N.b. Since the time of recording the video and podcast, this former Insight Paper was reissued as Practice Information, although no material changes were made by RICS.
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What is this week's blog about?
In this week’s blog, we take a look at the RICS Practice Information (formerly an Insight Paper) IFRS 16: Principles for UK Real Estate Professionals (Accounting for Leases on the Balance Sheet). This is essential reading for RICS APC candidates relating to the mandatory competency, Accounting Principles and Procedures.
You can download a full copy of the document here.
What is IFRS 16?
You can read about the fundamentals of IFRS 16 in a previous blog article.
Essentially, however, IFRS 16 brings almost all leases onto the balance sheet, where they are treated as finance leases. This makes it easier to assess an entity’s lease commitments and to compare different entities, using their financial statements.
Under IFRS 16, a lease is defined as a contract that ‘conveys the right to control the use of an identified asset for a period of time in exchange for consideration’.
Why do I need to know about IFRS 16?
Although accountants and financial professionals primarily deal with IFRS 16, property professionals may be asked for professional input on real estate-specific matters. Understanding the high-level principles and practical application is, therefore, essential.
What key principles of IFRS do I need to be aware of?
Right of Use Asset
IFRS 16 introduces the term, right of use asset. This is the right of the lessee to use the asset for a term certain and to incur a liability to pay rent or other lease payments.
The term certain, or non-cancellable period, will include any option to extend (where this is reasonably likely to be exercised) or any option to break (where this is reasonably likely NOT to be exercised). As such, an entity cannot simply adopt the shortest term certain to limit the impact of IFRS 16 on their balance sheet.
This should, therefore, be a reasoned decision based on the most likely operational decision and is likely to require the input of an experienced surveyor.
Models
There are three models that can be adopted when transitioning to IFRS 16 or entering into a new lease. The default position is the cost model, in particular where there is a market rent and there is a short term (which limits material increases in value) or regular rent reviews (to prevent the property becoming over-rented).
The other two models which may be adopted are the fair value model for investment property or the revaluation model for specific asset types:
Non-specialised assets where there are relevant events such as a change in the lease term or change in future lease payments
Specialised property, e.g., PFI hospital contracts, using the depreciated replacement cost method of valuation
Specific detail on the different models can be found in Sections 2.2 and 2.4 and Parts 5 and 6 of the Practice Information.
Discount Rates
IFRS requires that lease payments are discounted to present value at one of two discount rates:
Interest rate implicit in the lease, i.e., the lessor’s internal rate of return
Lessee’s incremental borrowing rate, if the above cannot be readily determined
Section 4 of the Practice Information provides full guidance on establishing the appropriate discount rate based on the specific circumstances. The latter of the two options above is likely to require the input of a business or debt valuation specialist.
Other
The Practice Information also deals with sale & leaseback transactions in Section 2.3 and how these should be accounted for. Surveyors may be involved in providing advice on fair value at the time of the transaction.
How does IFRS 16 apply to the public sector?
IFRS 16 become a requirement for the public sector to adopt from 1 April 2022. Additional guidance can be found in the HM Treasury Financial Reporting Manual and CIPFA Code of Practice for Local Authority Accounting, amongst others.
The basic definition of a lease under IFRS 16 is extended for central government to include intra-UK government agreements where non-performance may not be enforceable by law.
There are also a number of other areas where IFRS 16 is adapted for use by the public sector, which are outlined in Part 3. One key example is the exclusion of leases under 12 months from the application of IFRS 16.
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N.b. Nothing in this article constitutes legal, professional or financial advice.