Think Tank

Indian Accounting Standards: Keeping Pace

Raghu Iyer, Adjunct Faculty, SP Jain Institute of Management & Research and Great Lakes Institute of Management

In July 2017, ICAI’s Accounting Standards Board (ASB) issued an Exposure Draft (ED) of Ind-AS 116 – a new standard on accounting for lease transactions. Ind-AS 116, which is largely converged with IFRS 16, is a fundamental change in lease accounting, requiring lessees to recognise most of their leases on the balance sheet. As a result, companies that lease major assets are expected to see a significant increase in their reported assets and liabilities. The accounting guidance will impact a large number of entities, including airlines that lease aircraft, retailers that lease stores, power purchasers, companies that outsource technology contracts or transportation arrangements, those who avail equipment-finance, and other businesses with large lease portfolios. The changes are nuanced and demand prioritisation by CFOs, not just to ensure compliance, but also to maximise financial performance and cash flows, and avoid a potential impact on credit ratings.

Ind-AS 116 Framework: Key Changes

The new leasing standard requires entities to make more adjustments, and also to make more disclosures (e.g. discount rate, other qualitative information)

Definition of a lease

Ind-AS 17 defined lease as ‘an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time.’ However, the new standard provides additional guidance on the following aspects:

  • Identified asset, substitution rights and economic benefits: A contract contains a lease only if it relates to an identified asset. While a contract may continue to explicitly or implicitly specify an asset, the lessee will not have control over its use if the lessor has the practical ability to substitute the asset, and if the lessor benefits economically from exercising its right to substitute the asset. For instance, a coffee vendor’s agreement with an airport will not be considered a lease because the vendor can be allocated space anywhere in the airport.
  • Right to direct the use of an asset: Similar to IFRS 16, a contract contains a lease if a customer has the right to direct how and for what purpose the asset is used and/or if the customer has the right to operate the asset, without the supplier having the right to change those operating conditions, and/or if the customer designed the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

Lessee accounting undergoes a major change, while lessor accounting largely remains unchanged

For lessees, the existing distinction between financial and operating lease goes away

Most leases now come on to the balance sheet as a right-to-use asset and a corresponding lease liability representing its obligations

Accounting treatment by lessees

Ind-AS 116 introduces a single lessee accounting model to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value (the threshold is yet to be defined). Other accounting changes on the part of lessees include:

  • Initial recognition and measurement: Lessees are required to initially recognise a lease liability for the obligation to make lease payments and a ‘right-to-use’ (ROU) for the underlying asset for the lease term. The ‘lease liability’ is measured at the present value of the lease payments to be made over the lease term. The ROU asset is initially measured at the amount of the lease liability and adjusted for lease prepayments, lease incentives received, the lessee’s initial direct costs, and an estimate of the restoration, removal and dismantling costs.
  • Subsequent measurement: A lessee would be required to subsequently measure right-of-use assets similar to other non-financial assets (such as property, plant and equipment) and lease liabilities similar to other financial liabilities. A lessee would recognise depreciation expense on the ROU asset and interest expense on the lease liability, and also classify lease payments into their principal and interest portions, and present them in cash-flow statements. This is expected to result in a front-loading of expenses for most leases.
  • Presentation: Both ROU assets and lease liabilities are required to be either presented separately from other assets on the balance sheet, or disclosed separately in the notes. Depreciation and interest expenses cannot be combined in the statement of profit and loss.

Impact on Financial Position

Sectors like airlines, retail, power generation will be impacted the most…

…as more assets and liabilities will be put on a lessee’s balance sheet…

…and rental expense that was being debited in P&L earlier will be replaced by amortisation of lease liability and depreciation of rent-to-use assets

The new standard, applicable from 1st April 2019, is expected to affect a wide variety of sectors and entities. The larger the lease portfolio, the greater the impact on key reporting metrics and financial ratios. One key benefit will be greater transparency and comparability. At the same time, certain types of arrangements may require a detailed evaluation to see if they meet the definition of leases as per Ind-AS – for example, outsourcing contracts, third-party manufacturing contracts, and power purchase arrangements.

Ind-AS 116 will also bring more assets and liabilities on the lessee’s balance sheet, because it eliminates the need for lessees to classify each lease as either an operating or a finance lease. This will impact debt-equity ratios, and may also cause some entities to breach their existing debt-covenants.

The new standard also impacts P&L in the sense that the rental expense being debited in case of an operating lease is now replaced by: (a) amoritisation of lease liability; and (b) depreciation of the ROU asset. The depreciation charge is evened out over the life of the asset, while interest expense reduces over the lease period. Earlier, the rental was an above-EBITDA item. Now, the amortisation of lease liability and depreciation of the ROU asset are post EBITDA items. PBT levels will be impacted adversely, at least in the initial years, on account of the interest and amortisation. In the long run, however, the new standard will lead to improved EBITDA and cash flow from operations.

Transition requirements

Lessees can use either a full retrospective on transition for leases existing at the date of transition, or apply it only to new or amended contracts

Entities are not required to reassess existing lease contracts, but can elect to apply the guidance regarding the definition of a lease only to contracts entered into (or changed) on or after the date of initial application (‘grandfathering’). However, a full retrospective application is optional. The lessee can elect to apply the simplified approach and not restate the comparative information. The cumulative effect of applying the standard is recognised as an adjustment to the opening balance of retained earnings at the date of initial application.