Accounting of Perpetual Lease - Ind AS 116 / IFRS 16

 Ind AS 116 (IFRS 16) Leases, which is in supersession to its predecessor Ind AS 17 (IAS 17), have significantly modified the accounting treatment of leases particularly in the books of the lessee. The earlier standards recognised leases in the statement of the profit and loss on straight line basis, over the period of lease. However, Ind AS 116 requires lessees to put most of the leases on their balance sheets.

The Impact

How the new standard works

The new accounting principle for lease (operating lease in the books of lessee) requires the lessee to recognise a right-of-use asset and corresponding lease liability at the commencement date of a lease agreement.

Lease liability is the present value of lease payments to be made by the lessee in accordance with the lease agreements entered. The below calculation will clear how lease liabilities are computed and recognised along with right-of-use assets.

Factors that measure lease liability

The computation of lease liability and corresponding right-of-use assets is based on certain internal and external factors viz.,

 - lease rentals / payments which are required to be made during the course of lease;

 - implicit discount rate;

 - incremental borrowing rate (in case implicit discount rate is not available);

 - lease term.

Lease term

Lease term = non-cancellable period + extension period + termination period 

Non-cancellable period is the period where lessee has the right to use an underlying asset. Period where an option to extend the lease has been stipulated, shall be included in lease term if lessee is reasonably certain to exercise such option. Further, the period covered by an option to terminate the lease shall also be included in lease term where lessee is reasonably certain not to exercise such option.

Significance of Lease term

As it can be seen, measurement of lease liability and corresponding right-of-use assets would require assessment of lease term by the lessee. Any incorrect evaluation of lease term would mean that lease liability and right-of-use assets have been measured wrongly. The lessee need to first determine lease term and rentals pertaining to such lease term and then calculate present value.

Further, leases where lease term is 12 months or less are classified as short-term lease and such leases are exempted from complying with the recognition principle. Consequently, there is no requirement to measure lease liability and right-of-use assets in case of short-term leases. 

The Concern

Perpetual lease

Perpetual leases are generally used where underlying asset is land. Many entities (specifically public sector entity) entered into perpetual lease agreement, for which one-time upfront premium is paid at the time of commencement and rent is paid on periodic basis. The terms of lease in most of the cases are such that any default in payment of periodic basis may lead to cancellation of lease agreement.

The problem with perpetual lease is evident (from the name itself) that the lease term cannot be determined by the lessee. A long-term lease of land (say 99-years) is sometimes regarded as being economically similar to purchase of the land. IFRS 16 does not specifically exclude such leases from its scope as:

 - conceptually, both long-term lease of land and long-term lease for assets other than land are not different. If the contract does not transfer control of the underlying asset to lessee, but gives only the right to control the use of the asset, the contract should be accounted as such;

 - present value of lease payments under long-term lease is likely to represent substantially all of the fair value of the underlying asset. 

ASC-842, which is US GAAP equivalent of IFRS 16 / Ind AS 116, includes very long-term lease (999-years) in its scope.

My Assessment of Perpetual Lease

In sum, in case of long-term leases, an important aspect to be examined is whether the agreement transfers control of underlying asset or only right to control the use of such underlying asset. If former is the case, the same should be accounted for as per Ind AS 16 / IAS 16, 'Property, plant and equipment'. However, Ind AS 16 does not provide guidance as to how "control" should be established. In general, control is established where future economic benefits from that resource (underlying asset) must flow to entity in question (lessee). If terms of the long-term lease agreements are such that the lessee can only sell the underlying asset with prior consent of the lessor or that sale proceeds shall be shared between lessee and lessor or that in the event of sell, lessor may impose such terms and condition as he thinks fit, it cannot be said that future economic benefits from underlying asset will flow to the entity entirely. Therefore, it cannot be said that lessee has obtained the control of the underlying asset. Accordingly, such underlying asset cannot be recognised under Ind AS 16.

In case of long-term lease (where it is established that the lessee have not obtained control of underlying asset),  the entity shall, at commencement date, recognise right-of-use asset and lease liability considering lease payments over perpetuity. So far as depreciation of right-of-use is concerned, if the underlying asset is land, no depreciation should be charged as land is a non depreciable asset and also the fact that the lease term is perpetual. For underlying assets other than land, depreciation should be charged on straight line basis over its useful life. It is also to be noted that the right-of-use asset is required an impairment test and entities should account for any impairment loss.

Revised Accounting Standards - One Nation One Accounting Standards

If you are a CFO or Finance Head of an Indian company and at ease about the fact that your company does not need to follow Indian Accounting Standards (Ind AS), it is time that you tighten up and follow the changes which are happening quietly but soon one announcement and your ease may become your biggest headache.

Two things come to the mind, while reading this, 

One is why would someone be at ease of the fact that his/her company does not need to follow Ind AS? and secondly, why this ease is being threatened?

Why Ind AS are troublesome?

Before going into the complexities of the explaining the hardship in complying with the Ind AS, let me serve you some starters to being with.

The Starters

Ind AS are nothing but the duplicate of International Financial Reporting Standards (IFRS). They are India's financial reporting framework (FRF) to move indian companies towards globally acceptable financial reporting. We, to be honest, live in the period of globalisation and the idea was to provide comparable international level picture to the users of the financial statements. We are, in fact, trying to move from generally accepted accounting principles (GAAP) to "globally" accepted accounting principles. But is the world really moving towards a common financial reporting framework? 

Fig-1

The above figure presents a world-wide overview of the various accounting standards followed in different parts of the world (Pakistan is one such country). India converged* with IAS and IFRS which enable indian entities to follow international standards (Indonesia is another such country) .

*There are 2 options available, if any country wants to follow IAS+IFRS. One is the "adoption" option wherein the country adopts them as it is. The other one is "convergion" wherein the country make slight changes in the standards on the basis of their home conditions.

Complexities in following Ind AS

1. To start with, there are 39 Ind AS as against 27 I-GAAP/AS. Therefore, one has to read them at large as compared to I-GAAP. Just to give an example, Ind AS - 1 is of 36 pages while AS - 1 has 5 pages to read with. So not only there are more numbers of Ind AS but also the vast matter to read with in a particular Ind AS.
2. The mandatory and encouraged disclosure requirements under Ind AS are immense which include preparation and presentation of two additional statements viz., statement of changes in equity and other comprehensive income (part of the statement of the profit and loss).
3. The use of fair value under Ind AS are extensive and require continuous monitoring including the involvement of senior finance personnel and experts. 
4. Certain Ind AS are considerably technical and complicated which require thorough understanding of the subject and are not everyone's cup of tea. This also made sure that entities hire good candidates in their financial reporting team thereby increasing their cost.
5. The restatement of financial statements in certain cases like material prior period adjustments.
6. Component-bases depreciation under Ind AS - 16.
7. Standards related to financial instruments.
8. Provisioning of trade receivables on the basis of expected credit loss (ECL) method or provision matrix.
9. Lease accounting in the books of lessee under an operating lease arrangement.

Silver-lining to Ind AS

With all complexities, there are silver-linings in following Ind AS. There were many matters wherein the existing I-GAAP were either silent or were full of ambiguity. The clarifications to these matters were long overdue and have been considered under Ind AS to certain extent.

1. Globally accepted and comparable financial reporting.
2. Ind AS 40 on "investment property" provides for treatment of immovable properties held for rentals or capital appreciation. There is no specific standard under I-GAAP.
3. Ind AS 115 on "Revenue" clarifies the recognition of revenue as against the AS - 9 which is unable to grapple with the new ways in which many entities are earning revenue specially start-ups.
4. Fair valuation and additional disclosure requirements enable the users of the financial statements to understand the entity's financial position much better than before.  

Practical case studies to understand the impact of Ind AS

Jubilant FoodWork Limited

Standard in focus - Ind AS 116 on "leases"

As it can be seen from Fig-2, the EBITDA margin of the company has increased by 52% to 22.57% as against the margin of 14.85% if effects of Ind AS 116 were to be eliminated. The rentals expense of the company has been reduced by Rs. 29,724.62 lakhs and the same has taken the shape of depreciation and interest on lease liabilities (finance costs) for Rs. 18,072.33 lakhs and 16,329.20 lakhs respectively. Both these expenses are eliminated while calculating EBITDA thereby making the case for increase in margins of the company. 

Not only that the company has an asset called "right-of-use" asset worth Rs. 1,31,479.01 lakhs and a liability called "lease liability" worth Rs. 1,65,103.59 lakhs which did not, at all, exist previously.

Sector-wise impact of Ind AS

93% sectors had negative impact of Ind AS with 71% companies negatively impacted by the adoption of Ind AS

Source - ICAI Impact study on Ind AS

As I mentioned Ind AS are not very convenient to follow and their negative impact on most of the sectors and companies operating therein make things difficult for you as a CFO or Finance Head. Just to add to the worry, you may have to explain these changes to your assessing officer in your income tax returns/assessments.

Imagine... an investor with no finance/accounting background, investing in the shares of Jubilant FoodWorks Limited and while reading the financial statements of the company finds out a liability of Rs. 1,65,103.59 lakhs which, earlier, did not exist at all. This is surely going to impact them as well. 

This is why I said that you are at ease in case your entity is not required to follow/not following Ind AS as its financial reporting framework.

Why your effortless comfort is not going to last for long?

Currently, we (In India) are following two sets of accounting standards viz., AS/I-GAAP and Ind AS. Ind AS are applicable to certain classes of the companies while rest of the companies are following the former. Both sets of accounting standards are duly notified under section 133 of the Companies Act, 2013. Ind AS can also be voluntarily followed by any company with effect from 01 April, 2015. Since, both AS and Ind AS are materially different, it may happen that companies operating in same industry may present a distinct picture of financial position via their financial statements just because one may follow AS and the other one Ind AS.

The Institute of Chartered Accountants of India (ICAI) has decided to revise AS/I-GAAP and accordingly the accounting standard board (ASB) has initiated the process of revision of these standards which will be applicable to entities not following Ind AS.

"To make it clear, the power to prescribe accounting standards rests with the Central Government under section 133 of the Companies Act, 2013. However, these accounting standards must be recommended by the ICAI. Therefore, the ICAI is, in fact, the guardian of the accounting standards in India. Accordingly, the decision of the ICAI alone is enough for us to get ready for what is coming next."

The principal purpose of revising I-GAAP is to make sure that we do not follow two different sets of accounting standards in one country. It's like:

"One Nation - One Accounting Standards"

The ICAI has already released 22 exposure drafts to revise these AS. One standard, AS - 10 on "Property, plant and equipment" has been revised in similar line with Ind AS - 16 on "Property, plant and equipment" and is effective as on date.

Links between Ind AS and revised AS

• The numbers of revised AS shall be same as Ind AS and eventually we are going to have 39 AS as well;
• The numbering and the name of a particular AS is going to be exactly that of Ind AS;
• The para numbers in revised AS are similar to what has been provided under Ind AS;
• The revised AS are being formulated as near as to Ind AS to make sure both types of standards are principally similar in nature.

However, going through the exposure drafts which I have studied thus far, there is a very little focus on use of fair valuation in the revised AS as compared to the extensive use of fair valuation under Ind AS. This, may be, is being done by keeping the small and medium sized companies in mind, which will find them difficult to comply.

There are certain questions which are unanswered at the moment. 

• Is the ICAI going to provide criteria for small and medium sized enterprises the same way which is currently provided under I-GAAP?
• Is the ICAI going to provide relaxation from certain provisions of the revised AS to some specified classes of enterprises the same way which is provided under I-GAAP currently?
• Are these revised AS going to be applicable to companies only or to other forms of entities also?
• Are Division I and Division II to the Schedule III to the Companies Act, 2013 going to be merged once these revised AS are effective?

The most important question that needs to be asked is "when these revised AS are going to be effective?"

One thing is clear that these revised accounting standards will require the management to update itself and its financial reporting team so that the upcoming challenge can be smoothly tackled with.

In my own opinion, this exercise of revising AS to have single set of accounting standards in India is actually not going to make a difference as Ind AS are principle based accounting standards and revised AS may just be lacking this approach. 

YouTube Video to understand nature of various accounting standards followed worldwide