Decompose Operating Lease Liability into Current and Non-Current Components

33 Total Operating Lease Liability 10,053 6,698 14,065 34 Estimated Current Portion 388 156 454 35 Estimated Non-Current Portion 9,665 6,543 13,611

Restated Balance Sheet

$ Millions AMR Delta UAL

1998 1998 1998

Assets

Current Assets 4,875 3,362 2,908 Freehold Assets (Net) 12,239 9,022 10,951 Leased Assets (Net) 12,200 6,997 16,168 Intangibles & Other 3,042 1,920 2,597

Total 32,356 21,301 32,624

Liabilities

Current Liabilities:

Current Portion of Capital Lease 542 219 630 Other Current Liabilities 5,485 4,514 5,492

Long Term Liabilities:

Lease Liability 11,429 6,792 15,724 Long Term Debt 2,436 1,533 2,858 Other Long Term Liabilities 5,766 4,046 3,848

Preferred Stock 175 791 Shareholder's Equity Contributed Capital 3,257 3,299 3,518 Retained Earnings 4,729 1,776 1,024 Treasury Stock (1,288) (1,052) (1,261) Total 32,356 21,301 32,624

Restated Income Statement

$ Millions AMR Delta UAL

1998 1998 1998

Operating Revenue 19205 14138 17561 Operating Expenses (16396) (11919) (15535)

Operating Income 2809 2219 2026

Other Income & Adjustments 198 141 133 Interest Expense* (996) (991) (1227)

Income before Tax 2011 1369 932

Tax Provision (805) (553) (318)

Continuing Income 1207 815 614

* Includes preference dividends.

Case 3-5—continued

f. We made several assumptions in estimating the effects of the lease classification. Some of the important assumptions are:

• Interest Rate Parity across Capital and Operating Leases. We use the average

interest rate on the capital leases as a proxy for the interest rate on operating lease. To the extent capital and operating leases are dissimilar, the interest rate estimate is inaccurate or biased. This problem arises especially if the capital leases and the operating leases, on average, have been contracted during different time periods with different interest rate regimes.

In this particular case, the interest rate on Delta’s capital leases is substantially higher than that on either AMR or UAL. While it is not impossible, it is improbable that lease rates could differ so markedly across similar companies in the same industry. The average remaining lease term offers a clue: for Delta’s capital leases it is 6-7 years compared to 10-12 years for AMR and UAL. Under the assumption that the average lease terms are similar across companies, this implies that Delta’s capital leases, on average, were contracted 4-5 years before AMR or UAL, which is consistent with the higher interest rate on Delta’s capital leases. To some extent, this problem is alleviated (at least on a comparative basis) because Delta’s operating leases also appear to have been contracted around three years earlier to AMR’s or UAL’s. It appears that the capital leases for all three companies were entered into at an earlier time than the operating leases. If these leases were entered at a time with a sufficiently different interest rate regime, we need to make appropriate corrections to our interest rate estimates.

• Depreciation Policy. We set the lease asset and liability equal to each other. In reality, the depreciation of the asset seldom equals the lease principal payments. Some people use a simplifying assumption such as lease assets should be equal to 80% the liability. However, these ad hoc rules are no better than putting them equal to each other.

Case 3-5—continued

g. Ratio Analysis on Restated Financial Statements

AMR Delta UAL

1998 1998 1998

Liquidity

Current Ratio 0.809 0.710 0.475

Solvency

Total Debt to Equity 3.831 4.295 8.943

Long Term Debt to Equity 2.931 3.118 7.078

Times Interest Earned 3.020 2.380 1.759

Return on Investment*

Return on Total Assets 5.89% 7.17% 4.47%

Return on Equity 18.69% 23.20% 21.87%

*computed on adjusted year- end asset and equity

balances

Note: We treat preference share capital as debt and include preference dividend with interest.

Capitalizing the operating leases significantly worsens the liquidity and solvency picture of all three companies. The impact on current ratio is not dramatic, but the current ratios are bad to start with. In particular UAL’s current ratio of less than 50% is cause for concern.

The solvency picture deteriorates significantly after lease capitalization. We realize that all three companies are extremely reliant on creditor financing, particularly through lease financing that constitutes between 25% to 50% of the total assets. The debt to equity ratios are significantly above acceptable levels. UAL’s debt to equity is particular high. Part of the reason for the high debt equity ratios is that these companies had all but wiped out their retained earnings during the recession in the early 1990s, which makes their equity base very low. While this is an explanation for the high debt to equity ratios, it does not absolve the risk associated with such extreme debt orientation in the capital structure. Despite the excellent profitability of all three companies, the interest coverage ratios are not as impressive as they appeared before the operating leases were capitalized. By classifying a significant part of their leases as operating, all three companies were able to underreport interest expense by over two-thirds. In particular, UAL’s interest coverage looks weak even when its profitability is spectacularly high.

The ROA has not deteriorated significantly although total assets have increased by at least a third for all companies. The reason is that operating income was significantly underreported earlier because the interest costs pertaining to operating leases were being treated as operating expenses. ROE has reduced significantly for all three companies, mainly because of drop in continuing income. The ROE is still good although not as spectacular as reported.

Case 3-5—continued

Sensitivity Analysis after lease capitalization

AMR Delta UAL

Drop in demand 5% 10% 5% 10% 5% 10%

Revised Income Statement for 1998

Operating Revenue 18245 17285 13431 12724 16683 15805 Operating Expenses (16191) (15986) (11770) (11621) (15340) (15146)

Operating Income 2054 1298 1661 1103 1343 659

Other Income &

Adjustments 198 198 141 141 133 133 Interest Expense* (996) (996) (991) (991) (1227) (1227)

Income before Tax 1256 501 811 253 248 (436)

Tax Provision (540) (276) (358) (162) (78) 161 Continuing Income 716 225 453 90 170 (275) % drop in Continuing Income 41% 81% 44% 89% 72% 145% Revised Ratios (1998) Liquidity Current Ratio 0.809 0.809 0.710 0.710 0.475 0.475 Solvency

Total Debt to Equity 3.831 3.831 4.295 4.295 8.943 8.943 Long Term Debt to Equity 2.931 2.931 3.118 3.118 7.078 7.078 Times Interest Earned 2.261 1.503 1.818 1.255 1.202 0.645

Return on Investment

Return on Total Assets 4.33% 2.77% 5.39% 3.61% 3.07% 1.66% Return on Equity 10.69% 3.36% 11.26% 2.24% 5.18% -8.37%

The sensitivity analysis after the capitalization of operating leases further highlights the high degree of risk in these companies. With a 10% drop in revenue all the three companies have little or no “cushion” to pay their interest costs. UAL in particular is highly unlikely to be able to meet its interest commitments in such a scenario (also realize that for operating leases, both the interest and principal portions need to be paid).

The results also highlight that the return on assets and equity will be considerably affected with a downturn in demand. In short, capitalizing operating leases shows that the solvency of the companies is clearly a risk, and this risk could come to the forefront if and when these companies experience even a moderate drop in revenues, which is not unlikely if history is any indicator.

Case 3-5—continued

h. Accounting Motivations for Leasing and Lease Classification: In (c) above we presented some economic arguments for the popularity of leasing in the airline industry. After the analysis in g and h, we added an important motivation that is purely related to financial reporting. By leasing a large proportion of their assets and successfully classifying most leases as operating, the airlines attempt to camouflage the high risk inherent in their capital structure.

The big question is whether managers can fool the market with these accounting gimmicks. Research does indicate that the market seems to consider the additional risk imposed by operating leases and to reflect what is not shown on the financial statements. However, a surprising number of even “sophisticated” investors fall prey to these window-dressing tactics—for example, many analyst reports and financial databases fail to adjust the solvency and other ratios for operating leases.

This case highlights the importance for a financial analyst to understand the accounting issues. It also highlights the importance of “getting ones hands dirty” by doing a detailed and careful accounting analysis before embarking on further financial analysis.

Case 3-6 (75 minutes) a.

Pension Benefits Health and Life Benefits Totals

1998 1997 1998 1997 1998 1997

Net Economic Position

Fair Market Value of Plan Assets 43,447 38,742 2,121 1,917 45,568 40,659 PBO 27,572 25,874 5,007 4,775 32,579 30,649 Net Economic Position 15,875 12,868 (2,886) (2,858) 12,989 10,010 Reported Position on Balance Sheet _{7,752 6,574 (2,420) (2,446) 5,332 4,128} Difference 8,123 6,294 (466) (412) 7,657 5,882 Original Restated Balance Sheets 1998 1997 1998 1997 Assets Current Assets 243,662 212,755 243,662 212,755 PP&E 35,730 32,316 35,730 32,316 Intangible Assets 23,635 19,121 23,635 19,121 Other 52,908 39,820 52,908 39,820 Total 355,935 304,012 355,935 304,012

Liabilities & Equity

Current Liabilities 141,579 120,668 141,579 120,668

Long Term Borrowing 59,663 46,603 59,663 46,603

Other Liabilities 111,538 98,621 103,881 92,739

Minority Interest 4,275 3,682 4,275 3,682

Equity Share Capital 7,402 5,028 7,402 5,028

Retained Earnings 31,478 29,410 39,135 35,292

Total 355,935 304,012 355,935 304,012

Relevant Ratios

Debt to Equity 7.25 6.98 6.00 5.91

Long-Term Debt to Equity 3.97 3.81 3.22 3.17

Return on Equity 21.54% 21.52% 18.29% 18.64%

Inference: Net assets (other liabilities) are understated (overstated) by $7.66 billion in 1998 ($5.89 billion in 1997). Both the debt to equity and the return on equity ratios decrease when the true economic position is depicted in the balance sheet.

Case 3-6—continued b.

Pension Benefits Retiree Health and Life Benefits Total

Post Retirement Expense Restatement _{1998 1997} Change _{1998 1997} Change _{1998 1997} Change

Permanent Income Reported Expense 1,016 331 685 (313) (455) 142 703 (124) 827 One-time charge 0 412 (412) 0 165 (165) 0 577 (577) Permanent Income 1,016 743 273 (313) (290) (23) 703 453 250 Economic Income Actual Return on Assets 6,363 6,587 (224) 316 343 (27) 6,679 6,930 (251) Service Cost (625) (596) (29) (96) (107) 11 (721) (703) (18) Interest Cost (1,749) (1,686) (63) (319) (299) (20) (2,068) (1,985) (83) Actuarial Changes (1,050) (1,388) 338 (268) (301) 33 (1,318) (1,689) 371 Early Retirement Costs 0 (412) 412 0 (165) 165 0 (577) 577 Economic Income or Expense 2,939 2,505 434 (367) (529) 162 2,572 1,976 596