Harvard Case - Accounting for Leases at American Airlines (A)
"Accounting for Leases at American Airlines (A)" Harvard business case study is written by Jonas Heese, Gerardo Perez Cavazos, Julia Kelley. It deals with the challenges in the field of Accounting. The case study is 23 page(s) long and it was first published on : Jun 2, 2020
At Fern Fort University, we recommend American Airlines adopt the new lease accounting standards (ASC 842 and IFRS 16) and implement a comprehensive strategy to manage the transition. This involves a multi-faceted approach encompassing accounting, financial reporting, asset management, and operational efficiency.
2. Background
American Airlines, a major U.S. airline, faced a significant challenge with the implementation of new lease accounting standards. These standards, ASC 842 in the United States and IFRS 16 internationally, required companies to recognize leases on their balance sheets, impacting key financial metrics like debt, equity, and profitability. The case study highlights the complexities of this transition, particularly the need for robust accounting procedures, financial analysis, and asset management strategies.
The main protagonists in the case are the accounting team at American Airlines, tasked with navigating the new regulations and their implications on financial reporting. The case study also touches upon the role of the board of directors and senior management in overseeing the implementation process.
3. Analysis of the Case Study
The case study can be analyzed through the lens of several frameworks:
- Financial Accounting Framework: The core issue revolves around the impact of the new lease accounting standards on American Airlines' financial statements. The company needed to understand how the recognition of leases on the balance sheet would affect its debt-to-equity ratio, leverage, and overall financial position. This required a comprehensive analysis of the company's lease portfolio, including the identification of all leases, their terms, and their impact on future cash flows.
- Asset Management Framework: The new standards necessitate a shift in how American Airlines manages its leased assets. The company needs to develop a robust asset management system that tracks the location, condition, and maintenance of leased assets. This ensures compliance with the new standards and enables efficient asset utilization.
- Change Management Framework: Implementing new accounting standards requires significant change management. American Airlines needs to communicate the changes effectively to all stakeholders, including employees, investors, and regulators. This involves training employees on the new procedures, updating internal controls, and ensuring a smooth transition to the new system.
4. Recommendations
American Airlines should implement the following recommendations to effectively manage the transition to the new lease accounting standards:
- Develop a Comprehensive Accounting Strategy: The company should develop a comprehensive accounting strategy that aligns with the new standards. This involves:
- Identifying and classifying all leases: This includes reviewing all existing leases and identifying any potential leases that may not be classified as such under the new standards.
- Developing a system for tracking lease information: This system should include key details like lease term, rental payments, and any related options.
- Implementing new accounting procedures: This includes updating accounting policies and procedures to reflect the new standards.
- Conduct a Thorough Financial Analysis: American Airlines should conduct a thorough financial analysis to assess the impact of the new standards on its financial statements. This includes:
- Estimating the impact on key financial metrics: This includes assessing the impact on debt-to-equity ratio, leverage, and profitability.
- Analyzing the impact on cash flows: This involves understanding the impact of the new standards on future cash flows, including lease payments and related expenses.
- Assessing the impact on financial reporting: This involves evaluating the potential impact on the company's financial statements and disclosures.
- Implement a Robust Asset Management System: American Airlines should implement a robust asset management system to effectively manage its leased assets. This includes:
- Tracking the location, condition, and maintenance of leased assets: This ensures compliance with the new standards and enables efficient asset utilization.
- Developing a system for managing lease expirations: This includes ensuring timely renewal or termination of leases, minimizing potential disruptions to operations.
- Implementing a system for tracking lease payments: This ensures timely payment of lease obligations and avoids potential penalties or disruptions.
- Engage in Effective Change Management: American Airlines should engage in effective change management to ensure a smooth transition to the new standards. This involves:
- Communicating the changes effectively to all stakeholders: This includes employees, investors, and regulators.
- Training employees on the new procedures: This ensures a clear understanding of the new standards and their impact on daily operations.
- Updating internal controls: This ensures compliance with the new standards and mitigates potential risks.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core competencies and consistency with mission: The recommendations align with American Airlines' core competencies in asset management and financial reporting. They also ensure compliance with the new standards, which is crucial for maintaining the company's reputation and investor confidence.
- External customers and internal clients: The recommendations consider the needs of external customers, such as investors, and internal clients, such as the accounting team. They aim to provide accurate and transparent financial reporting, which is essential for both groups.
- Competitors: The recommendations consider the competitive landscape and ensure that American Airlines remains competitive in the industry. By adopting the new standards, the company can maintain its financial stability and attract investors.
- Attractiveness ' quantitative measures if applicable (e.g., NPV, ROI, break-even, payback): While the specific quantitative measures are not provided in the case study, the recommendations aim to maximize the company's financial performance by minimizing the potential negative impact of the new standards.
- Assumptions: The recommendations assume that American Airlines has the resources and expertise to implement the necessary changes. They also assume that the company is committed to complying with the new standards and maintaining its financial stability.
6. Conclusion
Adopting the new lease accounting standards presents a significant challenge for American Airlines, but it also presents an opportunity to improve its financial reporting and asset management practices. By implementing the recommendations outlined above, the company can navigate this transition effectively, maintain its financial stability, and enhance its overall performance.
7. Discussion
Other alternatives not selected include:
- Delaying the implementation of the new standards: This would create uncertainty for investors and could lead to potential penalties from regulators.
- Outsouring the accounting and asset management functions: While this could reduce the workload on the internal team, it could also lead to a loss of control over the company's financial reporting and asset management.
The key assumptions of the recommendations include:
- American Airlines has the resources and expertise to implement the necessary changes: This assumption is crucial, as the implementation process will require significant time, effort, and resources.
- The company is committed to complying with the new standards and maintaining its financial stability: This assumption is essential for ensuring the success of the implementation process.
8. Next Steps
The next steps in implementing the recommendations include:
- Develop a detailed implementation plan: This plan should outline the specific steps, timelines, and resources required for each recommendation.
- Assign responsibility for each task: This ensures accountability and facilitates efficient implementation.
- Communicate the changes to all stakeholders: This ensures transparency and builds trust with investors, employees, and regulators.
- Monitor the implementation process and make adjustments as needed: This ensures that the implementation process remains on track and that the recommendations are effective.
By taking these steps, American Airlines can successfully navigate the transition to the new lease accounting standards and emerge as a stronger and more financially stable company.
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Case Description
In March 2020, as coronavirus reduced demand for air travel, an analyst was forecasting American Airlines' (American's) first quarter financial results. To develop a forecast, she needed to familiarize herself with Accounting Standards Update (ASU) 2016-02, "Leases (Topic 842)," passed four years earlier by the Financial Accounting Standards Board. ASU 2016-02 required companies to disclose all leases on their balance sheets, but it made an exception for leases with variable payments, allowing companies to leave such leases off-balance sheet. The Wall Street Journal estimated that more than 50% of American's leases remained off-balance sheet due to the exclusion of variable leases. Should American and other companies be allowed to leave variable lease payments off-balance sheet? How did the decision to leave these payments off-balance sheet affect companies' risk profiles and valuations?
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