New accounting standards for benefits, derivatives and hedge accounting have been in the news – but how many companies have considered the impact of IAS17, which tightens the tests on operating leases?
This could be a major problem for some businesses, partly because of the management time involved in compliance, and partly because some property leases will undoubtedly be reclassified as finance leases, impacting not only balance-sheet ratios but also the profit and loss account.
For one of our clients, the reclassification of an operating lease as a finance lease on a single property added over £1.5m to the initial P&L cost.
The principal difficulty is that, despite running to 40-plus pages, the standard is not definitive and has attracted wide-ranging interpretations.
Firstly, the overriding principle: ‘A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership’ to the tenant.
Under a standard UK commercial property lease, while most of the landlord’s risks (falling market rents, repairs, obsolescence and so on) are transferred to the tenant for the term of the lease, most of the rewards apart from occupation, (control, capital growth, rising rents, residual value and so on) are retained by the landlord.
Consequently there are very few leases where both risks and rewards are substantially transferred to the tenant. So what help is this to auditors looking for substance rather than form?
The standard is clear that every lease needs to be reviewed and it is fairly clear that rent should be apportioned between land and buildings for all leases before assessing the classification.
This time-consuming apportionment is only relevant for those that are finally classified as finance leases, and requires a complicated analysis of every lease using property market conditions and construction cost data, from the start date of the lease.
One can only imagine the time and cost involved for a multiple retailer with thousand of leases.
Once apportioned, the rent can be put to the various tests, most of which will indicate an operating lease, leaving two key tests likely to have an impact. Firstly, if the lease term is for ‘the major part of the economic life of the asset’ it will be a finance lease. Since owned buildings are conventionally depreciated over 50 years, this can be assumed as the economic life.
But there are auditors who take the view that economic life ends when capital expenditure, such as a plant replacement, is required. This might be 15-20 years for a new building, leading the auditor to automatically consider a 15 or even a 10-year lease to be a finance lease.
Secondly, it will be a finance lease if ‘at the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset’.
There are a number of variables. For cases where the preferred discount rate is specified as the rate implicit in the lease, a company needs to estimate, as at the start of the lease, the residual value of the building at the end.
Assessing a future residual value is at best subjective and differing outcomes could easily produce a spread of discount rates from, for example, 6-8%, with the resulting huge impact on the net present value test and result.
What does ‘substantially all’ mean? Jones Lang LaSalle has been involved in discussions with auditors who have put forward figures ranging from 75-90%. Most standard property leases would be caught by a 75% threshold.
What is ‘fair value’? The most commonly adopted basis is the open market value of the property with the benefit of the lease (the investment value), based on the hypothesis that there must be a lease in place.
There are some auditors, though, who maintain that it should be the vacant possession value (without a lease in place), which could be 30-40% less than the investment value.
On this basis, most standard property leases of over 10 years would be classified as finance leases.
We believe there are three main areas of concern. Firstly, the inconsistent approach will lead to widely different interpretations of IAS17, which will make inter-company comparisons more difficult.
Second, if leases are ‘incorrectly’ classified as finance leases, there could be a significant impact on both balance sheet ratios and on near-term reported profit. And lastly, there is a potentially huge commitment of time and cost to analyse large numbers of leases, which ultimately will not make any difference to the accounts.
We would like to see clearer guidance from the IASB on interpretation and methodology and would welcome a more consistent approach from the audit firms.
IAS17 may be seen by some as a side show to the main events in IFRS, but it would be wise for many companies to pay it due attention and respect.
Bill Monk is head of corporate solutions at Jones Lang LaSalle in the UK.
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