Airlines have long been known to lease rather than buy a significant chunk of their planes. But a 2016 rule by the Financial Accounting Standards Board (FASB) made it advantageous for air carriers to switch from leasing to buying their vehicles, with consequences for their idle capacity, flying routes and, potentially, for the wear and tear of their fleet.
Normally, accounting standards provide information about the company to investors, said Mohan Venkatachalam, a R.J. Reynolds Professor of Accounting at Duke University’s Fuqua School of Business. “They should not change how firms do business,” he said. “But surprisingly, for public airlines, we found that’s what happened.”
In the paper, “Leasing Loses Altitude While Ownership Takes Off: Real Effects of the New Lease Standard,” published in The Accounting Review, Venkatachalam and Bin Li of Vanderbilt University (a Fuqua Ph.D.) examined the effects of ASC 842, a rule that updated how companies should record their "operating leases" on their financial reports.
The researchers found that the new rule deeply affected airlines’ operational strategy, leading them to prioritize different sizes of aircraft and to fly shorter routes, the kinds of operational decisions that impact — among other things — the aging of the fleet and its maintenance requirements.
Why companies were incentivized to rent
Before the 2016 rule, public companies used to benefit from classifying equipment, vehicles, or buildings they rented as “operating lease,” Venkatachalam said.
When companies rented equipment for long-term use, they had — in theory — to record such equipment as “assets,” matched by an equal value in the “liabilities” section of the balance sheet. “In the case of an individual, think about the mortgage you have to repay for the house,” Venkatachalam said. “You have an asset, the house, but you also have a liability, the mortgage, which makes you look more indebted.”
Publicly traded companies didn’t like to show higher leverage, he said. Moreover, the increase in the asset column would also impact companies’ “Return on Assets” (ROA) metric, an important indicator of their profitability. “If you have more assets in your balance sheets, the denominator goes up, which means your ROA goes down,” Venkatachalam said.
Since they weren’t actually purchasing the equipment, companies found that by reporting their rentals as “operating leases” — as if the rentals were temporary, not long term — they could avoid recording them as assets and liabilities, practically hiding them off the balance sheet. This way, they would only add their rental costs as expenses — for example, the yearly rental cost of a plane, or a warehouse.
“They basically created a lease arrangement for 30, 40, 50 years, and called it an operating lease, which means you have no assets on the balance sheet,” Venkatachalam said. “They weren’t doing anything wrong. They were following the rules, but they were defeating the intent behind the accounting standard.”
How airline companies changed strategies after the rule change
The Financial Accounting Standards Board is an independent organization with the authority to set the accounting and financial reporting standards in the United States. In 2016, after many years of debates and conversations with stakeholders, the FASB introduced a new rule meant to stop their perceived abuse on operating leases, and bring those leases back in the balance sheets.
“It basically removed the incentives for managers to use the classification for operating leases for financial reporting benefits,” Venkatachalam said.
The researchers suspected the shift would affect the companies’ strategic composition of assets and, in the end, “the way they run their business,” Venkatachalam said.
The researchers tested their hypothesis on the airline industry, where information is readily available because the U.S. Department of Transportation mandates reporting on financial and operating disclosures.
“It is also an industry where firms lease a lot,” Venkatachalam said, pointing to the fact that in 2015, about 40% of the aircrafts worldwide were leased.
They found that after rule ASC 842, companies not only substituted leases with purchases, they also strategically switched to the higher-demand, shorter routes — and consequently focused their purchases on mid-size aircraft to best fit the shorter range.
“Domestic flights have the biggest market with numerous flying routes,” Venkatachalam said.
When companies buy an aircraft, he explained, they lose the flexibility afforded by leasing to adapt to variable demand. This means that they are less able to fill up all their seats in each flight and will have “excess capacity,” he said.
In these circumstances, shorter routes ensure more usage of the aircraft, Venkatachalam said. “We found that the flying distances went down by 140 miles per departure, on average,” he said.
And the midsize carriers which are the best fit for the shorter routes — including models such as the Boeing 737 and the Airbus A319 — have the added benefit of being the most liquid planes in the market, he said, because they are in high demand. “If I am stuck with a plane, I’d rather buy one that I can sell more easily,” he said.
Implications of the new leasing rule for the airline business
Despite the strategic adjustments put in place by airlines, the researchers found that the reduced operational flexibility post-rule “translated to four to five additional empty seats per flight for a medium-weight aircraft.”
“Imagine the average number of seats in a medium sized aircraft is about 200. Four to five lost seats are a lot of lost revenue,” he said. “We're talking about an average of $250 — it's like $1200 per flight. And imagine for a short flight between New York and Boston, with maybe eight flights back and forth each day. Multiply that by 360 days and it's several million dollars in lost revenue.”
Another implication of the shorter-route strategy is the potentially higher level of wear and tear of the fleet, the researchers noted.
“If you're going to land every three hours, your tires will go bad sooner,” Venkatachalam said, “whereas if you're going long distances, you are landing once a day at the most. So obviously more wear and tear means you have more maintenance, more replacements.”
The researchers also found that by switching to purchasing, the average age of the planes increases, as companies hold on to the purchased aircraft for longer.
Accounting rules do matter
These results impacted public airlines, not private ones, Venkatachalam said. Publicly traded companies have to disclose their financial statements, which are the major source of information for the shareholders, he said. “If all of a sudden you have more assets and liabilities in your balance sheet, all the investors will be asking, ‘What happened?’” he said.
Managers of public companies had more to lose with the new accounting standard, Venkatachalam said, and they changed their business strategy.
“The conventional wisdom is that companies make business decisions that they think are right for their business. Accounting should simply reflect what the firms do,” he said. “What’s happening instead is that companies are changing how they do business based on accounting. Financial reporting matters, not only for investors, but also for managers.”