessors, airlines and investors. Phil is a Senior ISTAT Certified Appraiser, and is the current elected Chairman of the ISTAT International Appraisers’ Program.

© 2016 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.

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Accounting issues - agenda 1. Acquisition of mid-lease aircraft (main focus for today)

2. Other accounting topics − IFRS 16 − Forward orders

© 2016 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.

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Maintenance intangibles

1. AerCap Holdings N.V. Annual Report year ended 31 December 2015 © 2016 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. 2. Fly Leasing Reports Fourth Quarter & Full Year 2015 Financial Results 3. Fly Leasing Limited Annual Report year ended 31 December 2015

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Key questions 1. How to recognise/value of; i.

Metal (aircraft)

ii.

Lease premium / deficit

iii. Maintenance intangible 2. Amortisation profiling of any intangibles recognised.

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Status and our clients This is still an evolving accounting issue: ■ The aviation sector is still working through the implications; ■ We understand there is some reluctance to recognise maintenance intangible liabilities notwithstanding they could arise under this potential approach (due to potential inflation of aircraft values); and ■ The proposed accounting is sometimes inconsistent with the commercial reality where often the current condition of the aircraft is viewed less relevant.

1. Believers – but waiting to see how industry evolves

2. Nonbelievers: quickly becoming extinct!

X

3. Believers – have applied the requirements.

Non- Believers

Believers but waiting to see how industry evolves

It now appears that only the third option is really a runner – the guidance should be applied!

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IFRS v’s US GAAP – Is there a GAAP difference ? US GAAP

■ The SEC have pointed to Topic ASC 350, ASC 360 and the contractual-legal element of ASC 805 in US GAAP in their comment letters. ■ Subtopic 350-30 addresses accounting for intangible assets acquired individually or with a group of other assets. Paragraph 805-5030-3 indicates that the cost of a group of assets acquired in a transaction other than a business combination shall be allocated to the individual assets acquired based on their relative fair values and shall not give rise to goodwill. ■ Fair value of aircraft can be more reliably determined due to the availability of independent third party-appraisers, fair value of the aircraft on an “as-is, where is” maintenance adjusted for physical condition basis should be used first to determine the amount allocated to the aircraft. ■ Material differences between the appraised amount allocated to the aircraft and the consideration paid for the aircraft would be an indicator of an intangible asset or liability.

IFRS

■ IAS-38 requires an intangible asset is initially recognised at cost if it is probable that future economic benefits that are attributable to the asset will flow to the entity; and the cost of the asset can be measured reliably. ■ Therefore it is necessary to recognise off-market leases and maintenance return condition elements separately –as the economic benefits that will flow to the acquiring lessor will be realised, likely, through a sale of the asset or through future rentals (or a combination of both). ■ Additionally IAS16 requires one to recognise the aircraft first-cost based on its then location and condition. Therefore it is not possible to include the MTX-intangible as a component of aircraft cost. ■ Need to consider difference between business combination (IFRS 3) and aircraft acquisition (IAS 16) in terms of the split-out of lease rate intangibles.

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Accounting for intangibles Intangible Assets

The recognition of maintenance and lease intangibles issue arises only in respect of the purchase of aircraft on lease, from other lessors/investors (i.e. it does not apply to new-purchases from OEMs or the PLBs with airlines, which were not previously on lease). The following example assumes that in all cases we are considering a single aircraft transaction which has been determined is not a business combination. But to note the identification and measurement of such intangibles is also required under business combination accounting, as evidenced by the AERCAP accounting for the ILFC transaction. Also, the subject of whether a single aircraft acquisition (on-lease) is a business combination is a lengthy debate !

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Worked Example On 1 January 2015, a 2013 vintage A320 aircraft in 50% maintenance condition is purchased from Lessor X for $38m with a lease attached. The below outlines a high level example of how the individual assets and liabilities would be calculated. Please note the below calculation does not factor in the time value of money. Lease Assumptions Remaining Lease Term: Maintenance Reserves: year Lease Rentals: month Re-delivery terms: Step 1:

Step 2:

Calculate the fair value of the aircraft on acquisition

Calculate the lease intangible

The fair value of the aircraft can be calculated using specific MSN appraiser values at date of acquisition if available.

A lease intangible is an asset/liability relating to any off market rental terms.

Lease Rentals: $300k Average lease rentals per appraisers: $280k CMV – 50 %

$33m Lease intangible= $1.2m (300k-280k * 5 years)

5 years $1 million per $300k per 100% MC

Market Assumption (A320-2013 aircraft) Average appraiser rentals: $280k per month Average appraiser CMV-full life: $35m Average appraiser CMV- half life:

Step 3: Calculate the Maintenance Intangible

A maintenance intangible is an asset/liability relating to the difference between the current aircraft maintenance-specific CMV at the date of purchase (half life) and the CMV at date of purchase based on the expected maintenance condition at lease end (full life). CMV of full life aircraft: $35m* CMV of 50% aircraft: $33m*

$33m

Step 4: Allocate the remaining purchase price on a proportional basis (1) The Remaining Purchase Price to be allocated is $1.8m ($38m-$33m-$1.2m-$2m). This is required to be allocated on proportional basis between all assets and liabilities identified. Aircraft: Lease: Maintenance Total

$34.64 (91% ($33m/$36.2m) of $38m) $1.26 (3% ($1.2m/$36.2m) of $38m) $2.10 (6%($2m/$36.2m) of $38m) $38m

Maintenance intangible =$2m ($35m-33m)**

* At 1 January 2015 ** On assumption the aircraft redelivers in 100% physical condition Aircraft

Aircraft: $33m

1.

Lease Intangible: $1.2m

Maintenance Intangible: $2m

$34.64

Lease Intangible

$1.26

Maintenance Intangible

$2.10

2016 KPMG, an Irish partnership and a member firmexample, of the KPMG using network of independent figures. member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in Ireland. There may be© other approaches of allocation, for balancing

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Accounting for intangibles (continued) BASED ON OUR WORKED EXAMPLE: Subsequent Measurement

Lease intangible ■ The lease intangible will be amortised to the Income Statement over the lease term. (US$1.2M OVER 5 YEARS = $20,000 PER MONTH) DR: P&L US$20,000 (PM) CR: Lease intangible US$20,000 (PM)

Maintenance Intangible and amortisation – Some potential options 1. Amortise over life of lease ■ Monthly charge to the P&L if $2.1m will be amortised over the remaining life of lease of 5 years

2. Derecognise at lease end ■ No P&L effect until end of lease. In year 5:

− −

DR P&I Expense US$58,000

−

DR P&L Expense US$2.1m

−

CR: Maintenance intangible asset US$2.1m

CR: Maintenance intangible asset US$58,000

(Cash paying lease).

(Upsy/downsy lease, offset against any upsy payment recorded in income).

3. Hold and capitalise onto the asset ■ No P&L charge ■ If determined maintenance check added value, intangible/portion of intangible may be capitalised. ■ If full maintenance check completed and determined value equals intangible: −

DR: Aircraft US$2.1m

−

CR: Maintenance intangible asset US$2.1m

■ Also need to consider any EOL income / expense as a separate P&L effect.

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Extract from recent 20F’s AerCap

“The maintenance rights intangible asset represents the contractual right under our leases acquired as part of the ILFC Transaction to receive the aircraft in a specified maintenance condition at the end of the lease (EOL contracts) or our right to an aircraft in better maintenance condition due to our obligation to contribute towards the cost of the maintenance events performed by the lessee either through reimbursement of maintenance deposit rents held (MR contracts), or through a lessor contribution to the lessee. For MR contracts, maintenance rights expense is recognized when the lessee submits a reimbursement claim and provides the required documentation related to the cost of a qualifying maintenance event that relates to pre-acquisition usage. For EOL contracts, maintenance rights expense is recognized upon lease termination, to the extent the lease end cash compensation paid to us is less than the maintenance rights intangible asset. Maintenance rights expense is included in leasing expenses in our Consolidated Income Statements. To the extent the lease end cash compensation paid to us is more than the maintenance rights intangible asset, revenue is recognized in lease revenue in our Consolidated Income Statements, upon lease termination.”

Fly Leasing ““The Company now identifies, measures and accounts for maintenance right assets and liabilities associated with its acquisitions of aircraft with in-place leases. A maintenance right asset represents the fair value of the Company's contractual right under a lease to receive an aircraft in an improved maintenance condition as compared to the maintenance condition on the acquisition date. A maintenance right liability represents the Company's obligation to pay the lessee for the difference between the lease end contractual maintenance condition of the aircraft and the actual maintenance condition of the aircraft on the acquisition date. The Company's aircraft are typically subject to triple-net leases pursuant to which the lessee is responsible for maintenance, which is accomplished through one of two types of provisions in the Company's leases: (i) end of lease return conditions (EOL Leases) or (ii) periodic maintenance payments (MR Leases). Maintenance right assets in EOL Leases represent the difference in value between the contractual right to receive an aircraft in an improved maintenance condition as compared to the maintenance condition on the acquisition date. Maintenance right liabilities exist in EOL Leases if, on the acquisition date, the maintenance condition of the aircraft is greater than the contractual return condition in the lease and the Company is required to pay the lessee in cash for the improved maintenance condition. Maintenance right assets, net are recorded as a separate line item on the Company's balance sheet. When the Company has recorded maintenance right assets with respect to EOL Leases, the following accounting scenarios exist: …. When the Company has recorded maintenance right liabilities with respect to EOL Leases, the following accounting scenarios exist:… (i) the aircraft is returned at lease expiry in the contractually specified maintenance condition without any cash payment by the Company to the lessee, the maintenance right liability is relieved and end of lease income is recognized; (ii) the Company pays the lessee cash compensation at lease expiry of less than the value of the maintenance right liability, the maintenance right liability is relieved and any difference is recognized as end of lease income; or (iii) the Company pays the lessee cash compensation at lease expiry in excess of the value of the maintenance right liability, the maintenance right liability is relieved and the excess amount is recorded as an aircraft improvement.” © 2016 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.

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Key valuation considerations

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It’s complicated

www.ibagroup.com

What do you see?

www.ibagroup.com

Let’s take a closer look at that A320 “Maintenance Value” Element A320-200 Maintenance Value - 2016 Constant USD - V2500-A5, 2:1 (W.Europe) Maintenance Value

HL Level

16.00

Maintenance Value US$m

14.00 12.00 10.00 8.00 6.00 4.00 2.00 0.00 0

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www.ibagroup.com

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12 13 14 Age (years)

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Let’s take a closer look at that A320 “Maintenance Value” Element

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A swing of 14mUSD from a run out aircraft and engines versus full life

•

Circa 7mUSD delta from “half life”

•

And that is today - the inflated future cost and value will be a higher delta.

•

Maintenance cost inflation has averaged 3-5% per annum in last 10 years

www.ibagroup.com

What do you see?

•

www.ibagroup.com

A five year old B777-300ER with a CMV in half life condition of 100mUSD?

What do you see?

AIRCRAFT LEASE AGREEMENT Lessor: B777#4 Limited, Dublin Lessee: Good Credit Airlines, The Republic of Good Credit B777-300ER: Serial Number 12345 Registration: FUL-LIFE Term: 12 years Delivered: Jan 2011 Redelivery: Jan 2023 Lease rate: Fixed @ 1.3mUSD pm Delivered Price: 160mUSD Maintenance Reserves: None Redelivery Condition: Full life

www.ibagroup.com

What do you see?

AIRCRAFT LEASE AGREEMENT Lessor: B777#4 Limited, Dublin Lessee: Good Credit Airlines, The Republic of Good Credit B777-300ER: Serial Number 12345 Registration: FUL-LIFE Term: 12 years Delivered: Jan 2011 Redelivery: Jan 2023 Lease rate: Fixed @ 1.3mUSD pm Delivered Price: 160mUSD Maintenance Reserves: None Redelivery Condition: Full life

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Aircraft sold by B777#4 Limited to Newco Leasing in Jan 2016 for 125mUSD

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FMV @ sale - average of appraisers FMV = 105mUSD

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Delta of 20mUSD uses “full life added value” and buyers view on “value of income”

www.ibagroup.com

Illustrative Example……. Appraisal Variances for CMV: $

2011 777 300ER

•

The start price

•

Depreciation

•

Economic life

Then complicated by intangible of •

“Value of RC” • $20m spread using 2016USD •

Value of the full life redelivery condition Cost of task versus value impact

Full life/half life delta

Versus “today’s CMV and Lease rate”

2011

www.ibagroup.com

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Then… rationale for the trade, macro economics, IFE trends and reconfigs

•

Ticking the box might be a false economy

2023

What is the source of the value presented to investors?

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An Appraiser website – generic data dump?

•

More informed assessment using current maintenance data?

•

Detailed assessment considering review of lease?

That’s just one aircraft, throw in 40 planes and: •

X operators

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Y jurisdictions; and

•

Z contracts

Then the picture gets exponentially more complex at portfolio level.

www.ibagroup.com

Tax considerations

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Corporate Tax IssuesTax/Income Tax Legal form v. accounting treatment? Single asset (metal)

Separate assets

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Corporate Tax IssuesTax/Income Tax Metal

Capital allowances claimed on entire purchase price

No tax deduction taken for amortisation of lease intangible or maintenance intangible

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Corporate Tax IssuesTax/Income Tax Separate intangible asset

Capital allowances restricted to that part of purchase price attributable to metal

Is tax deduction available for amortisation of intangibles / is rental income reduced purchase price attributable to intangibles?

Or does the ease intangible or maintenance intangible represent a capital asset on which no capital allowances can be claimed?

© 2016 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.

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Deferred Tax Implications Tax Issues

Treated as single asset (aircraft) for tax purposes

Capital allowances claimed on entire purchase price but assets (metal, lease intangible, maintenance intangible) split in accounts

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Deferred Tax Implications Tax Issues Separate assets for tax purposes

Capital allowances restricted to purchase price attributable to metal

Separate deferred tax calculation for lease intangible and maintenance intangible

Not deductible: Permanent Difference

Deductible: Timing Difference

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Transacti onal Tax Issues Tax Issues

Stamp duties on assignment / novation of lease?

Capital gain on sale? Sales taxes / VAT on assignment / novation of lease?

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Concl on Tax Iussisues Purchase contract for aircraft (only)

No purchase price allocation to lease – change in market conditions impacts value of the aircraft

No purchase price allocation to maintenance right – lessee obligation to pay for maintenance relates to capital expenditure

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Other valuation hot topics

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Other Valuation Hot Topics

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Valuation of new aircraft – differences in appraiser methodology of “newness”

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ABS structures – Appraiser Base Value and Rating Stress Test

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Access to publications and on-line values -

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Reliance on appraisals without appraiser knowing the objective

Dick Forsberg’s “Values and Valuers” report -

Reaction

-

Follow-up

www.ibagroup.com

Other accounting hot topics

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IFRS 16 - What’s the issue? Currently analysts adjust financial statements for off- balance sheet leases Under IFRS 16, lessees will bring these leases on balance sheet, using a common methodology

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Lessees face major changes All major leases on balance sheet

Balance sheet

P&L

Asset

Lease expense

= ‘Right-of-use’ of underlying asset

Depreciation

Liability

+ Interest

= Obligation to make lease payments

= Front-loaded total lease expense

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Commercial & other considerations ■ Buy vs. lease decision? ■ Shorter lease terms? ■ Leases with more variable rentals? Eg PBH ■ Residual Value Guarantees more prevalent? ■ Sale & Lease back more favourable under US-GAAP? ■ FX management? ■ Taxation?

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Forward Order Sales ■ Lessor A enters forward order with OEM for 100 aircraft for delivery in future periods ■ Lessor A negotiates leases with Airline X for 10 of aircraft subject to forward order ■ Lessor A then negotiates the Financial Investor-I to sell them 3 of the aircraft subject to lease to Airline A and to novate lease to them on delivery Accounting considerations:

■ Does the sale of aircraft ( and novation of lease) to financial investor I breach “own use exemption”? ■ If “own use exemption” breached, does aircraft purchase/sole contract meet definition of derivative and require to be fair valued? Need to assess and determine ■ Is the purchase of 100 aircraft from OEM: I. a single transaction to purchase 100 aircraft II. a contract that includes separately identifiable transactions for each of 100 aircraft

■ If (I) sale means that not held for receipt or delivery in accordance with usage requirements, sale has resulted in net settlement → Fail own use and need to fair value entire forward order if meets definition of derivative. ■ If (II) need to apply judgement to assess if “past practice” of net settling – any sales outside of 10 with leases may/may not conclude breach of own use Compare/contrast derivative definition with aircraft sale/purchase contract ■ Value change in response to change in underlying ■ No initial net investment ■ Settled at a future date

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Future sessions Impairment testing Depreciation – UELS and RVs PPN’s/cash-sweep instruments Other suggestions welcomed!?

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Contacts Ian Nelson Partner, Financial Services KPMG t: +353 1 410 1989 e: [email protected]

Gareth Bryan Partner, Tax KPMG t: +353 1 410 2434 e: [email protected]

Phil Seymour President and CEO International Bureau of Aviation t: +44 1372 224 481 e: [email protected]

© 2016 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.

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