On January 1, 2019, lease accounting under International Financial Reporting Standards (IFRS) underwent a significant overhaul as the new accounting standard, IFRS 16 Leases, came into effect. The accounting impact of the standard has hit the headlines with the fact that almost all leases come onto lessee balance sheets, meaning significant changes to indebtedness and metrics such as EBITDA (earnings before interest, tax, depreciation and amortisation).
Conversely, the guidance for lessors remains substantially unchanged from the previous IFRS guidance. Lessors are still required to classify leases as either finance or operating, and the indicators used to make that distinction are again unchanged. So, a reasonable initial reaction for landlords would be there is little to be concerned about. But, as with much of accounting change, that well-used phrase ‘the devil is in the detail’ starts to ring true on further analysis.
Perhaps the most notable impact is accounting for ground leases. Real estate companies can often hold investment properties that are located on leased land. In turn, these ground leases are often for long periods of time, 99 years for example. The very nature of ground leases means real estate companies are lessees in respect of the ground lease and are required to apply IFRS 16. As a result, real estate companies will recognise a right of use asset and lease liability in relation to these leases.
In turn, the right of use asset is classified as an investment property given the leased land is held solely for the purposes of holding the related investment property building. Where the real estate entity applies the fair value model for its investment property, it will equally be required to apply this model to the right of use assets that meet the definition of an investment property. So, how would all this affect the accounting for ground leases?
On initial recognition, the right of use asset and an associated lease liability for the ground lease would be measured in accordance with IFRS 16. Where a ground lease is negotiated at market rates, on initial recognition, re-measurement of a right of use asset from cost to fair value should not give rise to any gain or loss on day one. The amounts reflected in the balance sheet at this point will be an investment property right of use asset and a lease liability of an equal amount. This effectively shows the gross position of the ground lease investment property fair value since valuation models for investment property will include ground lease payments as cash outflows. These cash outflows are now reflected on the balance sheet as a lease liability, and IFRS does not permit this liability to be presented net against the investment property.
Nevertheless, accounting for ground leases in this way could mean substantial increases in investment property on the balance sheet as well as increases in the number of reported lease liabilities, particularly where ground rents are for significant amounts and a long lease term.
While the accounting for ground leases might have the most visible impact on landlord balance sheets, there are several other impacts of the new standard to consider. IFRS 16 is clear that lessors must account for lease and non-lease components of an arrangement separately. This will have a particular impact where landlords have a single contract in place with tenants that covers lease of the property, common area maintenance and payments for property taxes and insurance.
In separating these types of arrangements and identifying non-lease components, landlords must consider whether a good or service is transferred to the lessee. The right to use the real estate will usually be a lease component and common area maintenance a non-lease component. However, payments for insurance and property taxes typically do not involve a transfer of a separate service, and they generally do not represent a separate lease or non-lease component. Instead, these payments form part of the consideration for the lease and non-lease components.
There are then further steps to determine the overall consideration in the arrangement and then allocate consideration to the lease and non-lease components. Each of these steps comes with its own complexities and judgements.
Notwithstanding the above, other areas of the change introduced by IFRS 16 include revised guidance on the definition of a lease, further guidance around determining lease term, specific guidance around accounting for variable lease payments and a different model for sale and leaseback transactions. In addition to these considerations, IFRS 16 also introduces additional disclosures for lessors around the nature of a lessor’s leasing activities and how risks associated with rights retained in underlying real estate assets are managed.
The degree of impact of these areas will, of course, depend on specific circumstances, but there is no doubt that landlords should take a careful look at the standard beyond the headlines.