13/05/2011
For many years, the accounting regulators have been concerned that company accounts do not truly reflect a company’s financial position as the significant future liabilities and benefits of leases are not reflected in the accounts. Currently the impact of any property lease to a company’s accounts is limited to the rent appearing as an expense in the Profit and Loss (P&L) account and a comment on the liability in the Notes.
In August 2010 the accounting regulators published proposed changes to the treatment of leases in company financial statements. If implemented these proposals would cover all publically quoted companies reporting under IFRS, Central Government departments and many large private companies, and would be mirrored throughout Europe. In time these rules may apply to all UK companies.
Although this article only addresses property leases, the new lease accounting model will account for all leases under a “right to use” model,. This means that the right to use creates:
- an asset on the balance sheet, and
- an obligation to pay rent which is reflected as a liability on the balance sheet.
Under the model, leases will be treated in a similar manner to purchases with 100% finance with the asset being like ownership, the liability being like a loan and with the asset being depreciated over its life, the term of the lease. Rental payments will be split into capital and interest.
The overall impact will be that although cash flow is unaffected, there will be higher charges to the P&L in the first half of the lease term. Although these charges will average out over the life of the lease, in its early years the impact could be to inflate the lease expense by as much as 10-20%. The rent charge will come out of the P&L and be replaced by interest and depreciation meaning the EBITDA measurement will be inflated.
On the balance sheet, large assets and liabilities will now appear with a potential reduction in equity over the life of a lease. There will be an increase in the occupier’s level of debt and this may have implications for gearing and covenants, regulatory capital requirements for financial institutions and other management performance measures. The impact on the financial statements will require careful communications to banks, investors, analysts and credit agencies. In the meantime there are no plans from HMRC to change the way they calculate tax liabilities.
It is intended that the new accounting standards will come into force in 2013. To reduce the impact companies need to prepare. RICS recommend that early action is taken in the following areas:
- Ensure your company has the right lease data to be able to calculate the new accounting liability and that their lease database contain all the relevant information
- Look at each property in the context of your property strategy and the likelihood of exercising breaks and options.
- Is your company in a position to forecast contingent rentals on a lease by lease basis?
- The changes will raise the profile of property in the business – are systems in place for the finance and property teams to work together to respond to this?
- Are the right people in the company aware of the changes and the impact they will have and can they explain them to the management?
- How will the accounts team deal with the additional burden placed upon them? Given that HMRC propose to calculate tax based on the existing system are the accounts team in a position to run dual bookkeeping systems?
The proposed changes will have a significant impact on the financial statements of companies and create practical issues of collating and number crunching the lease information. Companies will need to develop property strategies to address this and to mitigate any adverse impact on their financial position as well as keeping their investors and bankers informed of the impact of the changes on their published financial standing.
Whilst it is proposed that the new regime will come into force in 2013, this is not yet certain. But if it does, companies will need to be able to provide prior year comparable accounts to ensure that they are not caught out and must structure their future property strategy and data recording with this in mind.
