IFRS 16 Leases: Here’s what you need to know

September 4, 2018 | Commercial Real Estate

Image of a balance sheet

On 13 January 2016, the International Accounting Standards Board (IASB) announced a new accounting standard on leasing which will come into effect on 1 January 2019. The new rules are set to turn balance sheets and internal processes on their heads and will dramatically affect tenant liabilities. So, do you know what these changes will mean for you?

What exactly has changed?

The major shift from the current standards is that businesses reporting under IFRS or US GAAP (around 50% of listed companies) will now be required to recognise commercial leases of more than one year on their balance sheets.

The changes will take effect retroactively. That means that leases that expire after January 1, 2019, that are currently not included on the balance sheet will need to be included for the remainder of the lease.

What changes on the balance sheet?

The new standards view a commercial lease as a tangible asset which depreciates over the lease term. And interest, on the other hand, is recognised as a liability.

For tenants, this means leases will now have to be marked as a “right of use” asset on the balance sheet (in the same way as property, plant and equipment). There will also need to be a corresponding liability (accrued rent), which reduces each year as rent is paid.
Indirect lease costs such as leasing fees, surveys and make good obligations may also be recognised. Lease options may also be taken into account, as long as they will definitely be exercised.

The below is an example of a 5-year lease recorded on lessee’s balance sheet (assuming no annual rent increases, interest + $200,000 of principal repaid annually).

YEAR LIABILITIES (Accrued Occupancy Costs) ASSETS (Property, Plant & Equipment)
0 $1,000,000 $1,000,000
1 $800,000 $800,000
2 $600,000 $600,000
3 $400,000 $400,000
4 $200,000 $200,000
5 $0 $0

How will the changes impact profit? 

Due to the financing cost of the lease – that is, the combination of right-of-use asset depreciation and lease liability (interest expense) – net profit will probably be lower at the beginning of a lease.

However, this will change during the lease term as the lease liability is repaid.

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What are the exemptions?

Short-term leases (under 12 months) and low-value leases (circa US$5000) are exempt from the new rules.

How are annual rent increases accounted for?

Future cash flows should be forecasted using known and fixed rate increases. But, when rental rates change, the lease liability must be calculated again.

Take this example of a 10-year lease with annual CPI increases. The leased right-of-use asset has the original asset depreciated over 10 years. The CPI adjustment after year 1 is then depreciated over 9 years, while the CPI adjustment in year 2 is depreciated over 8 years, etc.

This accounting may require changes to software and existing accounting processes.

How is the Interest Rate for Deductions Calculated?

The interest rate will either be an incremental borrowing rate or implicit in the lease.

What other effects might the changes have?

Since these changes do not affect short-term leases or those under circa US$5000, we may see more tenants opting for short-term leases and an increase in options for renewal.

Lessees may also ask for indexed rent reviews to CPI rather than fixed reviews to reduce their liability. Gearing will be impacted as interest cover and return on capital will fall, with loan contracts requiring re-negotiation.

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How can you prepare for the changes?

  • Educate the relevant stakeholders
  • Set up a project structure for your tenancies
  • Make an inventory of lease and rental contracts to determine the impact on the business (rental offices, copiers/printers, lease cars, software, hardware, furniture, etc.)
  • Contact IT systems and software providers to discuss the consequences for propriety and third-party systems and software
  • Prepare for the new accounting policies and procedures, including your transition strategy

For further and more detailed commentary on the application of IFRS to commercial real estate, we recommend contacting the team at Tenant CS or reading PWC’s paper, “Applying IFRS for the Real Estate Industry”.

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