Accounting for leases – the problem of rent reviews in capitalising lease liabilities
| Pages | 79-108 |
| Published date | 01 April 2003 |
| DOI | https://doi.org/10.1108/14635780310469094 |
| Date | 01 April 2003 |
| Author | Neil Crosby |
| Subject Matter | Property management & built environment |
Academic papers:
Accounting for
leases
79
Journal of Property Investment &
Finance
Vol. 21 No. 2, 2003
pp. 79-108
#MCB UP Limited
1463-578X
DOI 10.1108/14635780310469094
ACADEMIC PAPERS
Accounting for leases ± the
problem of rent reviews in
capitalising lease liabilities
Neil Crosby
Department of Real Estate and Planning, School of Business,
The University of Reading, Reading, UK
Keywords Accounting standards, Leases, Commercial property, Valuation
Abstract In 1996, an International Accounting Standards Committee (IASC) working party
suggested that current methods of accounting for leases should be changed and in 1999 this work
culminated in a position paper from the UK Accounting Standards Board (ASB) which made a
number of suggestions for consultation (ASB, 1999). The paper assumes that the overall thrust
of the proposed changes will be accepted and that will mean that occupying lessees will be required
to capitalise the liability to pay rent for their lease and place that liability on the balance sheet. It
will also require that property owners identify the value of the lease and the residual property
value separately. These are by no means the only issues that are raised by the position paper but it
is the implications of these two proposals for valuation methodology that is the subject of this
paper. The property industry response in the UK to these two proposals is outlined and it shows
that a minimalist approach is recommended, which incidentally is the preferred approach of the
UK ASB. This paper argues that market valuations should already be carried out by techniques
that attempt to identify the different values of the lease and the residual property value. The
minimalist approach will replace one missing set of information with a misleading set, meaning
that the IASC attempt to improve the ability of accounts to provide a ``fair view'' of companies will
be thwarted. Alternative valuation models should be adopted which accurately appraise the assets
and liabilities distributed by the lease and also identify the residual property value. Conventional
market valuation approaches do not work in this context.
1. Introduction
In 1996, a special report by the group known as G4 + 1 put forward a new
approach to the accounting for leases (McGregor, 1996). This group is made up
of representatives of the accounting standard setting bodies of the UK, USA,
Australia, Canada and New Zealand. The group thus represents organisations
that have a common objective of providing quality financial reporting
standards for the primary purpose of providing information useful to capital
market participants. The group also has the objective, amongst others, of
seeking common solutions to financial reporting issues.
The distinction between finance and operating leases is one such issue and is
fully discussed in Goodacre (2001) who identifies that the current lease
accounting standard is SSAP 21. A lease which transfers substantially all of
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The author gratefully acknowledges the input into the discussion of the interest rate selection
and advice of other aspects of the paper from Professor Charles Ward at the University of
Reading.
JPIF
21,2
80
the risks and rewards of ownership to the lessee is a finance lease while a lease
that does not transfer substantially all of the rights and rewards is termed an
operating lease. At present, only finance leases have to be shown as an asset
and liability on the balance sheet. Operating leases require the lessor to reflect
the ownership of the asset but the lessee only has to place the periodic rent
payment on the profit and loss account as a expense. Beatie et al. (1998)
suggested that operating leases outnumber finance leases in the UK by 18 to 1.
In particular, most property leases are currently classified as operating leases.
Different countries have different definitions of what constitutes operating or
finance leases so at present the same lease could be accounted for differently in
the different places (Jones Lang LaSalle, 2000).
The G4 + 1 proposal is that all leases should be treated as finance leases.
This paper assumes that this overall principle will be accepted. A number of
commentators from the property industry also appear to take this view and
argue for the principle (Jones Lang LaSalle, 2000; RICS, 2000). It is interesting to
note that the discussion in the UK property press has invariably concentrated
on the effect of the proposals and not on arguing against the logic of them.
This proposal will therefore necessarily affect the majority of property
leases and this will have a significant impact on accounting for property leases,
in particular in the UK. Not only are the majority of property leases treated as
operating leases, up to 1990, the vast majority of the UK quality leased
property stock was let on standard institutional leases which attempted to
transfer substantial proportions of the property risk to the tenant. The
standard lease was for 20 to 25 years with five yearly upwards only reviews
and a full transfer of all repairing and insuring obligations to the tenant. In
1990, around 90 per cent by value of the investment property databank was let
on these terms (Crosby et al., 2000). The transfer of risks and rewards of
ownership is therefore substantial.
During the 1990s, lease lengths fell significantly and break clauses appeared,
so transferring much of the risk back towards the landlord. By 2000, the
proportion on 20 year plus leases was around a third by value (BPF, 2001). But
UK leases are still substantially longer than most other countries in the world
and in all of the other G4 + 1 countries so the impact is greater.
Another development relevant to the discussion on lease accounting is that
since the mid 1990s, the difference between the value of leases and residual
property values is better understood in UK property investment markets. They
are now considered as part finance and part property investments for the first
time and, even more recently, attempts have been made to securitise the
various components of the property cash flow. The current lease rent
capitalised to the end of the lease is considered a bond secured on the tenant
covenant and not subject to traditional ``property'' risk. The second part of the
cash flow is the right to possible increases in rent at each rent review between
now and the end of the lease, still secured on the tenant covenant and the
upwards only provision. The third element is the property reversion or residual
value at the end of the lease. As lease lengths shorten and/or breaks appear, the
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