Lease Accounting Changes: IFRS 16 Edition 3
The new lease accounting standard, IFRS 16, is set to change the treatment of surplus leases. While the new standard means that onerous lease provisions will no longer apply, the alternative may prove more onerous still.
What is a provision?
If an occupier currently leases a vacant property, it is required to provision for the onerous lease. This provision is effectively the net future cost of the lease.
Once IFRS 16 becomes effective, in January 2019, provisions for onerous leases will no longer be required.
So what is replacing a provision?
Under IFRS 16, the gross liability for all leases will be ‘on balance sheet’ anyway, so there will be no need for a provision. Occupiers will instead need to perform a test for impairment for leased assets.
What is impairment?
Impairment is a reduction in the reported value of an asset. Whenever an asset is impaired, a loss equivalent to the difference between the asset value on the balance sheet and the current value of the asset is recognised on the P&L.
Impairment occurs when the asset value on an occupier’s balance sheet is higher than the current value of the asset.
When does an occupier need to perform an impairment test?
In reality, occupiers will need to test for impairment in the event of:
- A leased asset becoming vacant / underperforming; or
- The market falling since the date of lease start; or
- Poor economic performance and restructuring events or
- Physical obsolescence.
Importantly, impairment for surplus leases is likely to occur only where an asset is vacant and the market has deteriorated. Moreover, impairment is an auditable topic. In other words, in a falling market, auditors are likely to question if there has been no impairment testing undertaken.
But why does all this matter?
Firstly, testing for impairment is in itself an onerous task. It requires the occupier to always keep one eye on market movements and the other on their operations.
Secondly, impairments can have significant impact on financial statements: they require disclosure in financial statements, decrease the asset value on the balance sheet and show a loss in the P&L.
Finally, under the current accounting rules the occupier only ever has to provision for the net future cost of the lease, meaning they only have to provision for the period until an assumed sublease/assignment. Under the new lease accounting rules, the gross liability for the full remaining lease term will sit on the balance sheet until such time as a sublease/assignment is actually signed. On top of this, there may also be an impairment requirement.
For occupiers with multiple surplus leases, quick and efficient disposal will be of even greater importance under the new lease accounting standard. In recent years, a number of specialist providers have emerged providing an effective alternative to in-house asset management of surplus leases. Leasehold liabilities for entire surplus lease portfolios can be transferred to these providers at a price that is comparable to the Fair Value of the lease. These providers have the capacity and market knowledge to dispose of surplus portfolios generally within 12 to 24 months, reducing the gross liability for the occupier in one fell swoop and offering an attractive way to potentially circumvent impairment requirements.
Perhaps now is the time to rethink your strategy for surplus leases…
Laura Zavala is a Senior Consultant in Strategic Consulting EMEA at Cushman & Wakefield.
Laura is a Chartered Accountant and specialises in supporting corporate occupiers with IFRS 16 implementation, real estate modelling and deal structuring.
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