Bottom line on leasing change

Bottom line on leasing change

Auckland Office Workplace – February 2020

Auckland’s office sector in prime location

Alexander Knyazev of Ernst & Young offers a plain-English explanation of what a new international accounting standard will mean for your lease.

What’s changing?

In short, lessees will need to bring almost all their leases on the balance sheet.

The previous standard separated operating leases – generally shorter in term – and finance leases. Accounting for operating leases was like renting a house; finance leases were more akin to mortgaging it.

IFRS 16 – a sexy codename for the new leasing standard – effectively eliminates this difference, making all leases mortgage-like.

Let’s take a six-year lease at monthly rent of $10,000. When entering this agreement, the lessee signs up to an obligation to pay a total of $720,000 over the following years. The old standard kept this liability off the books until it was time to pay; IFRS 16 says “show it to the world”.

As usual, with obligation comes a right. In this case, it is the right to use the leased property during the lease term. Previously, with the liability kept off-balance sheet, the same approach was used for resulting rights. IFRS 16 requires showing those right-of-use (RoU) assets.

How does it work in practice?

The quantum of the lease liability and resulting RoU asset will depend on agreed rent and many other things, such as the lessee’s creditworthiness, any incentives paid by either party, additional services provided by the lessor, rights of renewal and how likely they are to be exercised.

Let’s see how that happens.

Creditworthiness

A mortgage analogy is useful here: as a debtor’s creditworthiness increases, the total amount they would be required to pay decreases, and vice versa.

In lease accounting, entities generally work backwards: the amounts to be paid are generally known, so a lower borrowing rate translates into a higher lease liability and related RoU asset.

Determining an appropriate rate to discount lease liabilities has proven to be one of the most challenging areas in practice. Keeping in mind that each and every lease of the entity could have a different discount rate, it is no wonder many entities are struggling.

Incentives

An incentive paid by a lessor to a lessee is treated like a discount on a “purchase” of an asset – in this case, the RoU asset – reducing its initial carrying amount. If the lessee makes an initial payment, this amount is added to the initial measurement of the RoU asset.

Additional services

It is not uncommon for a lessor to provide additional goods or services to lessees; think power, water, cleaning, security, etc. IFRS 16 gives lessees a choice to consider these payments as part of the lease or to treat them separately. If the latter option is used, there is a special approach to allocate total payments due between lease and non-lease components.

Rights of renewal

Getting the length of lease term right is paramount for lease accounting under IFRS 16. Renewal options were often overlooked under the previous accounting standard. It didn’t make much difference for operating leases, as assets and liabilities were kept off-balance sheet.

Here’s how it impacts reported assets and liabilities now that the new standard is in. Think of a lease with an initial fixed term of six years with two rights of renewal of four years each. Such a lease could translate into a liability of paying rent for six, 10 or even 14 years with corresponding growth in value of the RoU asset.

Further, the appropriate discount rate could be quite different: 14-year borrowing would generally command a higher rate than six-year borrowing.

The lease term includes an initial fixed period plus any subsequent periods that the lessee is “reasonably certain” to extend for.

Reasonably certain is a high threshold, so IFRS 16 gives some useful tips requiring the lessee (and lessor) to consider the importance of the leased asset to the business, whether substantial leasehold improvements have been made, whether the lessee could suffer economic penalties when exiting the lease earlier and other relevant factors.

Lessors’ perspective and other matters

Lessors will be pleased to learn that IFRS 16 has not introduced major changes for them, retaining different approaches for operating and finance leases. We are also yet to see any changes to business decisions of the entities.

True, the new standard has removed a perceived benefit of leasing by requiring assets and – perhaps, even more importantly – liabilities to be brought onto the balance sheet; all the other benefits of leasing – reduced risk of ownership, available capital for investing in other assets, flexibility – remain significant.


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