Lease accounting – New rules from 1st January 2019 – Translation of an article that appeared in Slovenia’s daily financial newspaper on 22nd August

IASB (responsible for IFRS), and FASB (responsible for US GAAP) have undertaken a joint project to address how leases are accounted for in financial statements. After almost 10 years, IASB issued IFRS16, a new accounting standard that will come into effect on 1st January 2019.

With 85% of lease commitments left off balance sheet globally, this is going to have a widespread effect.

How to prepare for the new standards

Leasing is a common way for businesses to raise finance, both here in Slovenia and globally. When a company signs a lease agreement, it obtains the right to use an asset in exchange for future payments.

Under current lease accounting rules, leases are categorised either as ‘finance leases’, or ‘operating leases’.

Finance leases are reported on the balance sheet as assets and liabilities
Operating leases are disclosed only in the notes in financial statements, with a corresponding straight-line expense in the P&L (Income statement) for rent, they are off balance sheet

The classification of the majority of leases as operating leases has two key issues:

Lack of transparency: Market analysts and credit rating agencies currently make adjustments to financial statements that often result in over or under estimation of a company’s financial position

Lack of comparability: On the basis of existing financial statements, investors are unable to compare between companies that borrow to buy an asset and companies that enter into a lease agreement.

There are only a few companies in Slovenia large enough to have a corporate real estate department. Office, warehouse and retail leases are typically dealt with by the CEO or CFO. The first step in preparing for IFRS16 is to appoint a project team and assign responsibilities for liaising with internal and external accountants.

Under the new regulations, lessees will be required to determine on ‘day 1’ of the lease:

The lease term – this is the non-cancellable term – it will have to be justified to the auditor.
The discount rate, including the rate implicit in the lease, and the lessees incremental borrowing rate, i.e. the rate for similar financing
The unavoidable future lease payments – those that are indexed to inflation are based on the current rent

Annual reassessment of lease liabilities

The lease liability will have to be reassessed every time there is a contractual change in the actual cash flows, for example every time the rent is indexed in line with inflation, or when the lessee takes action which will impact the non-cancellable lease term (e.g. exercising an extension option, or when a notice period for exercising a break option lapses). This will increase the administrative burden on the team in your organisation responsible for real estate leases.

Companies can choose to transition using the modified approach, that does not require historical lease information for all assets and is easy to apply. Alternatively they can adopt the full retrospective approach and calculate lease liabilities as if IFRS16 had been applied at the lease start. The full retrospective approach is more onerous to apply, but recognises a lower liability on the balance sheet and lease payments on the P&L.

Which companies will be affected?

The financial statements for Airlines, Retailers and Travel & Leisure operators are expected to be most impacted. For these three sectors, the present value of lease commitments is greater than 20% of their total asset base. For example, Tesco, a British based supermarket chain, is expected to see an increase in net debt from 8.6bn GBP to 17.6bn GBP.

In contrast, healthcare providers, information tecnhology companies and distributors are expected to be least impacted. Such sectors have lease commitments which equate to less than 5% of their total asset base.

For financial institutions, including banks and insurance companies, the changes may have an impact on their regulatory capital requirements, as they will report higher assets and lower equity.

Is it still better to lease rather than own?

From an accounting perspective, the changes to lease accounting standards will narrow the difference between leasing and owning property. Both will result in a liability on the balance sheet. Some companies will reassess the benefits of leasing, particularly those that have traditionally entered into long term lease contracts, and those that lease business critical assets. Nevertheless, the practical benefits of leasing assets will remain unchanged:

Operational flexibility
Regular, fixed lease payments
Reducing residual and obsolescence risk
Alternative source of finance

A move away from leasing is not expected, however for some occupiers a change in property ownership may be justified

Now is the time for sale and leasebacks

By selling an asset to an investor (removing the asset and liability from the balance sheet) and leasing the asset back at an agreed rent (the payments of which are off balance sheet), financial statements show improved equity and reduced debt. Occupiers often show a profit at the time of the transaction, due to the difference between the net book value and the sales price achieved.

Under the new standard, this structure will no longer be off balance sheet, nor will occupiers be able to recognise the full profit between net book value and the sales price in their financial statements. Nevertheless, there are a number of wider benefits to sale and leasebacks.

There is a limited period until January 2019 when occupiers will be able to recognise the full profit from a sale and leaseback in their financial statements. Slovene companies can benefit from the current interest from overseas investors in acquiring income generating assets by entering into a sale and leaseback before the new regulations come into force.

Lease negotiations will change

Lease liabilities recognised on the balance sheet will directly reflect the non-cancellable term of the lease. This is generally the minimum fixed lease term. The non-cancellable term will include options to extend and periods after break dates, if it is reasonably certain that occupation will continue. Occupiers will need to be prepared to justify lease terms to an auditor.

Landlords typically want tenants to sign long leases that reduce the administrative burden and risk of rental voids. Some landlords in Ljubljana refuse to lease spaces for less than 3 years. Some provide incentives such as rent free periods, and lower rents,  in return for longer leases. WAULT (weighted average unexpired lease term), is an important metric in the valuation of a fully occupied office building.

Occupiers will have to weigh up the opportunities to negotiate better terms with their landlord in return for longer leases, against the impact on the balance sheet. Quality office space in Ljubljana is fast running out, with no certainty of new projects in the short term, it is likely that rents will rise in Class A buildings, and many occupiers might want to tie in today’s rent levels for the next 5 years, in spite of the increased burden on the balance sheet.

Turnover rent is common in shopping centres, it is paid as a percentage of the occupier’s turnover.  It is typically paid in addition to a base rent, once a defined threshold has been reached. Some retailers pay turnover rent only, but generally landlords accept such lease terms from only the strongest most successful brands. Turnover rent will not be recognised on the balance sheet under the new regulations and retailers will no doubt be intent upon agreeing reduced base rent and increased turnover rent in future lease negotiations.

(Thanks to the occupier finance team at Cushman and Wakefield in London, who provided much of the information for this article)

Jacqueline Stuart is a Director of S-Invest d.o.o.