IFRS 16 – Changes to the Financial Reporting of Leases

IFRS 16 – Changes to the Financial Reporting of Leases

Mitchell Perrott

Mitchell Perrott

Associate Director

t: +44 207 184 1943
mitchell.perrott@cbre.com

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?

And;

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?

Rational Decisions in a Sea of Uncertainty

Rational Decisions in a Sea of Uncertainty

Stephen Caffery

Stephen Caffery

Associate Director

t: +44 207 182 2296
stephen.caffery@cbre.com

Long Income: Rational decisions in a sea of uncertainty

One could only be forgiven for thinking that ‘the only certainty right now is that we live in a time of great uncertainty’, as it is the only common consensus amongst economic, social and political commentators alike.

An ironic statement for some, a paradox for others, it seems to be the only rational conclusion in explaining the continued demand in the Long Income property market. Hang on… is this all starting to sound like the next Christopher Nolan movie more than reality?

Nonetheless, we are living in the real world and this is neither the first time nor the last time this type of behaviour in property and financial markets has been or will be witnessed.

It’s really not surprising that given relatively low global returns, and surplus amounts of investment capital, the Long Income real estate market has become the investment flavour of the month by offering both stable and growing returns.

That said, like all other property markets, Long Income real estate will be exposed to the boom and bust nature of the property cycle and an eventual downturn will ensue, thus exposing another investment paradox, ‘markets can be both rational and irrational’.

It is therefore during the boom times that the market should continually remain grounded focusing on the fundamentals of any property investment to ensure they remain on dry land when the sea of uncertainty rises.

At the most simplistic level, a long term property investment is the function of three interlinking fundamentals being:

  1. The covenant and strength of the tenant to fulfil the entirety of their lease obligations,
  2. In the event the tenant should default, the value of the underlying property to support another tenant or its ability to convert into a different use, and
  3. The potential capital appreciation of the property over time.

Overall it is the combination of the above that determine the fundamental value of all investment income driven property, Long Income real estate is no exception.

The relative weakness of one fundamental can be counter balanced by the strength of another (rational). However, if the market becomes unbalanced on these key fundamentals (irrational) then eventual losses appear more certain over time.

Or is the difference between rational and irrational just a function of time? Perhaps a discussion for another day….