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IFRS 16 – Changes to Financial Reporting of Leases
What is IFRS 16?
In January 2016 the International Accounting Standards Board (IASB) issued IFRS 16 Leases to replace the previous standard, IAS 17 Leases along with associated interpretations. IFRS 16 will cover how leases are disclosed, measured, recognised and presented in financial statements. The new standard is effective from the 1st of January 2019 for companies that report under the International Financial Reporting Standard (IFRS).
The ultimate principal of IFRS 16 is that lessee lease liabilities with terms greater than 12 months are recognised on balance sheet, as opposed to being classified as either ‘finance’ or ‘operational’ leases, with the latter being recorded as an operational expense when incurred. IFRS 16 will have no effect on the amount of cash being transferred between the lessor and lessee; however for some companies it will have a marked effect on leverage, interest cover and ROE ratios.
Why the changes are being made?
It is estimated that there is around £2.3 trillion ($2.8 trillion) of global lease liabilities currently sitting off balance sheet for IFRS and GAAP reporting firms. This has resulted in some difficulty for investors when evaluating companies, particularly when attempting to gauge the size of a firm’s off balance sheet liabilities.
“These new accounting requirements bring lease accounting into the 21st century, ending the guesswork involved when calculating a company’s often-substantial lease obligations,” said International Accounting Standards Board chairman Hans Hoogervorst.
“The new standard will provide much-needed transparency on companies’ lease assets and liabilities, meaning that off balance sheet lease financing is no longer lurking in the shadows.
“It will also improve comparability between companies that lease and those that borrow to buy.”
What will change?
- Balance sheet treatment – All leases will be ‘capitalised’ by recognising the present value of the lease payments and showing them either as lease assets or together with PP&E. A company will also record a financial liability on their balance sheet, giving an indication of its future rental obligations. For companies with significant off balance sheet leases, the changes are expected to increase lease assets/liabilities, while reducing owners’ equity (all other factors being constant). This is because the carrying value of lease assets will usually be depreciated on a straight line, while the lease liability is amortized at the rate of principal repayment which is a lower amount for the majority of the lease term. This has the effect of a lease liability outweighing its corresponding asset for the lease.
- Income statement treatment – IFRS 16 will replace the typical lease expense recorded for most operational leases with an expense made up of both interest and depreciation components. Depreciation expense and interest expense cannot be combined in the income statement. Depreciation charges will be linear in most instances; however the interest expense will reduce over the term of the lease, which should result in a pattern of declining expenses as an individual lease liability matures. On an individual lease basis, the interest + depreciation expense will be higher than it was under IAS 17 for both the majority of the term, only falling below previous levels for the end portion of the lease.
- Cash flow Statements – There will be no change in the amount of cash flow recorded, however it will be present a decline in operational outflows accompanied by an increase in financing expenses.
Treatment of inflation linked leases?
Payments linked to an index or rate like those linked to the CPI and RPI indices will be forecast at their passing level, without factoring in future growth. The IASB considered using forward or swap rates to determine index growth, however considered it too complicated and costly for most organisations to implement. The projected lease payments will be discounted back at either the implied interest rate within the lease or the rate at which the lessee could borrow an amount similar to the transacted price, for a similar term, with the same level of collateralisation.
What this means for the long lease market?
Historically it has been a selling point to tenants that long lease transactions were a good way to release capital from real estate assets/leverage off strong credit without having to recognise balance sheet liabilities. From January 2019 this incentive will be gone, and with it the attractiveness to borrowers of this financing structure. This should reduce the willingness of tenants to enter into these agreements, reducing the supply of new stock and perhaps the number of long leases in the market as a whole. The question is:
a) To what degree will supply be constrained?
b) Will the commercial real estate market be able to leverage its experience and expertise to see value in assets that are overlooked or undervalued by traditional lenders?