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Understanding the new property lease accounting rules

The International Accounting Standards Board (IASB) is currently attempting to standardise corporate accounting practices across the globe. The aim is to achieve consistency and to enable investors to make simple and direct comparisons between companies.

The IASB issued a proposal in August 2010 on how property leases are to be accounted for within company financial reporting. The consultation on the initial proposal ended on 15 December 2010 and feedback on the consultation was released on 21 April 2011.

The current system of lease accounting understates assets and liabilities, and therefore investors are making decisions based on incorrect gearing and leverage information. The intention is to eliminate ‘off balance sheet’ accounting in order to create greater transparency, providing an accurate reflection of a company’s financial strength.

The new proposals will affect all those bodies who report under International Financial Reporting Standards (IFRS), published by the IASB. These include:

  • All Public Limited Companies
  • Central Government departments
  • Large Private Limited Companies

As these standards are international, the impact of these changes will be felt across the globe.

Under the current regime, leasehold assets can be categorised as a capital or an operational lease.  The majority of organisations opt to categorise their leasehold assets as operational leases as they are held ‘off balance sheet’ and not recorded as a financial liability within their profit and loss account.

The IASB is concerned that this element of the current system does not truly reflect the assets and liabilities of these organisations, as it portrays a distorted and overly positive analysis of their financial standing.

As a result of these concerns, the IASB proposes to bring all lease assets and liabilities onto the balance sheet.  The key potential changes for tenant occupiers are as follows:

  • Operational leases brought onto the balance sheet and listed as an asset, which are likely to be calculated on a straight line depreciation basis.
  • Operational lease rents brought onto the balance sheet as a liability and to be forecast for the term of the lease, to be assessed as their present value for all future payments over the life of the lease, discounted at the occupier’s incremental borrowing rate.
  • Disclosure of key information relating to each lease asset, such as lease term, break dates, rent reviews, etc.
  • No ‘grandfathering’, so changes will be for all existing and new leases.

Commercial landlords are to be exempt from the changes as long as they attribute a ‘fair value’ to their real estate assets under International Accounting Standards (IAS) 40.

Sub-letting accounting is to be more complicated, as the net asset and net liability is to be included in the balance sheet.

These proposals will have a significant impact on the balance sheet and profit and loss accounts of affected tenant occupiers.  It appears that they will result in a front loading of the debt interest costs, and give a profit and loss profile that is less favourable in the early years of the lease. Importantly for potential investors and shareholders, this will significantly affect the bottom line profit presented in an organisation’s financial statements.

It is thought that a significant proportion of companies will experience a doubling of their debt figures within their profit and loss accounts.

The proposed changes will also affect loan covenants and an organisation’s ability to raise finance in the future. In respect of financial institutions, this may increase their regulatory capital requirements. The most significantly affected will be those who rely heavily on real estate to generate revenue, such as retailers and banks.

The impact on the market is likely to be a ‘knee jerk’ reaction to reduce the length of leases in order to reduce the amount of liability placed on their balance sheet.  However, they propose to take into account the probability of renewal of leases, which also must be disclosed on the balance sheet.

Occupiers will no doubt consider ownership more closely as leasing will seem less desirable, due to its new-found adverse impact on the balance sheet.  Decisions will become more commercially driven rather than accountancy driven, causing a re-appraisal of occupier leasing strategies.

There has been large-scale opposition to the August 2010 proposed changes, particularly from tenant occupiers.  Numerous negative representations were made during the consultation period. The most recent progress report on the IASB and Financial Accounting Standards Board (FASB) convergence work identified that feedback on consultation was being considered and that changes would be made from August 2010 draft proposals.  Depending on the scale of the changes, they will assess whether a further consultation is required and revised proposals will now be issued at the end of 2011.

For more information, contact Allan Robertson, Director, or Simon Gorst, Chartered Building Surveyor, at Watts Group on 020 7280 8000.

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