The International Accounting Standards Board has thrown its proposed new lease accounting standard up in the air. The high number of responses it has received to its Exposure Draft, and the strength of feeling these have exhibited about some of the proposed changes, have forced the IASB to take the unusual step of reconsidering some of the key aspects of the proposed standard.
At recent meetings, the IASB and the Financial Accounting Standards Board agreed to change the approach taken to determining the term of a lease. In addition, they are consulting users on further aspects of the standard, one of which could fundamentally change the implications of the new standard for lessees and lessors.
The proposed new lease accounting model removes the distinction between operating and finance leases. Currently, 99% of real estate leases are accounted for as operating leases, which means that, in almost all cases, the profit-and-loss charge simply follows the cash payment profile. However, under the ED proposals, in future all leases will be accounted for as finance leases, which would result in a profit-and-loss profile as shown in figure 1.
The profit-and-loss charge under the ED proposals is higher in the earlier years than under the current accounting standard (and the actual rent paid). The longer the lease term, the greater the difference between the initial passing rent and the profit-and-loss charge. It is this factor that would be the major driver of future behaviour, not the balance sheet implications. Tenants would generally take much shorter leases, with leases longer than 15 years being seen only in exceptional circumstances (see figure 2).
There are further complications in the ED proposals concerning the term of the lease and contingent rentals. However, the lease term proposals have been simplified and the treatment of contingent rentals is being reviewed.
The fundamental problem is that the profit-and-loss profile under the new standard does not make sense for real estate leases. In most markets, one would generally expect rents to trend with inflation. The IASB and FASB have finally woken up to this and are now consulting on an alternative approach for “other than finance” leases, where the profit-and-loss charge would mirror the current operating lease model.
A change to this aspect of the accounting standard would be a victory for common sense and would be a boost for the real estate industry, tenants and landlords.
Despite this, the IASB seems determined to stick to its implementation timetable and to release the final accounting standard in June. It has said that it will report on the outcome of the consultation this month.
The possible changes to the ED proposals have the potential both to reduce the administrative burden on lessees and to soften the impact on lessees’ financial statements – outcomes that should both be welcomed.
Be in no doubt that leases are coming onto the balance sheet. However, this may not be the disaster the real estate market has feared – so watch this space.
Paul Vernham is a partner at Cushman & Wakefield
