TQ.2

The accountant of Lovely Airline Group (LAG) has drafted the airline's financial statements for 2019. The following information has been extracted from the draft financial statements:

LAG has many long-term leases of aircraft. In preparing the draft financial statements, the accountant has applied AASB 117Leases, which permits the leased aircraft to be off-balance sheet, with the lease payments recognised as an expense as incurred.

$M

Profit before interest and tax (also referred to as EBIT)

200

Interest expense

50

Profit before tax

150

Total liabilities

1 800

Total Assets

3 000

2

A new accounting standard, AASB 16Leasescomes into effect for annual reporting periods commencing on or after 1 January 2019. AASB 16 required the recognition of a right-of-use asset and corresponding lease liability for the aircraft. There will also be effects on the statement of profit or loss and other comprehensive income. Instead of recognising a lease expense, LAG will recognise interest expense and amortisation expense.

The accountant is considering early adoption of AASB 16 and has provided the following quantified information about the effect on LAG's financial statements:

Rent expense will decrease by $200 million

Amortisation expense will increase by $175 million

Interest expense will increase by $25 million

Total assets and total liabilities at the end of 2019 will increase by $ 1 000 million a) Using information presented in the draft financial statements, calculate

i) the interest coverage (EBIT/Interest expense)

ii) the leverage ratio (total liabilities/total assets)

b) Present the key figures as shown above, assuming LAG adopts AASB 16. c) Use the information calculated in part b) to calculate:

i) the interest coverage (EBIT/Interest expense)

ii) the leverage ratio (total liabilities/total assets)

d) If LAG does not adopt the new Standard, AASB 16, it must provide quantitative disclosures about the lease liabilities in the notes in accordance with the old Standard, AASB 17. Do you think the adoption of AASB 116 would affect LAG's share price? Give reasons for your answer.

e) Would your answer at b) be any different if LAG had a debt covenant that the leverage ratio should not exceed 65%?