The application in 2019 of this standard requires a single accounting model for leases on lessees’ balance sheets. It requires companies to be more transparent in their financial statements on leases.
Subject to the green light from the European Commission, International Financial Reporting Standard IFRS 16 for leases will enter into force on 1st January 2019. While the situation remains virtually unchanged for lessors, with the maintenance in its principles of IAS 17 standard on the distinction between operating leases and finance leases on the balance sheet, the situation is different for companies that regularly use leases. The application of this single international accounting standard, aimed at clarifying companies' financial statements, implies significant changes in accounting and financial aspects as well as in terms of organisation, information systems and rental strategy.
From an accounting point of view, operating leases, previously recorded off-balance sheet, will now be treated as a rental right-of-use on the assets side in exchange for a rental payment obligation to be recorded as a debt on the liabilities side. Only short-term commitments (up to 12 months) for low unit value assets (up to €5,000) and service contracts are exceptions.
An impact on debt ratios
In addition to an impact on the balance sheet, this new international standard will have an impact on the income statement and cash flow: commitments reclassified as debt will lead to an increase in financial debt and, consequently, affect the debt ratios of companies that have a large stock of warehouses, retail space and other premises. As cost of the rent will be divided between asset’s declining balance and financial expenses. According to the IASB, the International Accounting Standards Board, companies will have to reincorporate leases on their balance sheets to the tune of some $2,800 billion. These additional debts will impact their cash flow and encourage investors to be cautious. The reading of financial ratios by analysts and bankers who operate as lessors will therefore evolve. The present value of the contractual rents will be calculated on the basis of a property discount rate or, failing this, the marginal debt rate.
For the major French banks, the impact of this accounting standard on the balance sheet could amount to several billion euros. According to the new framework, assets will be weighted at 100%. The impact of this measure should be significant on banks’ solvency ratios set by prudential standards.
New business challenges
In the interests of transparency, IFRS16 focuses on the use of assets and the qualification of contracts. This new situation will oblige lessees to check more closely the financial information communicated reliability. Hence, the need for them to draw up an exhaustive and detailed list of their rental property portfolio, and above all to make new estimates of their rental contracts, taking into account the contract’s nature and duration as well as discount indices.
The challenges to be met are all the more numerous as this accounting system implies the creation of new solutions and methods to organise this work of recording contracts, collecting and processing data essential in order to evaluate leased assets’ rights-of-use. To achieve this, the lessees will have to apply for several jobs in the company: financial, legal, IT, operational and real estate departments in particular. And above all, encourage them to work together to define the procedure to follow in making decisions regarding real estate strategy for renting or buying.
Reexamine investment strategies
In this context, some companies may have to review their investment strategy in relation to the impact of IFRS 16 on their financial statements. All options will be analysed: purchase or lease, leasing, sale and leaseback. For banks, more than 90% of the accounting impacts will concern the real estate inventory. They usually have a highly diversified contracts portfolio that will have to be valued under the new standard, just like real estate leases. Banking groups’ real estate management will therefore be called upon to play an important role in this new system.