Effective from 1 January 2019 a company will be required to recognise its leases on the balance sheet if they come within certain criteria under the new leases standard - Accounting Standard IFRS 16. This involves recognising:
- a 'right-of-use' asset; and
- a lease liability.
The lease liability is initially measured as the present value of future lease payments. For this purpose, lease payments include fixed, non-cancellable payments during the term and option terms to the extent that extension is 'reasonably certain'. The initial measurement of the right-of-use asset is based on the lease liability, with adjustments for any prepaid rents, lease incentives received and initial direct costs incurred. In subsequent periods, the lease liability is accounted for similarly to a financial liability using the effective interest method. The right-of-use asset is accounted for similarly to a purchased asset and depreciated or amortised.
Leases are captured under the new leases standard if they satisfy the following criteria
- the lease is for a term of more than 12 months;
- there is an identifiable asset (i.e. defined premises);
- the tenant has control or an economic benefit through a 'right-to-use' the premises; and
- consideration is payable under the lease.
The new lease accounting standard is likely to be felt most by businesses with substantial leased assets portfolios, with obvious impact on loan covenants, credit ratings and borrowing costs. The change may also bring about some businesses to re-assess aspects of their real estate lease interests, including portfolio management and structuring of their lease undertakings.
Occupiers have many drivers in determining the structure their leases that include cash flow via rent and incentive arrangements, security of tenure in the duration and renewal rights and tax considerations. The change in the accounting treatment of leases and its potential effect on the business's debt covenants, tax treatment of leases and perhaps even executive remuneration schemes if these are based on financial metrics are now additional elements which may compete against these traditional key leasing issues. There may be more thoughts on the following:
- is there any benefit or opportunity to structure deals to address the new standard? For example;
- entering into a series of consecutive leases of 11 months and 30 days over the one premises to different entities within the one corporate group, each consecutive lease starting at the end of the previous lease;
- replacing renewal options with first and/or last rights of refusal;
- separating the "rent for premises" component from the "fee for service" component provided by a landlord;
- can the very nature of a landlord's offering be re-configured? For instance:
concepts such as colocation in data centres or shared space in "workshare offices" with no defined premises, where a service is being provided, could be extended to other property sectors such as retail concept or pop-up stores that can revolve in various locations in shopping centres;
can an institutional landlord provide a "warehousing" solution to tenant of a minimum space that is not a fixed but determined by the landlord within a building or defined property portfolio;
is it possible for workshare office providers to restructure their tenancies as "management/services" agreements akin to hotel management agreements between owners and hotel operating companies.
Valuation of lease
The new standard requires a tenant to determine the value of the lease liability in its accounts, an exercise that is likely to require the consideration of:
the appropriate discount rate for determining the net present value of rent over the term;
aside from the possibility of having rights of rights of refusal in lieu of renewal options, the inclusion of options in calculating the lease liability. Any extension of a lease that is reasonably certain is required to be accounted for under the new standard. What factors and their respective weight should be considered as to whether a lease extension is "reasonably certain"? This question may turn on the nature of the property, business requirements and market practice and conditions. As an example, if a tenant is taking its lease incentive up front as a contribution to fitout with landlord owning the fitout and the rent payable under an option is a "face rent", would this lead to a conclusion that an extension is unlikely as there would be no real economic incentive to the tenant? Does this analysis change if the premises are a critical site with substantial tenant improvements?
Lease vs own
The new standard may influence business decisions as to whether to lease or to hold or acquire properties. Would businesses be more inclined to make acquisitions, particularly if the properties designated to be flagship premises or headquarters for the business or there are strategic reasons to invest or to secure more control as an owner of the property on the prospect of future expansion or transformation of the business.
The new standard calls for tenants to have or invest in information management systems to manage and store required lease data. In addition to lease documents, given the common practice of lease incentives being agreed in side deeds, lessees will need to ensure that the details of these arrangements are captured. Finance and accounting teams will need to have a full and accurate picture of lease commitments to enable compliance with the new standards and manage its impact on the overall financial reporting and performance metrics of the business entity.
Finally, landlords will need to be cognisant that the new standard may result in tenants re-assessing their leases and leasing strategies which may include delving into some of the above issues and seeking a collaborative solution.