Air
Canada is Canada’s largest airline, operating domestic and international
flights on a full-service basis. During 2003, the company ran into financial
difficulty and took steps to reorganize its operations and rethink its business
model. The company needed to obtain significant additional financing and was
looking to undergo a financial reorganization under which control of the
company would likely change hands.
In
March 2004, the company set up voluntary separation programs, which allowed for
up to 300 non-unionized employees to “retire” with severance payments.
Unionized employees were covered by a separate similar plan. In addition, it
was planned that certain employees would be terminated and receive severance
payments under pre-existing contracts. Many lease contracts were renegotiated
and/or terminated. While operating under bankruptcy protection court orders,
the company had ceased to pay its lessors. GE Capital Corporation and its
subsidiaries leased, managed the leases of, or had an interest in 108
aircraft—the bulk of Air Canada’s aircraft. GE’s lawyers notified the airline
that it must either pay the back rent or return the planes, noting that the
company should not be allowed to hide behind the bankruptcy protection and use
the planes for free. The company had many of its leased planes recorded as operating
leases. Aircraft operating lease rentals over the lease term were amortized to
operating expense on a straight-line basis. The difference between the
straight-line aircraft rent expense and the payments as stipulated under the
lease agreement was included in deferred charges and deferred credits ($1.8
billion).
The
following is an excerpt from the financial statements:
11.
Convertible Subordinated Debentures
In
December 1999, the Corporation issued $150 convertible subordinated debentures
which have an annual interest rate of 7.25%, payable quarterly, and are
convertible at $16.00, at the holder’s option, into Air Canada common shares
and Class A non-voting common shares (“Class A shares”) at any time up to and
including maturity in December 2009. This equals a rate of 6.25 shares per
$100.00 principal amount of convertible subordinated debentures. There are no
principal payments until maturity in 2009. The Corporation can force conversion
into common shares and Class A shares at any time following the seventh
anniversary of the issue if the weighted average closing price of the shares of
the Corporation for the 20 trading days prior to the date of the redemption
provides the holder an internal rate of return of at least 12% for the period
commencing from the date of issuance of the convertible subordinated debentures
and ending on the redemption date. The internal rate of return calculation
includes interest payments made by the Corporation under the convertible subordinated
debentures and the excess of the weighted average closing price above $16.00.
The
company entered into a new cobranding agreement with CIBC regarding Aeroplan
points and the Aerogold Visa card. The agreement revised a prior agreement with
CIBC increasing the amount that CIBC would pay for the Aeroplan points (by
24%). As a result of revising the old agreement, CIBC is seeking damages of
$209 million. In addition, the new CIBC contract also provides the Company with
a borrowing facility under which the Company received financing of $315.
During
the year, at CIBC’s option, the principal portion of the loan was reduced
through the offset of amounts owing from CIBC for Aeroplan miles purchased.
Instructions
Adopt
the role of Air Canada’s auditors and discuss the financial reporting issues.
For simplicity sake, use IFRS in the analysis.
Overview:
-
The company was under bankruptcy protection at the
time.
-
It is a public company and therefore GAAP is a
constraint. As noted in the case, use IFRS
for simplicity sake even though the company would have been following pre-2011
Canadian GAAP.
-
GE Capital is a key user and wants payment for leased
planes; it has accused the company of hiding behind bankruptcy protection.
-
The company is looking for new investors who will rely
on the statements —therefore it may try to make the statements present the
company in a favourable light.
-
Role of auditor— will want to be conservative – may be
sued if company subsequently goes under.
Issue: Classification of leased planes
|
Capital
|
Operating
|
|
- These planes are essential assets of the company,
i.e., the company cannot run without them. They should therefore be
capitalized and shown as assets and liabilities on the balance sheet.
- Would give GE more comfort seeing the liability
acknowledged.
|
- According to GAAP – qualify as operating leases
and therefore need not be fully capitalized.
- Should the total rent be spread over the lease
term (straight line) or should the company recognize the legal rent owed
according to the lease agreement?
- Makes more sense to look at the total to be paid
and spread this amount over the lease = economic substance.
- Recognizing the rent according to the contract
(legal form) leaves room for manipulation and does not reflect the economic
substance.
|
Recommendation:
Revisit the lease presentation analysis to ensure that
the planes should not be treated as capital leases. If operating, ensure
appropriate disclosure as to cash flow obligations. If operating, GAAP supports
spreading the total lease costs over the term of the lease. Regardless of
classification, these are obligations that should be reflected clearly in the
financial statements either as obligations (capital lease) or as future cash
outflows (operating lease) that become liabilities once the assets has been
used.
Issue: Convertible Subordinated Debentures. These
would have been recorded in 1999 and so not really an issue – compound
instrument – part debt/part equity
Issue: $209 million damages
-
Accrue if likely and measurable/probable—depends on
status of complaint. More information
is needed.
Issue: Offsetting of financing and amounts receivable
from CIBC.
-
May offset if legal right to offset and management
intent to settle net. Need more information.
Issue: How to account for severance plans
-
Recognize when entity committed and the amount can be
reasonably determinable.
o
i.e., when approved, when plan with specifics outlined
(no possibility of withdrawal of plan).
-
It sounds like the plan was articulated and approved
and that the terminations were carried out swiftly— therefore would recognize
costs and liability.
