Alaska Air Group, Inc. Accounting for the Costs of Returning Leased Aircraft

Transcription

1 Alaska Air Group, Inc. Accounting for the Costs of Returning Leased Aircraft Note: During the second quarter of 2002, Alaska Air Group revised its accounting practices relating to accruals for the costs of returning leased aircraft, and restated its prior period results to reflect this change. This change and its effects were described in our earnings release for the quarter ended June 30, 2002, which was issued on July 22, This document is intended to provide additional information on our accounting for these costs. Please note that this discussion only relates to the timing of when these costs are recognized as expenses in our financial statements; it does not relate to the nature or amount of work that is done to prepare aircraft for return to lessors, or to the cash payments that Alaska makes upon lease return. Also, this document relates to Alaska Airlines specifically. Horizon Air has a similar situation, although there are some minor variances due to differences in its maintenance program, which do not materially affect the discussion below. Background Alaska Airlines leases approximately half of its fleet under relatively long-term operating lease agreements. These aircraft are subject to periodic engine, airframe and other component overhauls based on our maintenance program. Depending on the aircraft type, airframe overhauls are known as D-checks, Structural Inspections (SIs), Heavy Visit (HVs), 15,000-hour checks (15Ks), or 30,000-hour checks (30Ks). Also, depending on the aircraft type, these checks have lives ranging from five to nine years. Engine overhauls have lives ranging from 5 to 10 years, depending on the engine type and the nature of the work done during the overhaul. Our long-standing policy has been to capitalize heavy airframe and engine overhauls, and amortize these costs over the expected lives of the overhauls. This is our practice regardless of whether the airplane is owned or leased. This practice means that the cost of an overhaul is put on our balance sheet as an asset, and then charged to the profit and loss statement in increments over the expected life of the overhaul. Many of our lease agreements contain provisions which require that, if certain minimum times remaining until the next airframe or engine overhaul are not met at the end of the lease, Alaska make a cash payment to the lessor. Many of these agreements are two-way pay arrangements; that is, the lessor reimburses Alaska if an airplane is returned with more than the stipulated time remaining until the next overhaul. So, at the inception of a lease, we know that we have a commitment to return the aircraft to the lessor with a stipulated number of days, hours or cycles remaining to next 1

2 overhaul. Typically, we can satisfy this commitment with either actual time remaining to the next overhaul, or, if the actual time remaining is less than the requirement, an equivalent cash payment. Often, we satisfy these requirements with some combination of the two. Also, if we do not have a two-way pay arrangement and we are therefore not reimbursed for time remaining to the next overhaul in excess of that required by the lease, we normally have an additional asset on our books at lease return. While we know our overall commitment to return the aircraft with a certain amount of time remaining until the next overhaul, we usually don t know the balance of actual time that will be remaining to the next overhaul versus the cash that will be paid to the lessor. Some of the reasons it s difficult to know this split are a) leases are typically long-term in nature and often span three or more overhauls, b) our aircraft utilization varies, c) engines get swapped between aircraft, d) our maintenance programs and intervals change periodically, and e) we often extend leases at the end of their original term. Issue The issue that this document addresses is how these lease return requirements are reflected in our financial statements. Under both our former method and our revised method, the total amount of costs are identical; the only difference is the timing of when these costs are reported. Timing is relevant because the costs can be significant. Major checks are often in the range of $800,000 to $2,000,000. Historical Accounting Methodology As we ve already discussed, we have historically capitalized the cost of major overhauls and amortized these costs over their expected lives in our financial statements. In addition, for leased aircraft, we have accrued for our costs of returning the aircraft on a straight-line basis over the life of a lease. For example, if we have a requirement to return an aircraft with a fresh Structural Inspection (SI) check or compensate the lessor for any shortfall, we know that we have an obligation at return equal to the cost of one SI check, which we can assume for this example is $1.2 million. Historically, we would have accrued for this $1.2 million cost on a pro rata basis over the life of the lease, so if the lease term is 17 years, we would have accrued $70,588 per year ($1.2 million divided by 17). As discussed above, depending on the time remaining until the next overhaul at return, this liability may be used to cover the cost of writing off any remaining net book value of the overhaul, cash payments to lessors, or some combination of the two. 2

3 A more complete example may help illustrate the point. Assumptions Lease term: Airframe SI-check/overhaul interval: Cost of SI-check/overhaul: Lease return conditions: 17 years 5 years $1.2 million Full SI check/overhaul at return, or cash settlement for any shortfall With these assumptions, our expenses related to airframe overhauls and to the return of the aircraft would be as follows over the term of the lease: Annual Overhaul and Lease Return Provision Expense - Old Method $700 $600 Total expense over life of lease is $4,080,000. Thousands $500 $400 $300 First SI Check is performed. Amortization expense is $1.2 million cost divided by 5 years. Second SI Check is performed Third SI Check is performed $200 $240 $240 $240 $240 $240 $240 $240 $240 $240 $240 $ $100 $0 $71 $71 $71 $71 $71 $71 $71 $71 $71 $71 $71 $71 $71 $71 $71 $ Year Lease Return Provision Overhaul Amortization Expense The total of the lease return provisions at the end of the lease term is $1.2 million ($70,588 x 17). There is an unamortized overhaul on the books of $720,000 which represents the remaining value of the overhaul which is for the benefit of the lessor ($1.2 million original cost at beginning of year 16 less two years amortization at $240,000 per year) and the lessor is owed $480,000 of cash (two years time used at $240,000 per year). 3

4 The $1.2 million lease return provision covers the $720,000 of unamortized overhaul, which must be written off, and the $480,000 payment to the lessor. As a result, there is no charge to earnings at the time of the return, and no acceleration of costs toward the end of the lease term. New Accounting Methodology Under our new method, capitalized overhauls will be written off over the shorter of the life of the overhaul or the remaining lease term. It is important to note that this will be the case even when it results in an obligation that is predictable well in advance being amortized over what might be a short period between the overhaul and the lease return. From a financial statement reader s perspective, the main difference in this methodology is that expenses will be lower in the early part of a lease and higher in the later part of a lease, and, for our portfolio of leased aircraft, more variable over time. Using the same assumptions as above, the following is our estimate of how our costs related to overhauls and to the return of the aircraft will be reported under the new method. Note that we are making one additional change under the new method; that is, we are accruing for the cash payments expected to be made to lessors over the last five years of the lease in this example, versus over the entire lease term. This is because we can t accurately predict cash payments (by themselves) at the inception of a lease, so we won t begin accruing them until the calculation is more certain. Annual Overhaul and Lease Return Provision Expense - New Method $700 $600 Total expense over life of lease is $4,080,000. Third SI Check is Performed. Because there is only 2 years remaining to return, amortization expense is $1.2 million cost divided by 2 years. $500 Thousands $400 $300 First SI Check is performed. Amortization expense is $1.2 million cost divided by 5 years. Second SI Check is performed $600 $600 $200 $240 $240 $240 $100 $0 $240 $240 $240 $240 $240 $240 $240 $96 $96 $96 $96 $ Year Lease Return Provision Overhaul Amortization Expense

5 As in the first example, the remaining value of the overhaul (which is really for the benefit of the lessor) is $720,000 at the termination of the lease. But because of the more rapid amortization period, there is no unamortized overhaul amount on our books at lease return. The lease return provision only needs to cover the cash payments to the lessor of $480,000 ($1.2 million minus $720,000 of value provided to the lessor). The $480,000 accrual is recorded in years 13 through 17 ($96,000 x 5). As you can see, total costs are the same in both scenarios, but are spread more evenly over the life of an airplane with the former method, and are more weighted toward the end of an airplane s life with the new method. Note that this comparison would be even more significant if an airplane was overhauled shortly before its return, and less significant if an airplane was returned with a longer gap between its last overhaul and its lease return. Summary Lease return accounting is an area where we have historically felt that generally accepted accounting principles do not provide specific guidance, and to the extent that guidance does exist, we have felt that it supported our historical accounting treatment. Also, we have believed that our historical method served readers of the financial statements by systematically allocating the costs of operating our aircraft to the years in which the aircraft helped us produce revenues. However, based on discussions with our new independent accounting firm and after much deliberation, we have adopted the new methodology above on a prospective and retroactive basis, which is in accordance with generally accepted accounting principles. Our historical disclosures in our 10-Ks and in the footnotes to our financial statements have described our previous accounting policy in this area. We will be changing these disclosures to help readers understand the effect of this change, for their use in evaluating our financial statements. As we stated at the outset, this change has no effect on how we do maintenance, when we pay for maintenance, or how much we pay for maintenance. That is, it has no effect on the economics of our underlying business. It only affects the timing of when the costs will be recognized as expense in our financial statements. One final note: The American Institute of Certified Public Accountants currently has a project on its agenda that could result in overhaul costs for businesses in many industries being charged directly to expense at the time the overhaul is performed. We will provide guidance on this project, and how it might affect us, as we know more. 5

6 Forward-Looking Information This report may contain forward-looking statements that are based on the best information currently available to management. These forward-looking statements are intended to be subject to the safe harbor protection provided by Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of Forwardlooking statements are indicated by phrases such as will, should, the Company believes, we expect or any other language indicating a prediction of future events. There can be no assurance that actual developments will be those anticipated by the Company. Actual results could differ materially from those projected as a result of a number of factors, some of which the Company cannot predict or control. For a discussion of these factors, please see Item 1 of the Company s Annual Report on Form 10-K for the year ended December 31, Alaska Air Group Finance Team July 22,