Today, we return from ranting (last week) to “wonky.” And, we do that despite knowing that only a small number of readers really need to know about lease accounting. We do it because a large number of our readers, though not needing to know, like and want to know a little something about the topic.
Today’s impetus is because the International Accounting Standards Board (IASB) just (January 13) issued its latest standard: IFRS 16, Leases. This is the culmination of a decade-long project, sidetracked by many, many issues, comments, and objections. Now, astute readers would rightly say: “Why do I care about the IASB. Here in the good ole’ USA, we abide by standards promulgated by FASB, the Financial Accounting Standards Board.” Well, that one is easy. IASB and FASB worked arm in arm on this standard and FASB’s version, expected to be published in February, will call for the very same things as this one.
There’s no need to spill your coffee or skip that bathroom break to read today’s posting. This lease accounting standard (and the expected FASB standard) becomes effective after 2018.
Here’s another important point. The FASB standards (being the ones that will be incorporated into GAAP – Generally Accepted Accounting Principles) will not be identical to the ones issued by the IASB last week. BUT, they will be pretty close. The two standards follow the same principles and share the same objectives.
And, another point: lessors (to us – landlords) will be unaffected. These standards (and the ones expected from FASB) are for lessees. Some lessees will be affected much more than others and one category of the more affected will be retail tenants.
At this time, some leases are characterized as “operating leases” and others are characterized as “capital or finance leases.” A finance lease is treated as if it were a loan and the “rent” is treated as a payment against what is owed. Thus, the time-adjusted total amount of rent to be paid is seen as the size of the “loan” plus accrued interest. For simplicity, we’ll ignore the “interest” and pretend that there is no such thing as a “present value” calculation. So, let’s say there is a 10 year lease and the rent is $10,000 a month. That means the total rent would be $1,200,000. Under the new standard, that would be treated on a tenant’s financial statements, primarily its balance sheet, as a $1,200,000 loan borrowed from the landlord for use of the leased property. Think of it as a deal where the tenant paid $1,200,000 up front for the right to possess the leased property for 10 years and needed to borrow the $1,200,000. Interest aside, the loan repayments would be $10,000 a month.
Before anyone has apoplexy, we’ll also point out that there is an offset to showing a lease’s liability (akin to the “loan” liability) on the balance sheet. The right to use the leased property is an “asset” and, in addition to a balance sheet having a liability column, it has an asset column. Again, we’ll analogize this to a loan. If one borrows a million dollars, that amount will show up as a liability on the balance sheet. BUT, it will also show up as an asset: cash of $1,000,000. So, why would anyone care if their “net assets” or “shareholder equity” remain unchanged? Well, try this one: financial ratios will change and that might cause the tenant to violate some financial ratio triggers, most of which are found in loan documents.
Before we continue, we ought to explain why these long-debated changes are being made. We also need to caution readers that today’s treatment is very, very, very superficial. Think of today’s posting as just a notice and not a textbook. This is serious accounting stuff. Accountants who have been following these debates and the various iterations previously released are the ones to consult. Without doubt, following publication of the new FASB lease accounting standards, there will be many sources, programs, and writings, to teach us – lowly scriveners of leases – how to prepare lease to maximize the benefits and minimize the detriments a tenant will see when the new standards go into effect. Perhaps a better way to express that prediction is to say that we’ll all be learning how to mitigate the effects of the new lease accounting standards.
A good summary of the preceding paragraph is that today’s blog posting is merely to prepare readers to understand the discussion and to caution that this is technical stuff that goes beyond an individual lease. Also, we’re describing the international (IFRS) standards; the domestic (FASB – GAAP) ones will be different in detail, though not in principle. Many small tenants will be unaffected because of company size (unless a lender or other requirement requires compliance). That having been said (written), here we go.
What was “broken,” i.e., what are the “problems” sought to be cured? The overriding goal is to improve the quality of financial reporting, especially for companies with significant off-balance sheet lease liabilities. The financial community doesn’t think that disclosure, usually in the form of footnotes, is enough. At best, footnotes and other disclosures are the basis for each individual “analyst” to make estimated adjustments to a company’s financial statements. Inexperienced readers of financial statements, and that includes this writer and most readers, are unequipped to make those adjustments.
What adjustments? We’re talking about comparability between tenants who own their store building and those who lease them. Both have the “right to use” the store space, but their financial statements just don’t compare one to the other. Currently, on average, the present value of retailers’ off-balance sheet lease obligations is over 20% of their total assets. According to the IFRS, its “analysis of some retailers that have gone into reorganization/liquidation shows that the value of off balance sheet leases was almost 66 times the value of on balance sheet debt.” That’s the reason why rating agencies make adjustments for off-balance sheet leases. When balance sheets conform to the new lease accounting standards, the ordinary reader will see those kinds of adjustments already built-in to them.
Here is the way the International Accounting Standards Board puts it:
The IASB expects IFRS 16 to significantly improve the comparability of financial information. This is because companies will:
(a) recognise assets and liabilities, in essence, for all leases;
(b) measure all lease assets and all lease liabilities in the same way; and
(c) recognise only the rights that are obtained, and the liabilities that are incurred, through a lease.
As a result, financial statements will reflect the differing operating decisions made by different companies. When a lease is economically similar to borrowing to buy an asset (for example, a lease of a new aircraft for 20+ years), then the amounts reported applying IFRS 16 will be similar to the amounts that would be reported if the company were to borrow to buy the aircraft.
However, when a lease is economically different from borrowing to buy an asset (for example, a lease of a new aircraft for seven years) then the amounts reported applying IFRS 16 will reflect those different economic decisions. The assets and liabilities reported will be less than would be reported if the company were to borrow to buy the aircraft. In this scenario, the company’s right to use the aircraft for seven years is substantively different from the rights that it would obtain if it were to buy the aircraft. Accordingly, the amounts recognised applying IFRS 16 are expected to be substantively different from borrowing to buy that asset.
The only explanation we’ll offer about that quoted material is that the British spell “recognize” that way.
It isn’t only a tenant’s balance sheet that will be affected; its profit and loss (income) statement will be as well. Think about a loan. At the time of the loan, the income statement will be unaffected. The borrowed money is not income. As the loan is paid, each payment is handled as having two components: a principal repayment portion and an interest payment portion. Only the interest portion is an expense that reduces operating profit. Financial analysts are very interested in a “tool” known by the acronym: EBITDA, “Earnings Before Interest, Taxes, Depreciation, and Amortization.” Under current lease accounting, rent is treated as an operating cost. As such, it reduces EBITDA. Under the new standards, with rent being treated as part depreciation and part interest, no part of it will reduce EBITDA. So, EBITDA will look higher. The depreciation portion will get “subtracted” from EBITDA and the resulting figure will be “operating profit.” The interest portion is a financing cost and when that is subtracted from operating profit you get “profit before taxes.”
OK, Ruminations, what is this “depreciation” thing? How can rent be seen as depreciation? Well, under the new accounting standards (IFRS and the soon to be released FASB standards), when a tenant has a lease, it has an asset. That asset is the “right to use” the premises for the term of the lease. As time goes by and the remaining term gets smaller and smaller, the value of the “right to use” gets smaller and smaller. Basically, it depreciates. If the same tenant owned the property, its income statement would show annual depreciation for that property. Under the new accounting standards, rent payments would be treated the same way (at least with respect to the amount above imputed interest).
Almost certainly the expected FASB treatment as to how depreciation is calculated will differ from that required under the new IFRS 16 lease accounting standards, but that will be a difference in degree, not principle. Under either standard, even if the “depreciation” charge remains uniform over the term of the lease, the interest charge will get less and less over time as the “principal. i.e., depreciation” is paid.
So, from an altitude of 30,000 feet, why should anyone care? The most direct effect will be on key financial ratios. A lesser, but certain, effect will be on metrics derived from “profit and loss” statements.
For an individual lease, in the words of the International Accounting Standards Board:
Applying IFRS 16 to an individual lease, the carrying amount of the lease asset would typically reduce more quickly than the carrying amount of the lease liability. This is because, in each period of the lease, the lease asset is typically depreciated on a straight-line basis, and the lease liability is (a) reduced by the amount of lease payments made and (b) increased by the interest— reducing over the life of the lease. Consequently, although the amounts of the lease asset and lease liability are the same at the start and end of the lease, the amount of the asset would typically be lower than that of the liability throughout the lease term. Because this effect is expected for each individual lease, it is also expected when considering the ‘portfolio effect’ of companies holding a mix of leases with different remaining lease terms.
This means that shareholders’ equity will be reduced, with the actual effect depending on the tenant’s financial leverage, its leases’ remaining terms, and how big a part of its total equity is made up of those leases. Companies who would otherwise have had a significant amount of off-balance sheet leases can expect to see higher EBITDA and operating profits.
Recognizing a lease as an asset will increase the company’s asset base and that will affect ratios such as “asset turnover.” Under the new standards, a lease will also appear as a liability and that will affect “financial leverage,” a measure of long-term solvency. Current ratios, a measure of liquidity, will drop over today’s reporting because lease liabilities will increase without an increase in current assets. “Interest cover,” a measure of long-term solvency, may go up or down depending on the nature of the company’s lease portfolio. Operating profit will increase, as will EBITDA. There are many other financial indicators and they will change but the amount and direction will “depend” on a mix of factors.
All of these changes will affect debt covenants, and the short-range impact may need some “wisdom” in the marketplace. With implementation of the new lease accounting standards at least a couple of years away, those involved in negotiating loans and other agreements that include financial ratio and similar tests must prepare for the future and probably provide for parallel sets that are linked to the lease accounting standard then in effect.
Here are a few things to keep in mind for the future:
If a lease’s rent can be separated into a component for “use of the premises” and a component for “services to be received,” only that part allocated to “use of the premises” will be subject to the lease accounting standards.
Retailers are expected to be most affected.
Some smaller companies may be unaffected unless required by third-parties to apply the new standards. Expect, however, that over time these new lease accounting standards will be applied to small companies.
There is an exemption for low asset value leases. Leases of one year or less will be treated as having a low asset value.
Implementation of the IFRS 16 lease standards (and the expected FASB lease accounting standards) is expected to reduce the number of sale-leaseback transactions because the “accounting” incentive to do so will have disappeared.
A ten-year lease will have the same treatment as a five-year lease with a five-year extension option IF the likelihood of exercise of that option is high; otherwise, not.
Now, that we’re at the end of today’s blog posting, remember that reading about a change in how brain surgery will be taking place next year does not make the reader into a brain surgeon. Let’s leave the accounting to accountants. Our job is to know that the way we “write” and “design “leases” affects the tenant in a way beyond the landlord-tenant relationship and that we will need to learn what changes we need to make in our leases going forward.