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Everything you need to know about IFRS 16 in five minutes

Reading time:  4 Minutes

New IFRS 16 legislation could make long-term office-space lessees look to more flexible solutions, says Alexander Garrett

 

Ships and planes, oil rigs and trains, shops and hotels – they all have one thing in common. Businesses have snapped up these valuable holdings in recent years through operating leases, as part of a massive spending splurge that has allowed companies to get their hands on the asset without having to put it on their balance sheet. From January next year that will come to a halt when the introduction of a new international accounting standard – IFRS 16 – means that lease contracts will have to be reported as liabilities in company accounts and can no longer be hidden.

And, in case you’re wondering what this has to do with you, here’s another item that can be added to that list: offices. If your organisation (as with most) doesn’t own the majority of its workspaces but leases them on a long-term contract, then you’ll have to declare those liabilities in full from next year. For companies where corporate real estate is one of the biggest outlays, that’s going to make waves on the balance sheet – in some cases dramatically increasing the company’s level of borrowing.

What it will mean, in short, is that it’s time for a reappraisal of your leasing portfolio. Many believe that the innocuously named IFRS 16 will be the catalyst for a move away from long-term leases, and will accelerate the trend towards short-term, flexible workspaces that aren’t covered by the new standard.

Lease liabilities

The initiative for a new accounting standard on leases is credited to Sir David Tweedie, who, when chairman of the International Accounting Standards Board, liked to quip that “one of my great ambitions before I die is to fly in an aircraft that is actually on the airline’s balance sheet”. His point was that nearly all airlines at that time leased their planes to mask the true extent of their debt.

IFRS 16 has been a long time coming, and its key provision is that for tenants or occupiers of property, there will no longer be a distinction between operating and financial leases; all must be reported as ‘lease liabilities’. There is an exception: short-term leases of less than 12 months’ duration, which are exempted so long as there is no built-in option to buy the asset at the end of the term. The IASB has estimated that listed companies have almost $3trn(1) of liabilities for leases that are currently off the balance sheet.

The extent of the new-found liabilities will vary significantly from industry to industry. A visually arresting infographic created by Aptitude Software(2) depicts the hidden liabilities afflicting different sectors as ‘leasebergs’, and reveals that retail and logistics have the greatest volume of leased assets.

Research by PwC, meanwhile, suggests that professional services companies, which lease mainly offices and cars, will see their debt level rise on average by 42 per cent in the post-IFRS 16 world(3).

Long-term losers

So why does this matter? “Where a company is party to substantial leases, the recording of major new assets and the associated liabilities will change gearing ratios, showing total debt as higher than before. Where companies have loan covenants based on total debt levels, this may lead to breaches simply due to the accounting change,” explains Paul Fenner, head of real estate at accountancy firm Moore Stephens. A survey of lenders in 2015(4) found that 80 per cent plan to change their approach for future agreements or adjust the level of ratios in loan covenants after the introduction of IFRS 16.

In some cases, investors may be spooked when the full extent of a company’s financial liabilities is revealed. When UK bookshop chain Borders went into liquidation in 2011, it became apparent that the company had exposure to long-term leases many times the liabilities on its balance sheet.

What does all this mean for the office market? At the very least, anybody who leases offices among other assets is going to find the process of accounting for them far more complex than it’s been in the past. In a multinational company, for example, offices are usually leased at local country level, and all that information will have to be compiled across borders, languages and currencies to feed into global accounts.

Flexible solutions

But the more significant change is likely to be seen in how the introduction of IFRS 16 changes the office market. There is a general consensus that companies will look for shorter leases, thus keeping their new balance-sheet liabilities to a minimum. And some office leases may be converted to service agreements, as a way to avoid capitalising the lease, according to the occupier services team at property agents Savills. According to Savills: “Serviced offices and collaborative workspaces may receive a major boost from the changes.”

This view is echoed by property consultancy Cushman & Wakefield, in its report Coworking 2018(5). “Leases or licences under 12 months can be excluded from IFRS 16, which is expected to result in an uplift in demand for flexible workplaces as there will not be a requirement to capitalise the rental liability on the occupier’s balance sheet,” the report’s authors said.

At the nub of the issue is ‘right of access’ – who’s really in control of the workspace. Flexible workplace companies such as Regus own the interest in the property and provide the occupier with space and services according to demand and availability, so this is unlikely to be deemed a lease under the new accounting standard. Cushman & Wakefield carried out its own survey of UK landlords(6) and found that “one third believe that the proposed change in lease accounting standards would definitely drive demand from traditional leased space to flexible workplace, with the remaining two-thirds stating that it was likely to result in a shift in demand. Not one respondent thought it would have no impact on future demand.”

Jonathan Steel, global head of occupier solutions at BNP Paribas, says the new standard is an opportunity for companies to spring-clean and decide which assets should be owned, leased traditionally, or occupied under serviced office tenancy. The more flexible the solution, the smaller the impact on the balance sheet – and that should keep both banks and investors happy.


 

Alexander Garrett is a British freelance journalist who writes on a wide range of business issues for the UK press

Sources:

(1) https://www.ifrs.org/-/media/project/leases/ifrs/published-documents/ifrs16-effects-analysis.pdf

(2) http://blog.aptitudesoftware.com/multinational-companies-heading-leaseberg-huge-proportions

(3) https://www.pwc.co.uk/assets/pdf/ifrs-16-the-leases-standard-is-changing.pdf

(4) http://old.efrag.org/files/ED%20Leases%202013/Feedback_report_on_loan_
covenants_consultation.pdf

(5) http://www.cushmanwakefield.co.uk/en-gb/research-and-insight/2018/coworking-2018

(6) http://www.cushmanwakefield.co.uk/en-gb/news/2018/01/coworking-report