What are the IFRS 16 Standards?
IFRS 16 is a new leases standard. Under these new standards, companies will be expected to report leases on their balance sheets using a common methodology. The idea is to make balance sheets more transparent, to help people better understand the financial statements of companies, and to help them conform with the United States’ GAAP (Generally Accepted Accounting Principles).
The new standards will eliminate the distinction between operating leases and financial leases in IAS 17, and provide a principle for recognising all leases on the balance sheet of lessees, including assets representing the right to use the leased asset during the term of the contract in consideration of a liability for the obligation to pay rent.
Under the IASB’s existing standards, IAS 17, lessees account for lease transactions either as operating costs or finance leases. As leases do not appear on the balance sheet, they are shown instead in the Profit and Loss statements (P&L) as an expense. But, after IFRS 16 comes into effect, the balance sheet will show an ‘obligation to make rental payments’ as a liability and create an equivalent ‘asset’.
The IFRS 16 standards were published as far back as 13th January, 2016, but don’t actually come into effect until January 1st, 2019. But don’t worry if you hadn’t heard of them before now – there is still time to prepare.
How should you look to transition to IFRS 16?
During the transitional phase, companies can take a ‘full retrospective’ approach where leases are assumed to have been under IFRS 16 from inception. This is seen as the most accurate reporting method, but it will increase reporting costs as two parallel accounts will be required based on IAS 17 and IFRS 16. If you intend to take this approach, you must be in a position to show restated figures from 1st January, 2018. Unless you are already well on the road to implementation, achieving full retrospective application will prove to be a significant accounting challenge.
The second approach, which 75% of companies surveyed said they are more likely to choose, is a ‘cumulative catch up’ approach which will not require dual accounting. Reporting on leases can be implemented in the financial year immediately after the implementation date assuming they are new. The degree of flexibility offered by this approach, plus the potential to implement various shortcuts, makes it much more attractive.
Regardless of which transition method is used, obtaining and compiling the relevant lease data in one location must be your priority. On average, it takes a qualified chartered accountant 45 minutes to go through a property lease. As some corporate portfolios can contain thousands of interests, this could translate into weeks of work. Even if you choose to automate this method, you will still need a professional second opinion. You will also need to make provisions to store this data.
Thankfully, after 1st January, lessees will also no longer be required to follow the application requirements of IAS 8. This is because IFRS 16 allows a modified retrospective approach under which comparative periods are not restated.
During the transitional phase, companies can take a ‘full retrospective’ approach where leases are assumed to have been under IFRS 16 from inception, or a ‘cumulative catch up’ approach which won’t require dual accounting. However you choose to transition, BNP Paribas Real Estate can support you
How will IFRS 16 affect the real estate sector?
A Bloomberg report in 2017 estimated that companies had placed as much as $3 trillion of operating lease obligations ‘off balance sheet’, demonstrating the scale of the transition. However, making the transition will also present companies with the perfect opportunity to have a ‘spring clean’ and reassess their property strategies to figure out what’s ‘core’ (own freehold), ‘non-core’ (continue to lease traditionally) and ‘flexible’ (consider serviced office occupancy).
As a result of IFRS 16, the Real Estate sector will start to see changes to its entire business model. Lessee needs will likely change, with more requests for short lease terms and more variable lease payments. This could lead to increased cash flow volatility and higher risk. IFRS 16 may also lead to a rising focus on services, which may lead to a change in lessors’ business models.
Perhaps the most important consideration is that real estate leasers and lessees should begin to work more closely with their accountants, ensuring ahead of the implementation date that their company is well submitted, and that they have a first inventory of their real estate assets, including leases and deeds.
As for occupiers, their behaviour is likely to change too, with more demand for shorter leases. Turnover rents are likely to be considered more regularly due to discounting and fixed increases will have a corresponding delayed effect. There may therefore be extra pressure for upfront rent free, and companies may start to offer fixes and minimum increases in order to maximise upfront gains. Turnover rents are likely to be considered by occupiers who can show landlords a strong case for sustained turnover levels.
Meanwhile, ongoing high demand for serviced office space could present a short-term opportunity, as annual serviced office leases could be exempt from IFRS 16 as they would fall below the twelve-month threshold. Companies with a retail presence, meanwhile, may want to consider turnover rents which could create a smaller liability compared to leases with fixed rental increases.
Under the current lease accounting standards (IAS 17), most property leases are defined as ‘operating leases’. But under IFRS 16, ‘operating leases’ will now be treated like finance leases
What kinds of leases will be affected?
The IFRS 16 standards apply to almost all leases, including subleases. Under the current lease accounting standards (IAS 17), most property leases are defined as ‘operating leases’. The cash and P&L are the same except for rent-free incentives and fixed rental increases, which are spread over the lease term in the P&L. The lease is not capitalised on the balance sheet. A minority of property leases are ‘finance leases’, which are capitalised, and depreciate with interest of over the lease term.
But under IFRS 16, ‘operating leases’ will now be treated like finance leases. The P&L will record depreciation and interest only. The Net Present Value of the likely lease payments will be stated in the balance sheet as both a lease liability and a corresponding ‘Right of Use’ asset. The net effect on the balance sheet on day one will therefore be zero. The total lease length ignores breaks and options to renew, except when there is an economic (or operational) reason to exercise options to renew or not exercise lease breaks.
Corporates will notice that, while their assets will roughly balance their liabilities, significant levels of debt will be added to their balance sheets and the assets will only be artificial. Property teams within Corporates will have to analyse the balance sheet impacts of future leasing decisions and pay closer scrutiny to forecasting rent reviews. Investors, meanwhile, will find that for large buildings on long leases, the negative impact of the lease obligation will be exacerbated, potentially making longer leases less attractive to occupiers.
Who will be exempt from IFRS 16?
There are many other exclusions to the new standards. 100% variable rents and contracts of less than one year will not apply. The model will also not apply to underlying assets with a low value.
In cases of a lease lasting 12 months or less, the lessee recognises the lease payments in profit or loss on a straight-line basis over the lease term. To apply this exemption, the lease term must be determined by all entities. Where there is an option to extend the lease, and where it looks likely that the lessee will look to take this extension, it is usually worth considering the lease to be long-term. If the lease contains a purchase option, it is not a short-term lease.
Assets of low value are defined by the IASB as those of values under $5,000. These will typically include personal computers and other assets, though in the real estate sector they could also apply to fixtures and fittings, undeveloped land, vehicles or equipment used on a site and so on. Entities should work out a method to recognise low-value assets and implement a different process to account for them.
The standards will not apply to the USA, but a similar accounting change will be implemented there.
IFRS 16 will also not apply to certain types of leases which may sometimes be seen in the Real Estate sector, including many of those in the minerals, oil, natural gas and non-regenerative resource industries, as well as those for service concession agreements, intellectual property and the rights to items such as manuscripts, patents and copyrights.
The IFRS 16 standards will also only apply to contracts that are, or contain, a lease if it conveys the right to control the use of the asset for a period of time. Where a supplier has a substantive right of substitution, the customer may not have a right to any assets. Tenants and occupiers should therefore be aware of the type of lease they have, if indeed they have one at all.
Is it too late to begin the transition?
Not at all. Whether you have already chosen your preferred method to ensure IFRS 16 compliance, or if you are still consider whether to take the full retrospective or modified approach, there is still time to prepare.
BNP Paribas Real Estate is helping companies around the world to ensure a smooth transition. We can guide you through all stages and provide you with consistent support for your new reporting needs. Whether you need help to determine the appropriate discount rate, to consolidate relevant lease data on a unified platform, optimise operational assets or identify new methods of value release, speak to us today to get the expert consultancy you need.
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