Bulletins | June 30, 2016

Balancing the books

What property owning business need to know about the new international financial reporting standard for leases, IFRS 16 Leases.

After a prolonged, and occasionally fierce, debate and a project lasting almost a decade the International Accounting Standards Board (‘IASB’) has finally issued IFRS 16 Leases. The fact that the IASB standard is not aligned with the US equivalent, despite this being one of the project’s stated aims, is an indication of just how thorny an issue the accounting standard setter found this to be. The new accounting standard, which applies to years commencing on or after 1 January 2019, fundamentally changes lessee accounting and has the potential to change business behaviour as well.

Current accounting standards classify leases into two different types: finance leases, where the risks and rewards of ownership are passed to the lessee; and operating leases, where the risks and rewards of ownership are retained by the lessor. Currently finance leases are recognised on the lessee’s balance sheet, with both the asset, and the associated liability, being included. Operating leases are not recognised on the balance sheet at all and an entity’s commitments under operating leases are merely disclosed. In the UK property leases were typically classed as operating leases and hence not included on balance.

IFRS 16 changes this accounting and removes the difference between finance and operating leases, recognising both types of leases on balance sheet as a right of use asset and an associated lease liability. This change also impacts the Income Statement as the rental expense previously shown for operating leases is replaced by an interest and a depreciation expense. Over the life of the asset the total charged will be the same as the rental expense however, the timing will be different as interest charges will be higher at the beginning of a lease and lower at the end of the lease. The charge in the Income Statement will, therefore, be further divorced from the cash payments made.

Why does this change matter? It matters because most businesses have property held under an operating lease and including this on balance sheet will significantly increase both the assets and the liabilities recognised. Sectors with a large number of leases, such as retail, will see a particular impact.

This technical change in the accounting then impacts key ratios which investors and debt providers often use to assess business strength and performance, including:

  • Gearing (which will look worse as liabilities increase);
  • Return On Capital Employed (which will look worse as the asset base increases); and
  • Earnings Before Interest Tax Depreciation and Amortisation (which will improve as the rental expense is replaced by an interest and depreciation charge).

Entities should ensure they spend time explaining to their investors and other stakeholders the impact of the new accounting standard.

The key question, then, is how this will change business behaviour, particularly when negotiating to take on, or extend, a property lease. As businesses seek to minimise the impact they could look to reduce lease terms or include additional break clauses and it may even impact an entity’s decision as to whether to lease or buy. These requirements may result in lessors either demanding higher rents in exchange for shorter term leases or alternatively offering improved lease incentives in order to encourage lessees to sign longer term leases. It is too early to tell how this will impact the market but understanding the changing accounting requirements will help both lessors and lessees when negotiating over how to structure leases.

One area of accounting that did not change was the accounting by lessors however if the standard changes the behaviour of lessees they will nonetheless feel the impact.

Author: Matthew Stallabrass, Partner, Crowe Clark Whitehill LLP