Impact of MFRS 16 on AirAsia Group Bhd

Disclaimer: The content in this blog post contains my own opinion and it should not be relied upon for making any decisions.

Recently, while I was browsing Facebook, I saw this news by The Borneo Post Online in Facebook:

AirAsia Group Bhd slipped into the red with a net loss of RM303.72 million for the financial year ended Dec 31, 2019 (FY19) compared with a net profit of RM1.97 billion in the preceding year.
Posted by Borneo Post Online on Thursday, February 27, 2020

According to the news, the reasons for AirAsia Group Bhd to suffer net loss in the financial year 2019 were partly due to the following:

"The weaker bottom-line, despite a 17 per cent jump in revenue to RM12.45 billion, was partly attributed to accounting treatment of the restructured aircraft ownership, moving from owning to leasing aircraft, despite recording similar cash outflow in either financing method, the low-cost airline said."

"According to the company, the adoption of Malaysian Financial Reporting Standard (MFRS) 16 reduced its net operating profit by RM130.9 million while the MFRS 137 accounting treatment led to a 43 per cent jump in maintenance and overhaul costs."

"The airline’s bottom-line was partly weighed down by a depreciation of right-of-use assets of RM1.76 billion and finance costs (lease liabilities) of RM505.87 million following the adoption of MFRS 16."

I thought it will be interesting to analyse the accounting treatments in this news as it will be relevant to ACCA students (especially SBR students as it will be good for you to apply what you learnt in the class to the actual business world). Hence, I write this post which contains my opinion on the impact of the above accounting treatments.

IFRS 16 Treatment

According to IFRS 16 Leases, when an entity leases an asset, the entity is required to recognise a right-of-use asset and a lease liability.

Generally, the right-of-use asset will be depreciated whereas finance cost will be recognised on lease liability.

This is in contrast with the previous IAS 17 Leases where an entity may have finance lease and operating lease. The accounting treatment of finance lease is similar to the current IFRS 16 treatment (hence there isn't much impact for finance lease under IFRS 16). However, for operating lease, the treatment was to expense off the lease payment in Statement of Profit or Loss (SOPL).

Refer to the table below for a comparison between IAS 17's operating lease and IFRS 16's treatment:

	IAS 17 Operating Lease	IFRS 16
Expenses	Lease payment  (rental paid)	Depreciation of right-of-use asset Finance cost on lease liability
Asset	None	Right-of-use asset
Liability	None	Lease liability

As we can see from the above, under IFRS 16, the entity may have potentially more expenses as well as having a higher asset and liability figure.

Let's have a look at AirAsia's recent fourth quarter report ended 31 December 2019 (the relevant results are summarised in the table below):

	Cumulative
	Year Ended 31/12/2019 RM’000	Year Ended 31/12/2018 RM’000
Aircraft operating lease expenses	-	(1,155,680)
Depreciation of right of use asset	(1,762,663)	-
Finance costs - lease liabilities	(505,873)	-
Total expenses related to IFRS 16 / IAS 17	(2,268,536)	(1,155,680)

As we can see from the above, there have been around 96% increase in the expenses once IFRS 16 is adopted.

Whereas for the increase in right-of-use asset and lease liability:

	As At 31/12/2019 RM’000	As At 31/12/2018 RM’000
Right of use assets	12,219,457	-
Lease liabilities – current liabilities	2,104,702	-
Lease liabilities – non-current liabilities	10,156,869

A full 100% increase. 

However, it should be noted that AirAsia Group Bhd did not apply full retrospective adjustment under IAS 8. It was mentioned in the notes to the unaudited financial statements that:

"On the date of initial application (of MFRS 16), the Group applied the simplified transition approach and did not restate comparative amounts for the period prior to first adoption."

In any case, with the increase in right-of-use assets (i.e. increase in capital employed), the return on capital employed (ROCE) of the company will definitely be impacted (i.e. reduced).

Not only that, the lease liabilities will also increase the gearing ratio of the company.

As such, we can now see that IFRS 16 might cause some impact on the financial statements which might be perceived as negative as investors (despite the fact that all these are just accounting adjustments).

Restructured Aircraft Ownership

Next, we shall explore the issue on the restructuring in the aircraft ownership of AirAsia Group Bhd. In the news, it was mentioned that the company was "moving from owning to leasing aircraft".

To understand this, it is necessary for us to understand what was happening to AirAsia Group Bhd in the year 2019. Let's look at one news on AirAsia in year 2019:

The company plans to fully shift to the new model by completely withdrawing from aircraft ownership.
Posted by The Star on Sunday, June 2, 2019

In short, AirAsia Group Bhd had decided to went into sales and leaseback agreements.

Image from IFRS Box.

Note: I have written the accounting treatment of sales and leaseback agreement previously. You can read more at the link below if you are interested to know more:

1. https://tysonspeaks.blogspot.com/2019/08/ifrs-16-sales-and-leaseback-part-1.html
2. https://tysonspeaks.blogspot.com/2019/08/ifrs-16-sales-and-leaseback-part-2.html

Borneo Post had mentioned that "MFRS 137 accounting treatment led to a 43 per cent jump in maintenance and overhaul costs". MFRS 137 is similar to IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

If you look into AirAsia's recent fourth quarter report ended 31 December 2019, you will realise the following:

	Cumulative
	Year Ended 31/12/2019 RM’000	Year Ended 31/12/2018 RM’000
Maintenance and overhaul	(1,320,820)	(938,369)

An increase of around 41% in expense, which is similar to what was being reported in Borneo Post.

In relation to the provision balance we see that provision balance has also increased, as shown below:

	As At 31/12/2019 RM’000	As at 31/12/2018 RM’000
Aircraft maintenance provisions / payables
-          Current liabilities	1,861,748	878,941
-          Non-current liabilities	3,547,776	4,049,068
Total	5,409,524	4,928,009

According to the notes to the unaudited financial statements, it is mentioned that:

"Aircraft maintenance provision/ payables relates to maintenance costs that needs to be incurred for maintaining the aircraft as long as it is currently still in use and on the return of lease aircraft."

It seems like the Borneo Post's news is implying that maintenance and overhaul expenses had increased because of the sales and leaseback transactions which happened during the year 2019 and the increase is due to requirement in MFRS 137 (or IAS 37).

Hence the question - why is it that when a company start to lease asset, they may need to recognise more expenses as well as more provision?

Well, here is my opinion on the possible reason (Note: this is only my own opinion and guess as I do not have the details of the sales and leaseback agreement).

Owning Aircraft

Look at the beautiful sky!

If an airline company owns aircraft, the aircraft is accounted for under IAS 16 Property, Plant and Equipment (PPE). In relation to the repair and maintenance cost of the aircraft, it is stated in IAS 16, paragraph 14 that:

"A condition of continuing to operate an item of property, plant and equipment (for example, an aircraft) may be performing regular major inspections for faults regardless of whether parts of the item are replaced. When each major inspection is performed, its cost is recognised in the carrying amount of the item of property, plant and equipment as a replacement if the recognition criteria are satisfied. Any remaining carrying amount of the cost of the previous inspection (as distinct from physical parts) is derecognised."

In short, major inspection (or overhaul) of aircraft is recognised as part of the PPE and the previous carrying amount of the inspection or overhaul will be derecognised.

Apart from that, under IAS 37, paragraph 14, it is mentioned that provision shall be recognised when:

(a) an entity has a present obligation (legal or constructive) as a result of a past event;
(b) it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and
(c) a reliable estimate can be made of the amount of the obligation.

As such, if an airline company owns aircraft, they may not be able to recognise provision on future maintenance or overhaul due to the reason that they may not be having present obligation as a result of past event to conduct the repair (unless they can demonstrate otherwise).

Instead, a major overhaul will be capitalised as PPE and minor repair will be expensed off as and when it occurs. Provision is generally not recognised for future repair or overhaul if the entity owns the aircraft.

Leasing Aircraft

If an aircraft is leased, there is a contract in place. The contract may stipulate that the airline has to conduct regular maintenance and overhaul on the leased aircraft. This means that the airline company will have a present obligation (i.e. legal obligation) under the lease contract to perform the regular maintenance and overhaul.

As such, if wear and tear occurs to the aircraft (i.e. past event has occurred), the entity is obliged to perform the maintenance and overhaul under the lease contract. Thus, provision needs to be recognised when the wear and tear occurs.

Note: It is important to know that a provision can only be created if it results from a past event. If there is no wear and tear, provision cannot be recognised. In other words, provision can only be created if there is a "present obligation" (i.e. the lease contract which gives rise to legal obligation) and a "past event" has occurred (known as obligating event, i.e. the wear and tear event which makes the company to be obliged to pay for the repair cost).

Hence, if a company moves from owning aircraft to leasing aircraft, it is possible for more provision to be recognised. This could explain the reason for the increase in maintenance and overhaul cost of AirAsia Group Bhd.

Conclusion

As we can see from the above, new accounting standard (i.e. IFRS 16) can impact financial statements in several ways and it is important for us to understand these impacts so as to be able to explain these impacts to the users of financial statements.

We can also see that a change in the ways of conducting business will have some accounting impacts. For AirAsia Group Bhd, sales and leaseback of aircraft might be a good way to raise finance, but it may result in lower profitability due to increase in provision as well as increase in expenses related to IFRS 16.

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