The single most eye catching change coming from the new lease accounting standard will be that rented real estate will come on-balance sheet for entities reporting on the International Financial Reporting Standard (IFRS).
The reason is - the value of real estate will substantially increase current balance sheet totals.
The European Financial Reporting Advisory Group (EFRAG), advising the European Union (EU) on whether or not to endorse a new IFRS standard, has taken up part of the fieldwork that the IASB (International Accounting Standards Board) has not done so far.
EFRAG has drafted a questionnaire to publicly survey the impact on financial covenants in loan agreements. EFRAG is helped with this survey by the national standard setters in France, Germany, Italy, the UK and Lithuania and supported by the IASB. With just a few weeks left before one may expect the release of the new standard on lease accounting, this action is rather late.
More importantly, the timing could suggest to the public that only an awareness as to the impact on ratios is needed to allow for a smooth introduction of the new standard.
If it was just that simple!
Unfortunately, the fieldwork in progress focuses on the effects on ratios as such.
However, one may expect underlying movements starting to develop. When the new lease accounting standard becomes effective by 2018 (or later), parties probably won’t continue their practises as before.
With the illustration of a real estate case, this article highlights that transparency and relevance, two main achievements for any new standard, will be severely compromised.
The article shows that worrying about the impact of financial covenants in loan agreements should come second to worrying about the unwanted side effects of this new standard.
In the case, four identical start-up companies are tracked in their real estate decisions. As with any case, some (realistic) assumptions are needed to enable meaningful comparisons.
One entity buys its property while three lease the items of real estate for varying periods of time and varying extension periods.
All other economic factors are considered equal (ceteris paribus clause). See the addendum for the assumptions applied and detailed outcomes.
Observations from the case
The observations below are derived from the outcome of the case. All calculations are made at a 7% annual incremental borrowing rate; for comparison reasons, this rate is also used in the ‘Sale’ profit and loss accounts.
Cash is king
The first observation is that substantially less cash is required in the first years for leasing compared to buying the real estate. In our example, for the 10-year lease, only in year 13 the aggregate cash out for lease rentals becomes higher than the purchase amount.
|Real estate balance sheet and P&L presentations|
|Amounts in currency unit * 1.000||Initial measurement||Annual lease rental||Total lease rentals|
|II Lease||10 years||803||114,3||1.143|
|III Lease||5 years||478||116,5||583|
|IV Lease||3 years||297||113,2||339|
Note: It is remarked that for a comprehensive real estate investment analysis all expenditure over the complete lifetime should be taken into consideration, known as the Life-Cycle-Costing (LCC) model.
Asset representations in balance sheet totals are far higher when buying
A second observation is that the measurement values for real estate property, be they initial or subsequent, is the highest when buying. This results in ‘poorer’ balance sheet ratios then when leasing the same property.
Asset values in the balance sheets are not comparable between companies
The third observation is that balance sheets between companies are not comparable.
For discretionary reasons, companies may decide to lease for long-term or for rather short-term periods.
Not only at the start (initial valuation) there is a wide variance from currency unit (CU) 1,500 when purchasing to CU 297 for just a three-year lease. Also during the lifetime of the lease, different annual depreciation amounts are presented (respectively CU 80.3, CU 95.5 and CU 99.0).
Same asset for the same lease term and yet not the same balance sheet totals between companies
A fourth observation is that the initial measurement value for the same real estate property is dependent on the actual market interest rate or the individual company’s incremental borrowing rate. This is shown for the 10-year lease in combination with three different incremental borrowing rates:
|Initial value as a function of incremental borrowing rate|
|Amounts in currency unit *1.000||Borrowing rate||Initial value||Interest||Depr + Intr.|
|II Lease||10 years||7,0%||803||340||1.143|
Please, note that the aggregate lease rentals are equal in all three scenarios since the (lessor’s) rental amount has no relation to the lessee’s (incremental) borrowing rate.
Lessee’s initial measurement of the real estate asset is determined by discounting its future lease payments at the incremental borrowing rate. The initial balance sheet value directly affects the depreciation element in the annual profit and loss accounts. In the above example, the annual (linear) depreciation is respectively CU 80.3, CU 86.2 and CU 97.5.
Asset and liability values do not move for equal amounts
Within one company, balance sheet values only have equal amounts for leased assets and lease liabilities at the start of a contract and when ended.
The start values are only visible when a lease is renewed and the start date is at/around the annual reporting date of the company. The end-value never shows (= zero). In the in-between periods, asset and liability values deviate from each other with liabilities normally being higher than assets.
For the profit and loss accounts, this implies that in the first half of the leases, total annual costs are higher than the annual lease rentals resulting in the so called front-loading of costs.
|Developments of real estate balance sheet presentations|
|Amounts in currency unit * 1.000|
|Subsequent measurement L(iability); A(sset)||1 year||2
|I Sale A||1.466||1.432||1.398||1.364||1.330||1.296||1.262||1.228||1.194||1.160|
|II Lease L||745||683||616||545||469||387||300||207||107||-|
|II Lease A||723||642||562||482||401||321||241||161||80||-|
|III Lease L||395||306||211||109||511||422||327||225||116||-|
|III Lease A||382||287||191||96||511||409||307||204||102||-|
|IV Lease L||205||106||202||105||-||=renewal period|
|IV Lease A||198||99||202||101||-|
Cash flow reporting becomes a random figure
We have seen from the above outcomes that the absolute amounts of the lease rental differ due to different lease terms.
For cash-flow reporting, the new standard requires a split of interest and depreciation in two separate parts of the cash-flow statement. The bad news is that the sum of depreciation plus interest doesn’t match the lease rental. So which is the amount to report as cash-out and in which part of the cash-flow statement? Is interest paid leading or is the depreciation element leading as it affects the future interest calculations?
P&L ratios move
A final observation is that operating costs will decline as; instead, interest and depreciation are being recorded.
This is good news for EBIT and EBITDA (earnings before interest, tax, depreciation and amortisation) but worsens the ICR (interest coverage ratio) which is widely used in bank covenants. And as we have seen before: a high incremental borrowing rate results in low interest amounts with the effect that ‘a bad company’ performs well for ICR.
The outcome of this analysis may be different for other parts of the leasing industry as some of those leases may be easier to compare to straight financing. At the same time, being forced to make such a reservation is proof that leases are not only one kind.
This article started by mentioning the efforts of EFRAG to see to the impact on financial covenants. By now, it is clear that before worrying about the impact on covenants to individual cases, one should worry about transparency and relevance of the new standard.
The new standard is not producing the transparency expected and the relevance of information is strongly compromised as under similar circumstances strongly deviating outcomes can be arrived at.
Having the knowledge, as shown from financial ratios, the balance sheet and disclosure notes, we have to conclude that the information is becoming ‘unworkable’ for comparison purposes.Perhaps, in fact quite an odd outcome, in the future analysts and investors should think about deducting leases from the balance sheet totals to arrive at comparable figures.
That would really be a remarkable outcome: the initial intention of the new standard was to produce insight in high-value off-balance sheet leases.
And the best way to do so is to deduct these leases from the balance sheet totals!
Real estate leasing, the case
For the sake of clarity, a case is required, abstracting to some extent from reality:
● A real estate developer has constructed four identical buildings with offices, working (packaging) areas and parking spaces, fitted with electronic entry controls, glass fibre and electric cabling, water supply and toilet areas;
● The buildings have an expected economic lifetime of 25 years;
● One piece of real estate is sold to cover all construction material costs; the other three buildings are rented out, covering labour costs, land acquisition costs, etc. and their financing costs;
● The piece of real estate sold is sold at market value of CU 1,500; amounts are expressed in thousands;
● There are four identical start-up trading companies, being subsidiaries of four (foreign) investors;
● All start in year 2x00 with identical starting dates, staff build-up, transportation and auxiliary equipment, etc;
● One company decides to buy the real estate; the other three companies decide to lease for respectively 10, five and three years with renewal options for resp. five, five and two years;
● The incremental borrowing rates for all companies are 7%, also for the renewal period;
● The index of construction/living/inflation rate is 2% per annum; the presumed market development of interest rates is based on expected normalised interest curves in the years to come:
Real estate leasing, outcome
Over the full lease term, the sum of depreciation and interest equals the cumulative contractual lease payments. However, when comparing different incremental borrowing rates for the 10-year lease (as example) we see varying initial values of the same lease contract. Initial values in leases equal cumulative amounts of depreciation for the lessee. And as interest is calculated over the remaining asset value, amounts of interest are on the move too.
The below work-out is done for an incremental borrowing rate of 7%. This percentage is applied to the interest charge in case of purchase (I), too.
The impact on the profit and loss accounts is:
|Outcome of the case in figures|
|Amounts in currency unit * 1.000||I sale||II Lease||III Lease||IV Lease|
|Sale price/total market value||1.500||1.500||1.500||1.500|
|Market value of land included in total||650|
|Economic lifetime/first lease period (yrs)||25||10||5||3|
|During (first lease) period:|
|Total lease rental (first lease period)||1.143||583||339|
|Initial value leased asset||803||478||297|
|Total depreciation charge to P&L||340||803||478||297|
|Total interest charge||943||340||105||43|
|Total P&L charge (first period)||1.283||1.143||583||340|
|During 1st renewal (extension) period:|
|First lease renewal period (yrs)||5||5||2|
|Market value at start 1st renewal period||1.828||1.656||1.592|
|Total depreciation charge to P&L||300||519||511||202|
|Total interest charge||364||114||112||21|
|Total P&L charge (extension)||664||633||623||223|
|During first lease and 1st renewal period|
|Total P&L charge first + extension periods||1.947||1.776||1.206||563|
Henk Uunk held the position of manager financial accounting and reporting at ING Lease Holding from 2004 to 2014. He is chairman of the accounting committee of the Dutch Leasing Association (NVL) and a member of Leaseurope’s accounting and taxation committee since 1992. Uunk is a contributor to the Dutch Accounting Standards Board working group on leases and acts as a consultant to the Dutch Car Leasing Association (VNA).