New lease accounting standards are on their way – the scouts’ motto of ‘be prepared’ is apt.
From January 2019, all leased assets, including those covering property, are required to be reported differently in financial statements. Coming into effect for the beginning of next year, this means that financial planning and budgeting for the financial year commencing in July 2018 will need to change.
The Australian Accounting Standards Board (AASB) has adopted the International Financial Reporting Standards – IFRS 16, designed to increase the transparency of lease reporting.
Dependent on the nature of the business and their leased property portfolio details, this will likely have a significant impact on annual financial statements, with off-balance sheet operating leases now recognised on the balance sheet as assets and liabilities.
Even as we move into the digital era, all operating entities require physical premises from which to operate. The use of these premises is usually secured by entering into lease agreements with landlords.
This symbiotic relationship means that businesses do not have to allocate scarce working capital to construct and own buildings, while landlords secure the rental income streams required to underpin their property investments.
For businesses, this arrangement has provided ‘off balance sheet’ funding that does not overtly reflect their future lease total liabilities. As most businesses know, when leased premises are no longer required, the full extent of the financial commitment of the remaining lease term does not ‘go away’.
The ongoing rental liability continues until a termination payment or assignment can be negotiated – this can cause the business to fail. This lack of transparency in statements of financial position is now about to change in alignment with international accounting trends. And this new transparency is likely to change decisions related to leasing portfolio strategies.
New Additional Challenge
Facilities managers already need to display a broad range of skills in managing a diverse range of ongoing property challenges, including relocations and consolidations, workplace churn, lease renewals, new premises rollout and maintaining various service performance standards.
With these new lease reporting standards, facilities managers will need to focus more on the priorities of the CFO (chief financial officer) of the business and demonstrate a clear understanding of the new lease reporting principles.
In determining future leasing strategies and specific transaction decisions, facilities managers are likely to be spending more time with their CFO and their auditors in assessing the appropriateness of how lease requirements will be managed and making judgements regarding the likely financial reporting implications.
From January 2019, all operating leases for defined areas, and longer than one year, are required to be recognised as ‘right of use’ assets on balance sheets with corresponding non-recurrent lease liabilities, being the obligation for the payments necessary to amortise such assets.
There will be a corresponding non-current lease liability representing the present value of lease payments. With this approach, in the future, all currently classified operating leases are likely to reflect the current treatment of finance leases with all financial obligations reported.
The current practice of assessing whether the risks and rewards of a leased property asset have passed to the tenant to determine the distinction between these two forms of leases will no longer be relevant.
For fixed-term leases with no options and fixed increases, determining the carrying amount for each lease liability and the ‘right of use’ asset value is likely to be relatively simple, adjusted for any initial direct costs and incentives. However, where leases have renewal options and contraction clauses, the process is likely to be more challenging.
A judgement on the probability of exercising these rights in the future will be needed to determine the ‘longest possible term that is more likely than not to occur’. This process will require some subjective judgement, possibly driven by the CFO or business unit leader – dependent on business priorities – in determining the occupancy term and the resultant ‘right of use asset’ value and lease liability reported on the balance sheet.
The discount rate is to be applied to the future lease benefits and payments to determine the ‘carrying values’. The standard directs this to be either the discount rate used by the landlord or, if unavailable, the tenant’s incremental cost of borrowing.
Interestingly, different companies with identical leases may have different accounting outcomes simply due to higher costs of borrowing. This may result in less creditworthy companies with higher costs of borrowing to have smaller financial impacts on their balance sheets than more stable companies – from the same lease structure!
In the future all leases currently classified as operating leases will be accounted for in a similar way to how finance leases were treated in the past. This will end the availability of the most common form of ‘off-balance sheet’ finance to companies via landlord leases. Being unable to avoid having to report lease obligations on balance sheets may lead to the re-emergence of complex financing and development leasing structures. In terms of other financial changes, EBITDA (earnings before interest, taxes, depreciation and amortisation) and cash flow from operations is likely to increase, with property leasing now seen as a financing activity under the control of the CFO.
Financial ratios will be impacted with some possible fundamental changes to debt to equity ratios, interest coverage ratios and loan covenants. This is certainly likely to attract the attention of debt and equity funding providers in the short- to medium-term until the hiatus period has settled down and new benchmarks entrenched.
With the ‘front-ending’ of the lease expenses and lower finance charges over time – in contrast to the current straight-line treatment of lease payments over the life of the lease – net operating income and distributable profits may reduce in the earlier years of lease agreements. This will surely be an area of focus for the executive leadership team.
Impact of Leasing Strategies
In determining future leasing strategies, occupiers will have to consider and deal with the possible impacts across a range of business and financial measures. There are now likely to be wider finance issues to address that may affect the business operating decisions other than merely the compliance aspects of the reporting requirements.
Portfolio leasing strategies will change. Shorter leases with reduced lease interest costs may become more attractive considerations for tenants – particularly those under financial pressure – realising that the longer the lease term, the greater the financial reporting impact.
This new lease reporting regime is likely to mean changes to business performance measures, profit-related remuneration, short-term internal accommodation charge-backs and even executive performance metrics.
A new focus on short-term (less than one year) and flexible accommodation arrangements (non-defined leased areas) will further drive the current impetus to move all or a large portion of accommodation needs to co-working hubs.
And because the services related to the leased assets – substantially being the building outgoings – are exempt from these new reporting standards, the industry may see the emergence of separate service agreements with payment structures and performance standards. These may no longer form an integral part of the lease agreement and rent payments, entrenching the trend to net rent lease structures.
Facilities managers, working with the finance team, will face new challenges in managing key accommodation decisions and the annual financial reporting requirements – particularly for large portfolios.
But most important is having full transparency of the portfolio of all current lease details – there are no ‘grandfathering’ provisions – at all times for those financial conversations with the CFO and the business unit leaders. Having and maintaining a lease information tracking system with all review, option and renewal dates, and ensuring the data integrity, is likely to become a more critical part of a facilities manager’s responsibilities.