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Ind AS 116: No More Off-Balance Sheet Treatment Of Leases

The new lease model will gross-up balance sheets, increase leverage and change income statement and cash flow profile.

A leasing sign sits in front of an office building.  (Photographer: Ty Wright/Bloomberg)
A leasing sign sits in front of an office building. (Photographer: Ty Wright/Bloomberg)

The decision to lease or own an asset has often been guided by the available financing options, the tax treatment and the accounting implications, like an off-balance sheet treatment of the underlying asset and associated debt. Under the existing rules, lessees account for leases either as operating leases or as finance leases, depending on complex rules and tests. These, in practice, use ‘bright-lines’ resulting in all or nothing being recognised on-balance sheet for lease transactions that are sometimes economically similar. However, this distinction will now largely disappear with the new lease model that is proposed to go into effect on April 1.

The New Lease Model

The Institute of Chartered Accountants of India has issued an ‘Exposure Draft’ on Ind AS 116 providing guidance on accounting for leases, which is largely converged with IFRS 16, Leases issued by the International Accounting Standards Board. It is proposed to be effective from April 1, 2019, pending notification by the Ministry of Corporate Affairs.

The new standard requires lessees to recognise nearly all leases on their balance sheets, reflecting their right-to-use an asset for a period of time and the associated liability for payments.

All lease liabilities are to be measured with reference to an estimate of the lease term, including certain optional lease periods.

There are optional exemptions for leases of terms less than 12 months and low-value assets. These do not have to be recognised on the balance sheet but can continue to be accounted as an operating lease similar to today.

The new model will gross-up balance sheets, increase leverage, and change the income statement and cash-flow profile.

The rent expense will be replaced by depreciation and interest expense in the income statement, similar to finance leases today. The lease liability is measured in subsequent periods using the effective interest rate method and the ROU asset is depreciated, done on a straight-line basis or another systematic basis, like other fixed assets today. The carrying amount of the ROU asset will, in general, be below the lease liability amount – resulting in the so-called effect of ‘front loading’ of lease expense, explained in the chart below. This might decrease earnings and equity immediately after entering into a lease, compared to an operating lease today.

Ind AS 116: No More Off-Balance Sheet Treatment Of Leases

Commonly used financial ratios and performance metrics will be impacted, such as gearing, current ratio, asset turnover, interest cover, EBIT, operating profit, net income, EPS, ROCE, ROE, and operating cash flows.

However, some measures such as operating profit, EBIT, EBITDA and operating cash-flows reported would improve, with no change in the underlying cash flows or business activity.

Service Contracts And Embedded Leases

The definition of a lease is different from the current guidance for evaluating embedded leases. That might result in some traditional service or supply contracts being treated differently in the future. Previously, there may not have been a lot of emphasis on the distinction between a service and an operating lease, as it often did not change the accounting treatment. Both the service and lease components were off the balance sheet and were expensed over the contract period.

However, companies will now have to necessarily record the lease component of the service contract as a liability on the balance sheet.

Industry Impact

Based on ‘PwC’s study on the impact of lease capitalisation’, key financial ratios and performance measures of companies listed on the NSE (Including in Nifty 50 and Nifty Next 50 benchmark indices) is expected to be impacted as depicted below. The impact of the new standard also differs between industries with the following sectors expected to have significant impact.

Ind AS 116: No More Off-Balance Sheet Treatment Of Leases
Ind AS 116: No More Off-Balance Sheet Treatment Of Leases
Ind AS 116: No More Off-Balance Sheet Treatment Of Leases

Business Impacts And Way Forward

Companies will need to carefully assess the effects of the new standard by performing an inventory check of its contracts. This will include extracting, gathering and validating lease data, assessing the impact and preparing for investment in re-design or implementation of new IT systems. Extracting lease data from contracts that currently are not systematised and/or collecting lease data from different operational or other ‘systems’, may prove to be difficult and time-consuming – like with foreign locations with their lease data requiring language translations.

In addition to contract and data management, companies will need to closely look at their asset financing decisions, changes to processes and controls and most importantly evaluate their supply and service contracts to identify any potential embedded leases - which may not have been a focus before. 

As discussed, the effect on financial ratios (such as gearing, leverage, interest cover etc.) could be significant, may trigger breaches of loan covenants and also affect credit ratings – requiring to agree amendments to covenants in existing and future financing arrangements. Changes in EBITDA measures could also impact remuneration and incentive schemes – something to watch out for.

Finally, with all of this, internal and external stakeholders will want to know more, requiring proactive stakeholder engagement and communication.

(The column was written before the notification. The MCA notified Ind AS 116 on March 29, 2019)

Sumit Seth is Partner at Price Waterhouse.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.