New Lease Accounting Regulations Meet New COVID Life Regulations

CFOs have been head over heels with the new accounting regulations that came into effect in January 2020.

In a nutshell, according to IFRS 16/AASB, lessees now have to recognize both capital and operational leases as liabilities and put them on their balance sheets. Rent payments are recognized as costs and rent collections as revenues. From the disclosure perspective, leases under 1 year do not count as assets and are not reflected on balance sheets; leases under 1 month are not subject to any disclosure. 

Tenants’ Perspective

Tenants’ CFOs have been trying to make their judgments about the new regulations, pondering such questions as whether “right of use“ should be considered a tangible or intangible asset, how to calculate  fair value and find the optimal balance between service and lease contracts. Once the corona crisis hit, the amount of unknown factors has virtually exploded, and CFOs have been brought to the forefront of constructing emergency plans.

About a quarter of US companies see their office leases to be the first target in their cost cutting strategies. Yet companies have little understanding of how much space they might need and what’s the right way of abandoning of their lease obligations.

Healthy balance sheets became the prime metric of companies’ abilities to make it to the other side. Keeping extra debt load off balance sheet might become a decisive factor in companies’ eligibility for state rescue programs and access to private debt. Creditors are tightening up their risk requirements and rigorously filtering out applications showing slightest signs of insolvency. Categorizing leases as expenses and keeping them off balance sheets might put some companies into the category of “fallen angels” in the eyes of creditors, resulting in favorable decisions for bridge loans to cover liquidity gaps.

That being said, the opposite cases may also occur, when a lessor would prefer to have their rent contractually guaranteed for a long term. For example, secured lease of storage facilities and fulfillment centers based in strategic locations might be a dealbreaker in negotiations with an industry investor looking at acquisition targets from a strategic perspective.

Finally, the costs of implementing new standards are expected to be high, especially if third party advice is needed. Hence, there are all kinds of incentives for companies to minimize the burden of new accounting regulations and limit the amount of disclosed information as much as possible, more so in the times of the corona roller coaster.

Landlords’ Perspective

Landlords seem to be more on fire about immediate tenants’ defaults, even though more long-term prospects are also starting to be discussed.

Owners got caught up in a situation when, by law, they had to recognize revenue regardless of payment delays or prospects of those to be ever collected at all. Rent deferrals and short pays have unfortunately become a common practice, and owners have no other choice but to wait. What remains unclear is whether rent concessions can be considered lease contract modifications.

What might be perceived as “alchemy of accounting” may in fact have dramatic consequences for assets valuations, investors’ decisions and borrowing capacities. International Accounting Standards Board has recognized the urgent need for  amendments to existing rules and has come up with a Draft of amendments to IFRS-16 re covid-19 related concessions (was open for public comments till May 8).

Long Term Outlook

When dust settles down a bit, tenants’ CFOs would probably start looking for the ways to take advantage of the new regulations, which seem to allow for some more flexibility of interpreting than they used to. But there is one underlying condition for exploiting those potential benefits – namely the ability and willingness of property managers to adjust their books accordingly, which in turn leads back to ownership structure and mandates received from owners.  

In the above context, could it be case for flexible space operators to come back to the forefront with the whole new agenda? Are they going to be as accommodating and client-oriented in terms of their financial engineering as they are when it comes to the physical side of rental relations? This remains to be seen. But if they do find a path to addressing these potential needs of CFOs, this could turn into an immense competitive advantage for them.