The overhaul of lease accounting: Catalyst for change in corporate real estate

In preparation for the new IFRS 16: Leases requirements, or to be more nimble in the current economic climate, C-suite at many companies with real estate dependencies are re-evaluating their corporate real estate strategy and operations to align with business objectives. The existing corporate real estate function may have originally been designed to support a very different operational structure compared to what exists today, or may even have been originally motivated by financing or tax considerations that are no longer applicable. The changes to lease accounting may provide a catalyst for change to these operations that goes beyond adapting to the technical requirements of the accounting, and may include reconsideration of strategy.

Overview of the new leases standard

• The biggest changes were made to lessee accounting. Generally, IFRS 16 will apply to pre-existing leases at the date of initial application of the new standard. Lessor accounting is substantially the same under the new standard compared to IAS 17: Leases.

• Essentially all assets leased under operating leases (except short term leases that are less than 12 months at lease commencement and low-value assets) will be brought on balance sheets. The lease liability will be equal to the present value of lease payments. A

corresponding right-of-use asset will be recognised based on the lease liability plus items such as an estimate of restoration costs and initial direct costs.

• A lessee may decide as a practical expedient by class of underlying asset whether or not to separate lease and non-lease components (services).

• A lessee will recognise in its income statement, depreciation of the right-of-use asset and interest expenses arising from the lease liability.

• The accounting of certain arrangements will continue to require significant judgment, whether they are within the scope of IFRS 15: Revenue from contracts with customers or IFRS 16: Leases.

• Lease accounting will require significant judgment when making estimates related to the lease term, lease payments, and the discount rate. Similar to today, the term of the lease will include the non-cancellable lease term plus renewal periods that are reasonably certain of exercise by the lessee or within the control of the lessor and periods covered by an option to terminate the lease that the lessee is reasonably certain not to exercise.

• Variable lease payments are generally excluded when measuring the lease liability, except those based on an index or rate, which are initially included based on the index or rate at lease commencement. IFRS 16 requires reassessment of variable lease payments that

depend on an index or a rate when there is a change in the cash flows resulting from a change in the reference index or rate (that is, when an adjustment to the lease payments takes effect). This can result in a significant amount of periodic remeasurement and

income statement volatility. The new guidance will require reassessment of the lease and remeasurement of the lease liability under

certain circumstances. This is substantially different than today’s “set it and forget it” model.

• When calculating present value, the applicable discount rate will be determined in a similar manner to IAS 17.

• A lease modification may be accounted for by the lessee as a modification to the original lease or as the creation of a separate lease depending on the nature of the modification. A lessor would account for modifications to an operating lease as a new lease and modifications to a finance lease generally as a separate lease or new lease depending on the nature of the modification.

• Financial performance ratios may be impacted and other new operating metrics may evolve as a result of the adoption of the new standard.

• For some companies, the new standard will require significant system and process changes prior to the adoption date.

• Companies with international operations many need to consider the impact of the new lease standard under US GAAP as there are significant differences between the IFRS and US GAAP standards.