Accredited retail specialist valuer Simon Fonteyn explains the changes to leasing requirements.
A new global accounting standard, known as IFRS16, will come into effect in Australia and globally on 1 January 2019. This will radically change the way leases are recognised in financial statements with a range of ramifications for the franchising sector.
The major changes that will be introduced require Franchisors with leases held in their names to recognise a “right of use” asset and liability equal to the present value of all certain future known rental payments under the lease. The exceptions to this rule are short term leases less than 12 months and low value assets worth less than $US5,000.
This will bring an end to leasing real estate and other asset classes as a means of off–balance sheet financing for Lessees. This will result in major implications for Franchisors’ financial statements.
There are a number of important business considerations for Franchisors including the need for lease abstraction, portfolio management and lease accounting systems which will be necessary to calculate and update their financial accounts going forward.
The implications for the franchise leasing market are still unknown, however our research has shown that there will likely be a change in franchisors’ requirements particularly in retail property, as the balance sheets of these types of businesses will swell dramatically and their below and above line Profit and Loss Statements will be dramatically affected.
Some of the likely changes to leasing requirements are listed below:
|Demand for Greater Net Leases||Several outgoings can be stripped out of the calculation, as they are treated as service charges.|
|Shorter Lease Terms||Reduces lessee’s Right of Use asset and liabilities.|
|Increasing Requirement for Options||As the take-up of options into the initial liability must be reasonably certain.|
|Increasing hold over and leases for a year or less||To avoid recognising an asset and liability.|
|Demand for leases that have conditional payments e.g leases based on turnover only||Leases that do not have known or conditional rental payments could be excluded from the calculation.|
|Change in incentive structures||Greater demand for rent free as opposed to contribution to fitout, as this reduces the right of use liability.|
|Possible Reduction of Sale and Lease back as a transaction method||The new standard reduces the gain on the sale of the building by the lessee, as the gain is measured by the difference between the sale price plus the right of use asset, minus the right of use liability and the fair value of the building.|
In 2016, the International Accounting Standards Board issued IFRS16 - a new model to recognise all leases regardless of whether they are operating or finance leases on balance sheet. The idea behind this was relatively simple – Leases are long term contractual obligations to pay money and therefore should be treated the same as any other company liability. Thus, began the demise of using operating leases as a form of off-balance sheet financing.
Despite the transition date for implementation being 1 January 2019, in reality, most Australian companies who report on a June financial year basis will need to have these standards adopted by 30 June 2020.
Impact on Retail Leasing
The biggest impact will be in chains of businesses that have a large number of leases required to operate their business. Their balance sheets will swell dramatically and their below and above the line P&L Statements will be dramatically affected.
A recent PWC global study revealed that the retail sector will be one of the industries hardest hit. It estimated that there will be a 90 percent increase in liabilities for all retailers, resulting in an average 41 per cent increase in EBITDA as a direct result of the implementation of this new accounting standard. This significant blanket increase will result from the lease liabilities, as 95 per cent of all retailers operate in leased premises.
Similarly, the increase in EBITDA will stem from the fact that rental expenses, which typically represent between 5 to 30 percent of a retailers P&L cost, will be replaced with amortisation and interest expenses of the liability, which are below the line and excluded from EBITDA.
Board and C Suite executives of larger companies will no doubt be scrutinising property leasing more heavily, as it effects their balance sheets and therefore a range of financial ratios including gearing.
The market requirements for leasing in these sectors are likely to be impacted with Franchisors looking for ways to reduce their liabilities or, in some circumstances, avoid or delay incurring additional liabilities.
Changes in Deal Structuring
1. Net v Gross Leases
IFRS16 allows for the recoverable outgoings component to be separately identified into ‘contractual’ and ‘service’ outgoings of the contract. Certain outgoings within a lease are deemed to be service components of the lease, such as maintenance, and therefore can be expensed rather than capitalised.
If leases are gross or semi-gross, it much makes it harder for a lessee to strip out these costs, as they are unknown.
Under IFRS16, a Franchisor is required to amortise a contribution to fitout or cash payment by the Lessor over the term certain of the contract, unlike rent free forms of incentives, which reduces the rent until it expires. This can have an impact on the Right of Use Liability calculation.
Lease Durations and Deal Structuring
One of the more difficult to predict elements of the IFRS16 change is, what will happen to lease durations?
1. Possible Rise of Hold Overs and Shorter-Term Leases
For renewal of leases with fully depreciated fitouts there may be a rise in holdovers and or shorter-term leases to reduce the liability going forward. This could especially be the case for underperforming stores.
For new leases, there may be a requirement for shorter term leases with more options, as options must be reasonably certain of being exercised before they are included in the right of use Asset and Liability.
There may be an additional requirement for break clauses within leases. Under IFRS16, if a Lessee incurs a penalty for terminating if reasonably certain of exercising this right, then this cost is calculated as part of the Right of Use liability. In other words, given leases are now a balance sheet item, Lessees may seek to transfer some of their balance sheet risk to Lessors.
2. Turnover Rent Only Leases
Under IFRS16, variable lease payments linked to sales or Lessee’s equity are excluded from the Lease Liability calculation. For example, turnover rent in shopping centres would be excluded. If a Lessee has a pure turnover deal, then none of these payments are included in the Liability.
There is a relatively short timeframe to get prepared for these changes, so action is required in the immediate future from Finance, IT and Property Departments.
Software that automates the extraction of critical data from commercial leases together with accounting and property systems that perform the IFRS calculations, will need to be implemented.
The introduction of IFRS16 will eliminate the long-standing practice of using leasing as a means of off balance sheet financing. There will be a range of implications for the franchising sector post 1 January 2019 with the retail property sector to be the most heavily impacted. Board and C Suite executives of these larger companies, will be scrutinising property leasing more heavily.
Changes to the demand for lease structuring could occur and therefore appropriate planning and strategy for this change is highly advised.
The views expressed in this column are the author's own and do not necessarily reflect this publication's view, and this article is not edited by QSR Media. The author was not remunerated for this article.
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