Tenants and landlords – commercial leases

By Andrew Clugston - January 11, 2017

Changes in leases accounting standard may impact financial results

AASB 16: what you need to know

After much debate, on 13 January 2016, the International Accounting Standards Board (IASB) released a new standard for lease accounting: International Financial Reporting Standards (IFRS) 16 Leases. Subsequent to this, in February 2016, the Australian Accounting Standards Board (AASB) published the Australian equivalent to IFRS 16 - AASB 16 Leases.

To date, the new Standard has not generated much discussion in the property industry, despite the impact the Standard is expected to have on the financial statements of parties to lease agreements, particularly tenants.

The new Standard won’t take effect until financial periods beginning on or after January 1, 2019, but if you’re signing a long-term lease on commercial property that will include periods beyond 2019, you will necessarily be affected by the changes.

The intent of the new Standard is to facilitate greater transparency in financial reporting by removing the ‘shadow debt’ created from operating leases. This enhanced transparency, however, will have significant accounting implications for tenants.

Other items based on earnings before interest, tax, depreciation and amortisation (EBITDA), such as banking covenants, business valuations and employee performance measures may also be impacted by the change.

Although impacted to a lesser extent, landlords should also be aware of the changes to aid negotiations with tenants.

AASB 16 – what are the changes? 

Currently, all leases are classified as either operating or finance leases, and are accounted for differently subject to their classification. Under the new Standard, tenants will account for all leases on the same basis.

Accordingly, under the new Standard there will be no distinction as far as tenants are concerned between operating and finance leases. 

Broadly, all leases (with some limited exceptions) will be accounted for under AASB 16 by tenants in a manner similar to the way finance leases are currently accounted for under the current Standard, AASB 117 Leases. Consequently, except in some limited circumstances, tenants will be required to recognise both an asset (‘right-of-use’) and a lease liability in respect of each lease. In contrast, there will be no substantial changes to the manner in which landlords account for leases.

The impacts of the new Standard on the reported results of tenants can be broadly categorised as follows:

  • Balance sheet
  • Income statement
  • Cash flow statement
  • Lease accounting administration

Balance sheet

Requiring tenants to recognise operating leases in their balance sheets will result in increased levels of reported assets and liabilities. 

Depending on the composition and structure of a tenant’s balance sheet, recognition of operating lease commitments as liabilities could have a detrimental effect on the tenant’s gearing and other related ratios, which in turn could have adverse consequences for their banking covenants. Similar to the current accounting for finance leases, the recognition of lease assets and liabilities may also necessitate tenants recognising deferred income tax balances arising from these operating lease
arrangements, further impacting their balance sheet structure and earnings profile.

Income statement

The current requirement for tenants to classify rental payments as an operating expense in their income statement will be replaced under the new Standard with the requirement to recognise separately depreciation/amortisation of a leased asset from interest expense in respect to the lease liability.

This change is expected to improve EBITDA measures, which may have flow-on implications for other areas, such as business valuation methodologies, employee performance measures and banking covenants that are based on EBITDA measures, although analysts are likely to normalise earnings to take in to account these changes.

Tenants should also be aware that not only will the classification of rental payments change under the new Standard, the pattern and timing of the recognition of lease-related expenses in operating profit are likely to change. Because interest expense will be calculated on a different basis (using the effective interest method) to the depreciation/ amortisation expense, this will generally result in a different rental expense profile as compared to that under the current Standard.

The following diagram illustrates the implications for lease expenses recognised by tenants under AASB 16.

Cash flow statement

Under the current Standard, financial lease payments are generally classified as arising from financing activities, whilst operating lease payments are generally classified as arising from operating activities. Under the new Standard, however, cash flows attributable to the reduction in the lease liability balance will be classified as arising from financing activities and cash flows attributable to the interest on the lease liability will be classified as either arising from operating or financing activities.

Lease accounting administration

In addition to the financial implications, it is worth considering if your current accounting systems are sufficiently robust to deal with the reporting requirements under AASB 16.

Although much of the information that will be required under AASB 16 is currently collected by tenants, most tenants would not have sufficiently sophisticated systems to enable them to calculate the carrying amounts of lease assets and liabilities on an on-going basis. A more sophisticated finance system may be required to capture and report on this information without error, particularly for those entities that are tenants in multiple lease arrangements.

Given the changes to lease accounting that are currently on the horizon, we recommend that prior to finalising any lease arrangement you consider meeting with your Pitcher Partners advisor to discuss how you might be affected.

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