Impairment from a lessor’s perspective

Welcome to the Aviation Thought Leadership Series, a series which has been designed to give you an in-depth look into topics within the Aviation sector. In this edition Rachel Horgan, a director in KPMG’s Aviation practice, sets out the key considerations in relation to impairment, and how KPMG can help in supporting clients.

From a lessor’s perspective a key focus of their annual financial reporting cycle will be their impairment assessment which accounting standards require you to complete at the end of each reporting period (for the asset, or CGU, when there is an indication of possible impairment, i.e. a triggering event, and annually for CGUs to which goodwill has been allocated, regardless of whether there is a triggering event) to ensure that the carrying amount of your aircraft (or CGU containing the aircraft) is not overstated.

The recoverable amount of an aircraft is the higher of the aircraft's fair value less costs of disposal and its value in use. An asset is impaired when its carrying amount exceeds its recoverable amount.

General market overview

Interest rates and lease rates

Rising interest rates in recent years mean that the cost of borrowing is clearly higher than it has been over the last fifteen years when interest rates were held low following the global financial crisis.

This combined with the shortage of aircraft means that aircraft lease rates have risen substantially over the past 12 months. New aircraft lease rates for the A320-200N and B737 Max 8 for example were below USD300,000 a month in January 2022 but are now around USD400,000.

As a result of tight supply, lease extensions, current engine issues and lack of new aircraft deliveries both the narrowbody and widebody market have seen aircraft values increase over the last 12 months.

Key considerations for lessors’ impairment assessment

Fair value less cost of disposal

In determining the fair value less costs of disposal for the purposes of the impairment test, lessors should ensure that the current maintenance condition of the aircraft is factored in, including all related intangibles.

Management may determine the fair value of an aircraft by engaging independent aircraft appraisers to provide a maintenance adjusted current market value. By obtaining a number of appraiser values management are provided with a range of values for the asset.

Management is responsible for assessing the reasonableness of the maintenance adjusted values provided by the appraiser and ensuring that the information provided to the appraiser is complete and accurate.

Alternatively, management may obtain appraiser half-life market values and determine the maintenance adjustment internally; there is a significant level of judgement in determining the maintenance adjustment to a half-life market value and management need to ensure they have the appropriate level of expertise in house.

For aircraft that have a fair value greater than the carrying amount of the aircraft, there is no requirement to complete a value in use assessment.

Value in use

IFRS requires lessors to use a pre-tax discount rate for the value in use calculation. This is the return that investors would require if they were to choose an investment that would generate cash flows of amounts, timing and risk profile equivalent to those that the entity expects to derive from the aircraft.

The discount rate used to measure an aircraft's value in use should not reflect risks for which the future cash flow estimates have been adjusted. Otherwise, the effect of some assumptions will be double-counted.

From a lessor’s perspective as there may not be an asset specific rate directly available in the market, and so a starting point in estimating the aircraft’s discount rate could be the entity’s weighted average cost of capital using for example the Capital Asset Pricing Model. Other factors to take into account are the entity’s incremental borrowing rate and other market borrowing rates.

The discount rate should then be adjusted to reflect the way that the market would assess the specific risks associated with the aircraft’s estimated cashflows, this should exclude risks that are not relevant to the aircraft's estimated cash flows or for which the estimated cash flows have already been adjusted.

Another key factor for lessors to consider in their value in use calculation is the contracted return condition of the aircraft on its current lease. There are several key judgements and estimates management are required to make in relation to forecasting utilisation of the aircraft, the timing of future maintenance events, and the costs of those events including the expected impact of inflation. This is applicable to both maintenance paying lessees and end of lease payers.

Where a lessor is assuming a sale at the end of the current contracted lease, the forecasted maintenance condition of the aircraft must be factored into the estimated sales price. In addition, lessors must also consider the impact of lease modifications and amendments on future cashflows. The maintenance condition of an aircraft can have a significant impact on the value.

For lessors that are assuming follow on leases from their current contracted lease, this can be more difficult to estimate given the inherent uncertainty particularly in determining the expected utilisation of the aircraft.

A starting point for lessors in estimating the assumed future utilisation for follow on leases may be historical averages for the aircraft or the aircraft type.

Key disclosure requirements in the financial statements

Given the significance of impairment to the overall financial statements of a Lessor, it is important that disclosures are included in the financial statements to explain the judgements in relation to the approach taken. The disclosures will include:

The recoverable amount of the asset and whether the recoverable amount of the asset is its fair value less costs of disposal or its value in use.
The assumptions made in a value in use calculation will likely be Level 3, this requires the lessor to disclose a description of the valuation technique used to measure the value in use. If there has been a change in valuation technique, the entity shall disclose that change and the reason(s) for making it.
IFRS requires a sensitivity analysis on material estimates used in the impairment assessment to assist the user in understanding the effect of the key VIU assumptions made in the impairment assessment. Key assumptions include, but are not limited to, the discount rate used in the value in use calculation. Sensitivity analysis shows the user a range of possible outcomes given the inherent uncertainty in developing estimates.
Each key assumption on which management has based its determination of fair value less costs of disposal. The key assumptions are those to which the recoverable amount is most sensitive.

Differences under US GAAP

When comparing impairment charges for aircraft lessors reporting under IFRS and US GAAP, there are several differences in the impairment methodologies. The below summarises the approach applied under US GAAP.

The key difference from a lessor perspective under US GAAP is that an impairment loss calculation is triggered for long-lived assets only if the assets, or asset groups, carrying amount exceeds its recoverable amount. The recoverable amount under US GAAP is the sum of the undiscounted cash flows that are expected to result from the use and eventual disposition of the asset or asset group.
Unlike IFRS Accounting Standards, if the carrying amount is not recoverable and if the undiscounted recoverability test is failed, then the cash flows used to measure the fair value and calculate the amount of the impairment loss are discounted using a market participant discount rate. US GAAP specifies that cash flows should be projected for the remaining useful life of the primary asset of the group – i.e. it does not limit the period for which cash flow forecasts may be used. The concept of ‘value in use’ is not used in US GAAP.

Under IFRS, the discount rate is based on a market-related rate that reflects the current market assessment of risks specific to the asset at the current date & an entity typically estimates an appropriate rate using the WACC formula as a starting point and may adjust the WACC to develop a market participant discount rate.

Under US GAAP, the market participant rate is applied. Under US GAAP, in determining the fair value of an asset, the costs to sell are not included in determining whether assets held for use are impaired. Unlike IFRS Accounting Standards, reversals of impairments are prohibited under US GAAP.

For lessors who report under US GAAP the likelihood of having an impairment charge is lower under US GAAP due to the above undiscounted cashflow assessment.

How KPMG can help

Completing an impairment assessment is a key focus area in the financial reporting cycle. KPMG can assist lessors in navigating the challenges associated with completing an impairment assessment.

KPMG has a specialist aviation team who can assist lessors in completing their impairment assessment. KPMG can assist with providing accounting advisory services on key judgements and assumptions used within an impairment assessment along with the requirements under the accounting standards including relevant disclosures.

In addition, KPMG’s Aviation team can provide a broad range of services including audit and assurance services, transaction services, corporate finance services, ESG, management consulting and risk consulting services and tax advisory services.

Contact our team below today and we will work with you to deliver a comprehensive solution. We would be delighted to hear from you.