LEASE ACCOUNTING CHANGES: CRE TO TAKE CENTRE STAGE

LEASE ACCOUNTING CHANGES: CRE TO TAKE CENTRE STAGE

CONTENTS THE NEED FOR CHANGE 04 THE NEW STANDARD 07 Application at lease start 08 Updates during the lease term 09 Exemptions 09 Transitional arrangements 10 IMPACTS OF THE CHANGES 12 Industry sectors 12 Financial metrics 13 CRE 13 Own vs. lease policy 14 Property finance 15 Lease terms 16 Lease incentives 16 Rent review 18 Turnover rents Inclusive rent contracts 21 Subleases 21 CONCLUSION 22 2 3

THE NEED FOR CHANGE Source: IFRS Foundation Leasing is a common way for a business to raise finance. In simple terms, when a company signs a lease agreement, they obtain the right to use an asset in exchange of future payments. Under current lease accounting rules (IAS 17), leases are categorised either as finance leases or operating leases. Finance leases are reported on the Balance Sheet as assets and liabilities Operating leases are disclosed only in the notes in financial statements, with a corresponding straight-line expense in the P&L (Income Statement) for rent; they are off Balance Sheet. $33tn VOLUME OF LEASE COMMITMENTS AT LISTED COMPANIES 85% PROPORTION OF THOSE LEASE COMMITMENTS WHICH ARE OFF BALANCE SHEET IASB New Standard IFRS 16 effective date IFRS 16 published 19 16 FASB effective date Private companies FASB effective date Public companies FASB to publish new standard in Q1 FASB New Standard The classification of the majority of leases as operating leases has two key issues: 1. Lack of transparency: Market analysts and credit rating agencies currently make adjustments to financial statements that often result in over or under estimation of a company s financial position 2. Lack of comparability: On the basis of existing financial statements, investors are unable to compare between companies that borrow to buy an asset and companies that enter into a lease agreement. The International Accounting Standards Board ( IASB responsible for IFRS) and Financial Accounting Standards Board ( FASB responsible for US GAAP) have undertaken a joint project to address these issues. After almost 10 years of deliberation, the IASB issued IFRS 16, a new accounting standard which supersedes IAS 17, on the 13 January 16. The effective date for IFRS 16 is 1 January 19. FASB is due to publish the new US GAAP accounting standard during Q1 16 1. 1 C&W will publish guidance on FASB lease accounting changes once the new standard is released. 1 in 2 PROPORTION OF LISTED COMPANIES REPORTING EXPECTED TO BE AFFECTED BY CHANGES TO LEASE ACCOUNTING 66:1 HIGHEST RATIO OF OFF BALANCE SHEET LEASE LIABILITIES TO ON BALANCE SHEET DEBT AT INSOLVENT RETAILERS ANALYSED 8x MULTIPLE OF ANNUAL LEASE EXPENSE COMMONLY USED TO ESTIMATE OFF BALANCE SHEET LEASE LIABILITIES. ANALYSIS SHOWS THAT THIS OVERSTATES LEASE LIABILITIES BY AN AVERAGE OF 12% IASB / FASB Joint Project Project update IASB single model Revised exposure draft Exposure draft Discussion paper Joint IASB/FASB project initiated 15 13 10 09 06 Project update FASB dual model 4 5

CHANGES TO LEASE ACCOUNTING Impacts on Reporting under IFRS and US GAAP THE NEW STANDARD - IFRS 16 NEW STANDARD CURRENT STANDARD IFRS 16 / US IAS 17 / US GAAP GAAP Finance leases Operating leases All leases Assets - Liabilities $ - $ Off Balance Sheet obligations - Balance Sheet IFRS and US GAAP to bring all leases on Balance Sheet Under IFRS 16, all leases 3 will be reported on the Balance Sheet, similar to finance lease treatment under IAS 17. This new model for measurement will provide additional benefits in terms of: Simplicity: The same measurement approach will apply for all leases Ease of understanding: The model is already in use (finance lease treatment under IAS 17), so there is no need to modify existing accounting systems. Under the new standard, lessees must: 1. Recognise an equal asset and liability on the Balance Sheet as at lease start. These will be calculated as the present value of unavoidable lease payments 2. Recognise an amortisation and interest payment for leased assets in the P&L. Amortisation will be recognised on a straight-line basis, while interest will be a front-loaded charge. Under IFRS 16, the lease payments in the P&L will be higher in the first half of the lease than those payments currently recognised for operating leases under IAS 17 3. Separate out the cash payments in the Cash Flow Statement into a principal portion, classified as financing activities (amortisation), and an interest portion, classified either as financing or operating activities (interest). CURRENT STANDARD IAS 17 NEW STANDARD IFRS 16 Finance leases Operating leases All leases LEASES COULD BE ABOUT TO MAKE A DENT IN YOUR COMPANY S P&L, make sure you understand why. Operating costs - $ - Depreciation and amortisation $ - $ Finance costs $ - $ CURRENT STANDARD US GAAP NEW STANDARD US GAAP 2 P&L Finance leases Operating leases Type A leases Type B leases Operating costs - $ - $ Depreciation and amortisation $ - $ - Financre costs $ - $ - IFRS and US GAAP adopt different models for recognition in the P&L IFRS 16 Application Impact Asset and liability Assets Balance calculated as: Liabilities Sheet PV of future lease payments Equity Lease expense calculated as: Amortisation EBITDA Depreciation P&L + Interest /Amortisation = Front-loaded lease Finance costs expense over the first half of lease Cash Flow Cash payment split into: Principal portion (finance activities) Interest portion (finance / operating activities) Cash from financing activities Cash from operating activities 000 1 100 80 60 40 P&L Impact of IFRS 16 Year IFRS 16 Amortisation Cash Payment IFRS 16 Interest ASSUMPTIONS: Rent: 100k pa Term: 10 years Discount rate: 6% 2 FASB (US GAAP) has opted for a dual model approach Type A: Normally not property (existing finance leases). Interest and amortisation are calculated (similar to IFRS 16) Type B: Property (existing operating leases). Payments are recognised on a straight line basis as a lease cost (similar to current IAS 17). 3 A contract will be considered to contain a lease where it conveys the right to control the use of an identified asset for a period of time in exchange for consideration. Importantly, this definition may now cover 3PL contracts. 6 7

PERFECT PROPERTY DATA IS THE STARTING POINT FOR IFRS 16. Is your lease administration system fit for purpose? APPLICATION AT LEASE START Under IFRS 16, lessees will be required to determine on day 1 of the lease: 1. The lease term: a. The non-cancellable term, including options to extend the lease, if they are likely to be exercised, and periods after the lease expiry date, if it is reasonably certain the lease will be renewed b. The non-cancellable term should include consideration of other factors such as customisation and the extent of tenant improvements. There is no exact guidance on determining the lease term. Each lease event will require consideration by the CRE function, who will need to be prepared to justify any judgements to an Auditor. For business critical facilities, it will be difficult to justify that breaks are likely to be exercised or short-term leases will not be renewed. 2. The discount rate: a. The rate implicit in the lease, effectively the investor s IRR, or b. The lessees incremental borrowing rate, i.e. the rate for similar secured financing. For occupiers with an investment grade credit rating, their incremental borrowing rate is likely to be significantly less than the rate implicit in the lease. Using the incremental borrowing rate would result in a substantially higher liability. Occupiers are therefore expected to adopt the rate implicit in the lease, despite the administrative burden associated with its calculation. 3. The unavoidable lease payments: a. All future fixed payments, including payments that increase at a fixed rate b. For index-lined payments (CPI or other), all future lease payments are based on current rent c. Turnover elements of lease payments are to be excluded. UPDATES DURING THE LEASE TERM One of the key changes under the new lease standard is the requirement to reassess the liability every time there is: A contractual change in the actual cash flows. In other words, for index-linked payments, there will be a need to reassess the liability every time the payments change (e.g. annually) A change in the lease term. In other words, where a lessee takes action which will impact the noncancellable term (e.g. on exercising an extension option or where a notice period for exercising a break option lapses). EXEMPTIONS There are a number of exemptions to the new standard: Service contracts: Contracts where the occupier does not have control of the use of the asset, e.g. a serviced office contract where the landlord has the right to substitute the area demised to the tenant Short term leases: Leases with a term of less than 12 months Low value leases: Leases where the underlying asset has a value of less than $5,000. The administrative burden for CRE will increase. THE LEASE LIABILITY WILL NEED TO BE REASSESSED EVERY TIME THERE IS A LEASE EVENT AND EVERY TIME THE RENT CHANGES. 8 9

TRANSITIONAL ARRANGEMENTS At the effective date (1 January 19), companies can choose to adopt one of two approaches. 800 700 600 Balance Sheet Impact of Transitional Approaches Are you prepared FOR DAY 1? Data collection / validation This approach does not require historical lease information. It is easy to apply, but recognises a higher liability on the Balance Sheet and lease payment on the P&L. MODIFIED APPROACH: Calculate the liability based on the remaining non-cancellable term and future unavoidable lease payments. 500 400 300 0 100 Year Changes to lease accounting are going to impact the data you need to hold You will need to keep and maintain detailed records for individual leases Updates to data will be needed at all lease events, including indexation, rent reviews, service of notices and even lapsed notice periods. FULL RETROSPECTIVE APPROACH: Calculate the liability as if IFRS 16 had been applied at lease start. P&L Impact of Transitional Approaches This approach requires historical information, including lease start dates and historic payment schedules. It is more onerous to apply, but recognises a lower liability on the Balance Sheet and lease payment on the P&L. Companies are not required to apply the same approach to all leases and may choose which to apply on a lease-bylease basis. The decision to use either approach will have an impact on financial statements. The full retrospective approach is expected to be chosen for those assets where the financial impact is significant. 140 1 100 80 60 40 Systems and processes update Your lease administration systems and processes are likely to need updating to accommodate these additional property data requirements. Year Modified Approach Full Retrospective Approach Education Is your CRE team aware of the changes? 10 11

IMPACTS OF THE CHANGES INDUSTRY SECTORS Under the new standard, occupiers with large portfolios of leased assets will see a significant increase in their Balance Sheet. The financial statements for Airlines, Retailers and Travel & Leisure operators are expected to be most impacted. For these three sectors, the present value of lease commitments is greater than % of their total asset base. As an example, Tesco s net debt is expected to increase from c. 8.6bn to c. 17.6bn, an increase of more than 100%. In contrast, Healthcare providers, Information Technology companies and Distributors are expected to be least impacted. These sectors have lease commitments which equate to less than 5% of their total asset base. For financial institutions, including Banks and Insurance companies, the changes may have an impact on their Regulatory Capital requirements as they will report higher assets and lower equity. In terms of the P&L, the impact for the majority of occupiers is expected to be modest; two out of three occupiers can expect a change in profit margin before tax of less than 1%. Nonetheless, this will vary by sector and for companies with a low profit margin, such as retail, the impact is expected to be more significant. The changes will impact industry sectors differently. HOW EXPOSED IS Industry Sector PV of future lease payments YOUR COMPANY? for off Balance Sheet leases / total assets BASED ON A SAMPLE OF 1,022 COMPANIES, THE INCREASE IN ASSETS ACROSS ALL SECTORS IS 5.4% 36% OF RETAILERS AND 38% OF TRAVEL & LEISURE COMPANIES HAVE ESTIMATED LEASE COMMITMENTS IN EXCESS OF 50% OF THEIR TOTAL ASSETS 58% OF RETAILERS AND 62% OF TRAVEL & LEISURE COMPANIES WILL SEE A DECREASE IN PROFIT MARGIN BEFORE INTEREST AND TAX OF BETWEEN 1% AND 5% Airlines 22.7% Retailers 21.4% Travel & Leisure.7% Transport 11.6% Telecommunications 6.1% Energy 5.5% Media 5.5% Distributors 4.3% Information Technology 3.0% Healthcare 2.2% Source: IFRS Foundation Do you know whether your leases will hit your company s profit or affect your debt covenants? FINANCIAL METRICS Application of the new standard is not expected to have a significant impact on profit, credit ratings or debt covenants. However, individual occupiers may find they are negatively impacted. This will depend largely on whether: 1. The occupier is in expansionary mode. Companies taking on significant additional leases will find profit margins negatively impacted 2. Credit rating agencies currently over / underestimate future lease commitments. Should the future lease commitments have been underestimated, the occupiers credit rating may be negatively impacted 3. Existing credit agreements include clauses that state that debt covenants are based on accounting standards in place at the time the credit was issued. Occupiers will need to check whether this is the case. CRE For most companies there will be a step change in the way CRE engages with the wider business in the future: Increased engagement with Finance Greater participation in audits Increased focus from key decision-makers on property strategy and negotiation of lease terms. 12 13

DO YOU NEED TO REVIEW your property strategy? ARE SALE AND LEASEBACKS STILL a viable option? OWN VS LEASE POLICY From an accounting perspective, the changes to lease accounting standards will narrow the difference between leasing and owning property. Both will result in a liability on the Balance Sheet. Individual companies are likely to reassess the benefits of leasing vs. owning assets, particularly those that: 1. Have traditionally entered into long term lease contracts, where there is a less significant difference between the Balance Sheet impact of leasing vs. owning; or 2. Lease business critical assets, where the benefits of operational and occupational control may outweigh the accounting benefits under the new standard. Nonetheless, the practical benefits of leasing assets will remain unchanged: Operational flexibility Regular, fixed lease payments Reducing residual and obsolescence risk Alternative source of finance We are not expecting a wholesale move away from leasing. However, for some occupiers, a change in property ownership policy may be justified. PROPERTY FINANCE Occupiers often use sale and leasebacks as a method of raising capital off Balance Sheet. By selling an asset to an investor (removing the asset and liability from the Balance Sheet) and leasing the asset back at an agreed rent (the payments for which were off Balance Sheet ), financial statements show improved equity and reduced debt. Occupiers often recognise a significant accounting profit at the time of the transaction, due to the difference between the Net Book Value and the sales price achieved. Under the new standard, this structure will no longer be off Balance Sheet, nor will occupiers be able to recognise the full profit between Net Book Value and the sales price in their financial statements. Nonetheless, there are a number of wider benefits to sale and leasebacks: Reinvestment of capital in the core business Alternative source of finance Reduction in residual and obsolescence risk Retention of occupational security for a fixed period Source of long term financing Realisation of full asset value. Under the new standard, there will be a reduced accounting benefit to undertaking sale and leasebacks. The question in the future will rather be one of closer alignment to property strategy and of effective deployment of capital - can you release value from real estate and invest the capital raised at a higher rate of return through your core business? There is a limited period until January 19 when occupiers will have the opportunity to recognise the full profit from a sale and leaseback in their financial statements. ACCOUNTING RECOGNITION FINANCIAL BENEFITS OPERATIONAL BENEFITS MARKET RISKS Benefits of Sale and Leaseback Off balance sheet financing Profit recognition Effective deployment of capital Alternative source of finance Source of long term finance IAS 17 IFRS 16 OWN LEASE 14 15

IS THE WAY YOU negotiate leases ABOUT TO CHANGE? LEASE TERM The scale of lease liability recognised on the Balance Sheet is directly linked to the non-cancellable term of the lease. As discussed above, the non-cancellable term is generally the minimum fixed lease term. Going forwards CRE will need to balance the potential for reducing Balance Sheet liabilities through shorter leases, with the benefits afforded by longer fixed lease terms of occupational security, reduced rental market risk and a longer period for depreciating capital costs. LEASE INCENTIVES Upfront lease incentives, such as rent free periods and/or landlord contributions, will decrease lease liability on the Balance Sheet and lease payment on the P&L. The positive accounting impact of upfront lease incentives is greater than an equivalent rent reduction over the full lease term. * The non-cancellable term will include options to extend and periods after break dates, if it is reasonably certain that occupation will continue. CRE will need to be prepared to justify lease terms to an Auditor. Contract Terms Potential total contract term (years) Non-cancellable term (years)* Lease liability on Balance Sheet day 1 P&L day 1 year fixed term 1,246k 126k 10 year fixed term with 10 year extension option 10 772k 118k year term with break in year 5 5 421k 110k Impact of rent free period vs. equivalent long term rent reduction 80 60 Under the new standard, we expect upfront lease incentives to be favoured by occupiers over incentives blended over the lease term. 40 1 2 3 4 5 6 7 8 9 10 Year P&L with 3 years rent free P&L saving in comparison to long term rent reduction 16 17

RENT REVIEWS The unavoidable lease payments will vary depending on the rent review mechanism in place. For index-linked rent payments (e.g. annual CPI uplifts), the liability on the Balance Sheet and lease payment on the P&L on day 1 assumes that all future payments will be at current rent For market rent reviews (e.g. 5-yearly upwards only market reviews), the liability on the Balance Sheet and lease payment on the P&L on day 1 assumes that all future payments will be at current rent Index Linked Rent Reviews 118 140 105 70 Market Rent Reviews 118 140 105 70 Fixed Uplifts 130 140 105 70 For fixed uplifts (e.g. 2.5% annual increase), the liability on the Balance Sheet and lease payment on the P&L on day 1 is calculated including all future uplifts. 35 35 35 Leases with index-linked or market reviews will have a lower lease liability on the Balance Sheet and lease payment in the P&L than leases with fixed uplifts. However, these leases will need to be reassessed each time the lease payment changes (i.e. annually for index-linked leases). + LOWER P&L IMPACT + LOWER P&L IMPACT - HIGHER P&L IMPACT - ANNUAL REASSESSMENT OF LEASE LIABILITY - REASSESSMENT AT RENT REVIEW (YEAR 6) + NO REASSESSMENT DURING TERM P&L Impact Year 1 Projected Cash Rental Payment 18 19

TURNOVER RENT As discussed above, the unavoidable lease payments exclude turnover based elements of rent payments. This has a positive impact on the lease liability on the Balance Sheet and the lease payment in the P&L, which are based only on the fixed element of any turnover rent. We therefore expect occupiers to favour turnover related rent payments wherever possible. Retailers in particular will be looking to minimise the impact of the new standard by moving from fixed to turnoverbased rents. INCLUSIVE RENT CONTRACTS Some lease contracts cover both a lease and a service element (e.g. service charge). The service element does not have to be included in the lease liability on the Balance Sheet. Where an inclusive rent is paid for both the lease and service element of a contract, there is no easy way to apportion payments between the lease and service elements. For inclusive rent contracts, CRE will need to balance the potential for reducing Balance Sheet liabilities through apportioning these payments, with the extra work involved from CRE to estimate (and evidence) this apportionment. SUBLEASES Under the new standard, head leases and subleases are accounted for in different ways. The head lease is recognised on Balance Sheet The sublease may be recognised as either an operating lease ( off Balance Sheet ) or a finance lease ( on Balance Sheet ). Where a sublease is co-terminus and on similar terms to the head lease, this will be recognised as a finance lease. For the head lessee, the impacts of the head lease and sublease will cancel each other out - this will effectively remove the liability associated with the head lease from the head lessees Balance Sheet and P&L. ASSUMES FIXED RENTAL PAYMENTS OF 100K PA Fixed Rent 1 Where a sublease is shorter than the head lease or the subtenant pays rent below that chargeable under the head lease, the head lessee will continue to carry the full asset and liability from the head lease on the Balance Sheet. 80 40 CRE will need to consider the potential accounting impacts when negotiating sublease terms. Securing a longer sublease, even at the expense of increased lease incentives, may have significant accounting advantages. ASSUMES TURNOVER RENT COMPRISED OF: Turnover Rent 1 80K PA FIXED PAYMENT K PA TURNOVER ELEMENT 80 40 Turnover rents ARE SET TO BECOME MORE POPULAR. P&L Impact Cash Flow (rental payment) 21

CONCLUSION CONTACTS The new standard represents a significant change in the way leases will be recognised in financial statements. These changes will directly result in an increased administrative burden for CRE and a step change in the way CRE engages with the wider business. We expect a fresh focus on lease negotiations from senior decision-makers due to the potential impact of individual lease terms on financial metrics. While individual real estate decisions may be impacted, we do not expect this to translate into major changes to the wider real estate leasing market as the majority of leasing decisions are not driven purely by accounting objectives. Whatever the outcome for the leasing market, one thing is certain CRE is set to take centre stage in the changes ahead. Are you ready? For further information on changes to lease accounting under IFRS contact: PAUL FRY Partner, Occupier Finance Strategic Consulting +44 (0) 7152 5672 paul.fry@cushwake.com For further information on changes to lease accounting under US GAAP contact: MARGO MCCONNELL Senior Managing Director, National Financial Consulting Group +1 813 4 5353 margo.mcconnell@cushwake.com HANNAH COLEMAN Associate, Occupier Finance Strategic Consulting +44 (0) 7152 5508 hannah.coleman@cushwake.com RYAN R. RAWLS Regional Director, National Financial Consulting Group +1 404 853 5365 ryan.rawls@cushwake.com LAURA ZAVALA Senior Analyst, Occupier Finance Strategic Consulting +44 (0) 7152 5575 laura.zavala@cushwake.com MITCHELL RUSBARSKY Managing Director of West Region National Financial Consulting Group +1 213 629 7319 mitchell.rusbarsky@cushwake.com NOTES Unless otherwise stated, workings assume: 100 pa rent 10 year lease term 6% discount rate. 22 23

About Cushman & Wakefield Cushman & Wakefield is a global leader in commercial real estate services, helping clients transform the way people work, shop, and live. The firm s 43,000 employees in more than 60 countries provide deep local and global insights that create significant value for occupiers and investors around the world. Cushman & Wakefield is among the largest commercial real estate services firms in the world with revenues of $5 billion across core services of agency leasing, asset services, capital markets, facilities services (branded C&W Services), global occupier services, investment management (branded DTZ Investors), tenant representation and valuations & advisory. To learn more, visit www.cushmanwakefield.com or follow @ Cushwake on Twitter. Copyright 16 Cushman & Wakefield. All rights reserved. CUS100136 02/16