Where on a company's balance sheet can you find details of its total lease liabilities? Well, at the moment you can't, at least not for its operating leases - although some companies do quantify their lease liabilities in the notes to their financial statements.
Under current rules, companies only need to record finance leases - and not operating leases - on their balance sheets. The balance sheet of a retail chain with 25 leases can look similar to one with 500 leases.
New international financial reporting standard no 16 will soon bring about a major change as tenants will now have to record all of their lease liabilities on their balance sheets. IFRS 16 comes into effect on 1 January 2019. It will cover not only real estate but also most other assets such as cars or photocopiers.
Operating leases vs finance leases
Under IFRS 16, finance leases and operating leases will now have to be treated in a broadly similar way.
- Finance leases: transfer to the lessee substantially all the risks and rewards of owning the asset. The lease term takes up most of the useful life of the asset, or the total rents equate to most of its capital value.
- Operating leases: do not transfer substantially all the risks and rewards of ownership. Most leases of shops, offices and industrial units fall into this category.
Finance leases have long been required to be capitalised in the lessee's balance sheet. Under IFRS 16, this will apply to operating leases too.
Effect on tenants
IFRS 16 will require lessees to recognise assets and liabilities for all leases of more than 12 months, unless the underlying asset is of low value.
One side of the tenant's balance sheet will show an asset representing the value of its right to use the property. The other side will show a lease liability, representing the discounted total of future lease payments.
The detailed rules are complex. For example, if a tenant has a break option then the balance sheet should show the asset and liability up to the break date. But if it is reasonably certain the tenant will not exercise the option, then the period after the break is also included.
Effect on landlords
Landlords will not have to change their own accounting treatment, but they may be affected as tenants possibly seek shorter lease terms or put pressure on pricing.
The role of technology
The new accounting standard has been nearly 20 years in preparation, and there are now technological solutions available to tenants. Mishcon de Reya has been working with LEVERTON, an intelligent information business that helps global companies extract data from their lease files to simplify transition to IFRS 16.
Richard Belgrave, Head of Europe at LEVERTON says, "The lease accounting changes present not only a structural shift in the way data is reported, but an unforeseen challenge with respect to data capture, aggregation and validation. January 2019, whilst on the surface a distant deadline, is in fact fast approaching. Leveraging artificial intelligence will greatly reduce the burden of processing large volumes of stored leases.
"LEVERTON provides a centralised, multi-language and document agnostic approach to the creation of structured data out of unstructured documents. It is time and cost-effective compared with a manual approach. Overcoming this challenge with one piece of technology will ensure unparalleled consistency and data transparency, using market-leading algorithms that get smarter the more they do, as opposed to more tired and error-prone like humans."