CHANGES TO ACCOUNTING COULD HAVE DRAMATIC EFFECTS 0N PROPERTY LEASES, says BDO audit expert
John O’Callaghan, an audit partner with BDO, warned tenants and landlords of commercial property that proposed changes to accounting for property leases could have dramatic effects.
Speaking at an IBEC hosted seminar with property consultants Knight Frank Ireland in Dublin (Wednesday, June 1), Mr. O’Callaghan outlined to an audience of commercial lessors and lessees the implications of changes to be introduced under International Financial Reporting Standards (IFRS) in 2014.
John O’Callaghan said that the most dramatic change would occur under the heading impairment and would particularly affect tenants with long leases taken out at the property peak and where significantly lower rents are available today. He explained that this could result in significant write downs in profits and net assets of companies.
He advised that under the new rules property leases would now come ‘on balance sheet’, in a manner similar to how finance leases are currently treated (e.g. with a car lease you bring the car on balance sheet as an asset and also bring in a corresponding lease liability).
In broad terms, he advised that the asset to be recognised with a property lease (called right to use or ROU) would be derived by calculating a net present value (NPV) of rent payments to be made over the entire life of the lease, with a corresponding liability also recognised.
Mr. O’Callaghan outlined some of the implications that this new approach would have. By increasing both assets and liabilities, debt ratios and other ratios would change. This is particularly magnified with long leases (e.g. 25 years) where the quantum of both the asset and liability could be considerable. EBITDA is also different, (increased) under the new approach and he stressed the importance of realising this particularly if valuing a company based on a multiple of EBITDA.
The question of impairment of the lease asset (ROU) from a lessee perspective was outlined with an example of a 25-year lease at an annual rent of 425,000 being signed in 2007 and then a comparable premises being let in 2009 at €250,000 per annum. The example indicated an impairment (write down) requirement of approx €2.3 million reducing profits (and possibly reserves available to pay dividends) and net assets.
John O’Callaghan outlined the concerns this could cause shareholders and lenders. He concluded by advising his audience to ensure that they review their lease portfolio and prepare pro forma financial statements in advance of the new rules in order to consider the possible effect and to communicate to key stakeholders.
Summary address by: Andrew Watt, Head of Professional Services, Knight Frank Ireland
The proposed International Financial Reporting Standards (IFRS) on leases will have a big impact on the commercial property market.
The proposal will effectively bring occupational property leases onto the balance sheets of companies that report under IFRS. At the moment, rental payments appear as an expense on a companies profit and loss account, but leases are effectively “off balance sheet”. The proposal will treat the leasehold as a liability, and the right to use the property as an asset, and this will have the effect of inflating balance sheets.
Occupiers are already starting to consider the new proposals in taking property decisions.
In the current market, tenants want flexibility, and few are willing to take long term leases. I see that trend continuing as a result of these proposals, because a short lease will have a much smaller impact on a balance sheet than a long lease.
Where occupiers have a long term commitment to a location, the decision to rent or buy becomes finely balanced under the new proposals. Traditionally, occupiers have chosen to rent property, so as to keep it off their balance sheets, and to be able to use capital elsewhere. Rent under a lease, and debt for a property purchase will be treated in very similar ways from an accounting point of view under the new rules.
In my opinion, we will now see more occupiers buy buildings to which they have a long term commitment.
Two major Dublin office occupiers, Google and Pennys have already bought office buildings this year, and others seem likely to follow suit. Clearly, debt availability for property purchases is at an all time low, but for those companies with access to cash and finance, the present weak market presents a buying opportunity.
In summary, long leases become less attractive under the new rules, and the market trend towards shorter leases, and owner occupation looks likely to gather pace.
Andrew Watt MRICS BSC (hons)
andrew.watt@ie.knightfrank.com