IFRS 16 – the biggest change in property reporting in a generation – is now a requirement for companies after it was approved by the EU last year.
From January 2019, operating leases will no longer be ‘off balance sheet’ and will be included in company accounts as lease liabilities and corresponding right of use assets.
This means 2018 is the first accounting year that requires disclosures and early communication with investors. The International Accounting Standards Board has estimated that around $3trn (£2.2trn) of off-balance-sheet leases will be exposed.
These changes aren’t just the domain of accountants. Property expertise is required to justify many of the assumptions. In fact, anyone dealing with leases needs to understand the position for their business. There are various ways to transition to IFRS 16, which will affect comparability of accounts after 2019. And despite efforts, there are also other accounting standards that treat operating leases in different ways, such as US GAAP and FRS 102.
Many commentators have noted that credit rating agencies already adjust for leases, that lease liabilities/right-of-use assets will largely cancel each other out, that debt covenants often include ‘frozen GAAP’ and that total cash is unlikely to be significantly affected. But for us, three issues stand out.
First, the fundamental impact on property transactions needs to be understood. For example, variable performance-based rents such as turnover rents will be excluded from the balance sheet but auditors will be wary of this and will require ‘in substance’ variable rents. Another example is the ‘income strip’ sale-and-leaseback with £1 buy-back, which is no longer regarded as a ‘sale’ according to other new IFRS standards.
Second, the number of data points that need to be gathered is easy to underestimate. More than 80 potential input fields are required for each lease but expect over 100 with more complex lease structures and/or a ‘full retrospective’ transition to IFRS 16.
Third, the rate implicit in the lease versus incremental borrowing rate is a key area where people assumed the default measure would be the incremental borrowing rate, with easy grouping of leases and a generic figure similar to the weighted cost of capital. However, it is proving difficult to group property leases and the borrowing rate needs adjusting in each case for the quality of the underlying ‘security’ including blending debt and equity.
It is easy to be caught in the challenges of applying these new measures, but property professionals need to look ahead. IFRS 16 will present opportunities both before and after transition.