From 1 January 2019 new “International Financial Reporting Standard (IFRS) 16 Leases” makes significant changes to lease accounting for affected tenants who are now required to report lease liabilities on their balance sheets. This is likely to influence the length of leases taken by tenants in future and will impact tenants’ earnings and liabilities with consequential effect on covenant tests.
IFRS 16 has been long in gestation, first discussions dating back to 2006. The agreed Standard was issued at the start of 2016 but only became mandatory for annual reporting periods starting on or after 1 January 2019. Whilst the new Standard treats lessor or landlord accounting in a similar way to International Accounting Standard 17 (the superseded accounting standard on leases), the treatment for lessee or tenant accounting is significantly different.
The key purpose of IFRS 16 is to improve the transparency of the way affected companies account for their lease liabilities, including real estate leases. While the previous Standard recognised lease payments under a finance lease as a liability on the balance sheet with a corresponding asset, the rent expense under an operating lease was recognised in the profit and loss account as it fell due, with no liability arising on the balance sheet.
IFRS 16 changes the treatment of operating leases. Subject to a limited number of exemptions, all leases will be recorded on the balance sheet as liabilities reflecting the full term at the present value of the future lease payments. A tenant’s option to extend, renew or break may need to be taken into account if it is reasonably certain to be exercised. The primary exemption to this accounting treatment is for leases with a term no longer than 12 months. Also turnover rents are excluded from balance sheet liabilities as their amounts are unpredictable.
The effect of this change is that a company’s balance sheet potentially becomes more heavily indebted. This may have a significant adverse impact on the company’s financial ratios and potentially could lead to breaches of financial covenants in loan agreements, especially where the company is already heavily in debt.
The new Standard is most likely to impact on businesses with rack rent leases. Tenants may increasingly opt for leases with a shorter term to reduce the liabilities on the balance sheet. This reinforces the tendency of tenants over the last decade or so to take shorter leases, enabling greater flexibility in escaping lease commitments.
Consideration needs to be given to the effect of the accounting changes on profit tests for example for the release of a rent deposit. The new treatment of lease liabilities may deter some from entry into sale and leaseback transactions.
The accounting change is significant because, of itself, it makes tenants a poorer financial covenant, even though their businesses may remain consistently healthy. It remains to be seen whether lenders and landlords are sanguine despite the change.
Not all UK tenants will have to prepare their accounts under IFRS 16 and can continue to prepare them under UK GAAP. For example, if a UK company is not required by the Companies Act 2006 to prepare consolidated accounts, it is not required to use IFRS. GAAP can continue to be used for individual entity accounts.
Whilst the change has no significant accounting impact for landlords, the effect of the change on the letting market, with possible reductions in lease lengths, may well adversely impact on landlords.