New rules for lease accounting

The central government has recently notified Ind AS 116, which stipulates new rules for lease accounting.  Ind AS 116, which is fully converged with International Financial Reporting Standard (IFRS) 16, is applicable from the accounting period commencing on or after April 1, 2019. IFRS 16 is applicable from the reporting period commencing on or after January 1, 2019. It is commendable that India is implementing the new rules simultaneously with advanced economies. New rules have changed the accounting for leases by the lessees substantially. Accounting by lessors remains almost unchanged.  

The current practice is that the lessee classifies leases into operating lease and finance lease. If the lease is classified as a finance lease, the lessee recognises the underlying asset and the corresponding liability in the balance sheet. If the lease is classified as an operating lease, the lessee does not recognise the underlying asset and corresponding liability in the balance sheet and recognises the lease rent as an expense.  In a finance lease, the lessor transfers substantially the risks and rewards incidental to ownership to the lessor. The most important indicators that indicate that the lease is a finance lease are: (a) the lease term is for the major part of the economic life of the underlying asset; and (b) at the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset. 

For example, three entities, M, N and P, operate in the same industry and use a large pool of similar vehicles for inward and outward logistics.  The economic life of a new vehicle is 10 years. M takes the vehicles on lease for a five-year period, N takes the vehicles on lease for a 10-year period and P borrows money and purchases the vehicles. The PV of the lease rent of a vehicle, in a five-year lease, is not equal to its FV.  M classifies the lease as operating lease and N classifies the lease as a finance lease. Conse­quently, M does not recognise the leased asset and corresponding liability in the balance sheet, while N recognises the same. Therefore, analysts find it difficult to compare the financial position and performance of M, N and P. Moreover, in the case of a long-term operating lease, significant liability remains off-balance sheet. 

Illustration by Ajay Mohanty

Ind AS 116 requires that for every lease, the lessee should recognise the underlying asset as the ‘right-of-use asset’ and the corresponding liability in the balance sheet. However, it provides an option to lessees to recognise the lease rent of short-term leases (12 months or less) or of leases of low cost items as an expense in the statement of profit and loss and not to recognise the underlying asset and the corresponding liability in the balance sheet. If an entity enters into a contract for the short term, but retains the option to extend the contract, the period for which it can extend the contract is considered in deciding the lease period if the customer is likely to exercise the option. Thus, Ind AS 116 does not provide an opportunity to structure a lease contract in such a manner that a lease, which is in reality is not a short-term lease, can be classified as a short-term lease. 

A contract contains lease if the supplier has no practical ability to substitute the underlying asset and the customer has the right to enjoy the economic benefits and direct the use of the asset during the contract period. In contrast, a contract is a contract for a service if the supplier either retains the right to control or to substitute the asset. The supplier has the practical ability to substitute the asset if the benefit to the supplier is higher than the cost of substituting the asset. The customer has the right to direct the use of the asset if it has the right to decide how, where and for what purpose the asset will be used. Whether a contract is a lease contract or a service contract may not be straight forward in many cases. For example, grey areas emerge for contracts such as a charter arrangement in the shipping, oil and gas industries, power purchase agreements, and sub-contracted manufacturing service arrangements. 

Ind AS 116 brings sea change from accounting practices entities have employed for years. In the future, entities will not be able to mask lease liabilities. This will significantly increase the debt-equity ratio and reduce the borrowing capacity. Investors, lenders and creditors will benefit immensely from increased transparency.

The writer is  director, Institute of Management Technology Ghaziabad email: asish.bhattacharyya@gmail.com