IFRS 16 Leases - The impact for property investors

It’s been a long, long wait, but we finally have the international standard dealing with leases, IFRS 16.

It will still be a few years yet before the first financial statements are published which have to comply with the new standard, since it is effective for periods beginning on or after 1 January 2019, although early adoption is allowed.

Who will be affected?

In most cases companies will find that their arrangements under the old and new guidance will be the same. What will change is how some of those leases are treated.

The new standard covers all leases, whether the company acts as lessor or lessee.

The accounting changes for lessors, however, are fairly minor. Whether lessors currently have finance leases or operating leases, or both, the new standard largely carries over the current accounting model so will not lead to major change. For property investors leasing owned buildings to third parties, the new standard is therefore not expected to have a significant direct impact. However the impact on lessees is likely to have a knock-on effect on lessors.

Changes to lessees

Current international standards draw a distinction between finance and operating leases, depending on the terms of the lease such as its duration, the amounts payable and any options that may be included in the contract. Finance leases then give rise to the recognition of an asset and a financing liability, whilst operating leases are not recognised in the balance sheet but treated as giving rise to an expense spread over the term of the lease. It is this distinction which disappears under the new standard.

In future, all leases will be treated in the same manner. The new treatment is broadly similar to that of a current finance lease – companies will recognise an asset, being their right to use the underlying asset, and a liability representing the present value of their obligation to pay for that asset.

Effect of the changes

Where a lease is recorded under the new rules, having previously been treated as an operating lease, this will not always have a major effect on reported net assets. But it may make a substantial difference to gross assets and gross liabilities, changing ratios that are based on these figures.

Where a company is party to substantial leases, the recording of major new assets and the associated liabilities will change gearing ratios, showing total debt as higher than before. Where companies have loan covenants based on total debt levels this may lead to breaches simply due to the accounting change.

There will also be some effect on reported profit, although that will vary between companies. Current operating leases are nearly always spread evenly over their life, so the charge is constant. Under the new rules, the total charges will consist of two elements – the depreciation of the asset and the interest charge arising due to the financing. The depreciation will normally continue to be on a straight line basis, but the interest charges will be weighted towards the earlier part of the lease period. So whilst ultimately the total lease charges over the lease life will be the same as they were before they will be more front-loaded, with higher charges in the earlier years and lower charges in the later years. Obviously, the effect of this will be greatest on companies with just a few substantial leases, or even just one – those with a large portfolio of leases at various stages may find that even though the charges on each lease change, the overall charges remain broadly the same.

Impact of the changes for property investors

The move onto the balance sheet of leased assets for lessees will make long leases less favourable for tenants. Some may even look to renegotiate existing leases to shorter terms over the next three years.

Where service charges are not charged separately, tenents are also likely to want to split out any service elements within the lease such as cleaning and security, as these elements will not need to be accounted for as an asset and liability.

The potential deterioration of the tenants’ gearing ratios combined with shorter lease terms, will have an unwelcome impact on the market values of the tenanted properties. Property investors may well find their own balance sheets are therefore negatively hit by the impact of this standard, despite there being no direct accounting changes required.

How we can help

This summary does not cover all the changes required under the new standard, but we are happy to help provide guidance on the changes that will affect your business.

Businesses come to Moore Stephens because of our specialist knowledge of real estate and construction and the wide-ranging advice and assistance we can give them. For more information or to discuss how we could help you with the transition, please contact us.