David Tweedie, the Former Chairman of the International Accounting Standard Board once commented on International Accounting Standard 7 that, “One of my great ambitions before I die is to fly in an aircraft that is on an airline’s balance sheet.”
Indian AS 116 is nothing but the realization of that dream in the Indian sub-continent in the year 2019 or IFRS 16 internationally in the year 2016. Before we get into the depth of what exactly Sir David meant or the nuances of Ind AS 116. Let us try and understand the Lease Agreement, the historical procedure (pre Ind AS 116 i.e. Ind AS 17) for Accounting and ultimately the draw back of the then system which led to the present system.
The Lease Agreement and the historical regime
As per Ind AS 19, “A lease is a transaction whereby an agreement is entered into by the lessor with the lessee for the right to use an asset by the lessee in return for a payment or series of payments for an agreed period of time”
From the definition above we can identify the following important terminologies:
Let us take an example: Assume Person A (Lessee) runs a business to manufacture Automobile parts in India. He is interested in venturing into Additive Manufacturing and for the same requires a 3d printer (Asset). He contacts Person B (Lesser)owner of the 3d Printer. They enter into the agreement wherein A can use the printer given by B for monthly rental of Rs 1 Lakh (Payment). This is a typical example of a lease agreement.
Types of Lease:
Finance Lease: In this type of agreement the risk and return of the asset is completely transferred to the Lessee. The title of the Asset might or might not be transferred. This agreement also enables lessee to purchase the asset from lessor before the agreement ends. The asset under consideration is recorded as an Asset in the financial statement of the lessee. The future obligation to pay as liability. A depreciation is booked on the Asset and a charge on P&L for the lease payments to the lessor.
Operating Lease: In this type of agreement the lessee gets all the benefits of the usage of asset. But the repair and maintenance are incurred by the lessor. The asset is not recorded neither in the books of the Lessor or the Lessee. The timely payment to lessor such as rent is booked as an expense in the books of Lessee. Ind AS 19 defines Operating Lease as on which is not Financial lease.
The Problem: The biggest problem in the above methodology is the comparison between Business. Let us assume two business which are in the same line of business i.e. Ride hailing. One of them follows the Finance Lease model whereas the other one follows the operating lease model. Despite having a similar revenue mix the Financial Statements will appear very different. The reason being the Off-Budget financing that is there in the case of Operating Lease the visibility of which is not there to general public. This makes values of Assets and Debts not comparable and in a sense unrealistic as well.
We will get into the details of how the two will be different with the help of Case of Archies Limited in the end.
IND AS 116: Proposal
The biggest proposal of the IND AS 116 is that the Operating Lease needs to be treated same as the Financial Lease in the books of the lessee. What this essentially means is that in terms of accounting treatment the financial and operating lease will be same. Hence patching the issues of not being comparable and Off-budget financing.
Ind AS 116 also lays down a model to identify whether an agreement falls under the jurisdiction of Lease rules or not.
Apart from the above model which helps us in identifying whether a contract is a lease-based contract or not. There are few exemptions given as well (I.e. no need to book it in the accounts):
Explicit or Implicit Disclosure of the Asset
By explicit disclosure we mean that the agreement clearly states that XYZ asset given to the Lessor to the Lessee. For example: 100 HP Printers capable of Metal printing given to A by B. Here the asset can be directly identified.
By implicit disclosure we mean that the Asset is not directly identifiable but the condition of the Lessee makes it identifiable. For example: A will give a 3d printer to B. But there is only one printer that is there with B post the deal. Here, although the asset is not explicitly identified, the circumstances make it so.
One thing that needs to be kept in mind is that the right of substitution should not be there. Let’s say the lessee owns 100 cars and agreement just says “A Car” in the agreement. This allows lessee to substitute one car for another as Asset is also not explicitly or implicitly identifiable. This also constitutes to agreement not being a lease contract.
Controls the usage of Asset and Accrues all the benefits
An agreement is considered as a lease. If the control over the usage of the asset is with the lessee. Let us understand with the help of an example. Suppose A gives 3d printer to B, but lays down the condition that it should only be used for designing prototypes. The agreement won’t amount to lease because of the control by lessor. If the purpose was not defined then it would have been a lease. Similarly, let’s say if the end benefits of the asset are not accruable to the lessee. For example: All the Goods produced by the machine is taken back by the lessor. Then the agreement won’t be a lease contract.
The companies are required to incorporate the Ind AS 116 from FY 2019-20 onwards (Modified Retrospective) or with a retrospective effect i.e. covering FY 2018-19 as well (Full Retrospective).
Impact on the Financial Statements: Archies Limited
As you must have implied by now, the immediate impact of the adopting the Ind AS 116 is that the Assets and Labilities of the company will increase. The cost which was earlier identified as Lease Expense, will now be divided into Finance Cost and Depreciation. Hence, changing ratios like Gearing Ratios, Solvency Ratios and operational measure like EBITDA.
The Liability or Right to use asset is computed as: Sum of Present Value of all Future Lease payments
Let us look at the few figures and ratios of the said company:
As we can see from the above table. The EBITDA of the company grew by 189% while the Gross Profit was declining from 61% to 50% (because of other reasons). The sales were also down due to the impact of Covid. Hence, the change is directly attributable to the Ind AS 116 adoption. Other notable changes include increase in debt by 464%. Note that since the EV of the company was fairly similar (increase by 18%), due to a huge change in the Debt the Market Cap of the company took a hit. Apart from these ratios like Working capital as a percentage of Assets and Asset turnover ratio decreased. Simply because of the increase in the base of the concerned parameter.
In Nutshell, the adoption of Ind AS 116 patches the loop hole of Off budget financing and presents a fairer picture of the whole business. It also enables cross comparison between two business with different policy for leases. The Financial impact of the Ind AS 116 can be summarized with the help of following table.
Data Source: Annual Report Archies Limited, Refinitiv