IFRS 16 - change at hand on the balance sheet

In January 2019, the way leasing transactions are reported in financial statements will change, and the effects of new balance sheet liabilities could be dramatic. Clare Harman Clark summarises the key points in an article for EG.

New rules are poised to bring about the biggest shake-up in accounting practice in years. In January 2019, the way leasing transactions are reported in financial statements will change, and the effects of new balance sheet liabilities could be dramatic.

Anticipating this change is vital. Every business must understand the upcoming impact of International Financial Reporting Standard 16 (IFRS 16) on its statement of financial position (its balance sheet), and every behind-the-scenes adviser needs to appreciate the new consequences for how real estate transactions are structured.

For those who are not versed in accounting acronyms, the International Financial Reporting Standards are, essentially, a single set of enforceable and globally accepted accounting standards. Used to produce the financial statements of listed companies in 120 jurisdictions worldwide, they are promoted as bringing consistency and comparability that is welcomed by cross-border investors and regulators alike.

The latest incarnation of these standards, IFRS 16, has been available on a voluntary basis for early adopters since January 2016.

However, from 1 January 2019, it will become mandatory when compiling the consolidated accounts of all UK public companies. It will also apply retrospectively for financial years ending at any time after that date.

No accounting distinction between operating and finance leases

The headline change is that IFRS 16 eliminates the distinction between operating and finance leases for lessee accounting purposes.

Currently, tenants need to include only finance leases as assets on their balance sheets. Operating leases are treated as expenses, so the liabilities of rents (and other outgoings) appear as they fall due but do not impact the overall balance sheet position.

This distinction has been an important one, going to the heart of how companies structure their relationships with property. A finance lease involves the risks and rewards of asset ownership transferring, ultimately, to the tenant. This is more likely in cases with highly specialised or modified properties, but a finance lease label can be applied where there is an option to extend a lease at substantially under-market rent. All other leases, including the run-of-the-mill FRI lets, tend to be operating leases. Classification can prove challenging, but it is usually done at the inception of a lease arrangement. Where the nature of a lease changes over its term, it might become a finance or an operating lease moving forward, but original accounting entries are not retrospectively amended.

From next year, all operating leases above a rental de minimis and with a term over 12 months will be capitalised as right-of-use assets, meaning that practically all rental agreements will become front-loaded balance sheet liabilities. Landlords will be subject to some additional disclosure requirements, but crucially, tenants’ balance sheets will appear more asset rich, but also more heavily indebted.

Increased balance sheet volatility?

As balance sheets are affected, so are the key ratios that underpin corporate borrowing. Leverage is an established financing metric, but without accommodating drafting, existing financial covenants in loan agreements could be breached as gearing ratios or interest cover changes, potentially triggering events of cross-default.

For its new definition of "financial indebtedness", the Loan Market Association’s own financial covenants test appears to have settled for now on referring to a frozen concept of a "finance lease", but we might expect a more long-term solution to work with updated IFRS 16 standards.

Borrower balance sheets are certainly likely to become more vulnerable to volatility with every lease addition or disposal. Opco/propco structures could deliver oddities within a group’s accounts where lessors' statements do not mirror lessees' disclosure. Sale and leaseback transactions will now also require an accounting entry for the point at which a sale occurs, rather than depending on whether the leaseback itself is an operating or a finance interest, and there are "top-up" accounting requirements if the purchase price is not fair value. It seems likely that the use of this structure will decline.

Many hope that improving the visibility of lease obligations could have a positive impact on the cost of borrowing. Last year, the chairman of the International Accounting Standards Board, Hans Hoogervorst, fairly pointed out that "the majority of credit providers and rating agencies already take [operating lease liabilities] into account when evaluating a company’s ability to pay its bills, albeit often in an imprecise manner." It is clearly an inexact science, but corporates can currently expect about 8% of off-balance sheet leasing liabilities to be accounted for one way or another.

IFRS 16 will have the greatest impact on businesses with a large portfolio of short-leaseholds, such as retailers and hotel operators. IASB research from 2014 provides a salutary reminder that 85% of all lease liabilities will now count as formal financial indebtedness, potentially hiking levels of interest-bearing debt. Of course, it’s not all bad news, but reported operating profits will increase as the leases are capitalised. Management incentives dependent on earnings before interest, taxes, depreciation and amortization (EBITDA) could benefit as it grows with the new rules.

Brexit impact?

There is still no firm indication of what our accounting landscape will look like in the post-Brexit environment. The IFRS framework was introduced in the EU in January 2005, but unless legislation incorporates it directly into the UK, we risk an accounting rules interregnum after March 2019, just a few weeks after IFRS 16 becomes mandatory.

The accounting industry is still waiting for the government to be clear on this point. Worryingly, the Institute of Chartered Accountants of Scotland has pointed out that since the EU is a major and influential user of IFRS, Brexit might well mean sacrificing our national voice on how the standards are set and maintained. Still, there doesn’t seem to be a viable alternative to IFRS 16. ICAS also warned against the retrograde step of ditching the standards, pointing out that the UK’s Generally Accepted Accounting Principles model is not entirely fit for purpose when it comes to listed companies.

In the meantime, without any government steer, it is sensible to assume the new rules are coming.

Preparation is key

Awareness is essential to strategic and cost-efficient planning. The full impact of IFRS 16 will become apparent in time, but considering possible implications now will help tenant advisers develop transaction structures that are less vulnerable moving forward.

Tenant corporates should therefore consider the following:

• Review existing leasehold inventories: corporates must audit their data and capture all the required information to ease the path to compliance, asking, for example: is the available data robust? Do existing IT systems capture the required information efficiently?
• Model existing data on an IFRS 16 balance sheet: this exercise will help to highlight any impact of the new accounting rules on existing financial covenants. It is important to plan for conversations with investors, analysts and banks in the event that financial covenant breaches could be triggered by IFRS 16 balance sheets.
• Budget costs for compliance: it is important to speak to accountants early to budget in any practical costs of compliance.
• Consider IFRS 16’s impact when negotiating new financing deals: when entering into new lending, be aware of financial covenants that are measured by reference to accounts. Ensure covenants are unaffected by changes in accounting requirements, and ask questions about the tolerance of lenders for financial covenant breaches triggered by IFRS 16 balance sheets.
• New leasehold transactions: new leasing transactions must consider future accounting implications and the limited exemptions to balance sheet disclosure involving term or rental levels. It is not yet known how these will be applied. Low-value leases (less than £3,000 pa) or those with a term of 12 months or less, are not generally captured by IFRS 16, but there is currently uncertainty about the use of short-term interests coupled with purchase or renewal options. Such a structure might not circumvent disclosure where the options are likely to be exercised (eg where the tenant incurs initial capital expenditure on a fit out). Also, review other relevant clauses that tend to refer to applying specific accounting standards, for example, in connection with releasing guarantors or repaying rent deposits. Financial modelling should assess the impact of IRFS 16 on desired counter-party stability or the likelihood of being able to evidence covenant strength.
• Proposed sale and leaseback transactions: with new accounting requirements for this structuring mechanic, ask, what disclosure will the transaction require on the part of the lessee and what impact will this have? Is there an impact of a discounted purchase price and the need to "top up" on accounts? Heralded as one of the "most significant developments" in the history of IFRS, the new rules will provide investors and regulators with more transparent and reliable information about a company’s leasing commitments, but they carry the risk of considerable cost and upheaval.

The better prepared the client, and the more aware the adviser, the easier it is to mitigate the immediate impact.

This article was first published in Estates Gazette on 1 March 2018.