More often than not, businesses prefer leasing over buying assets, depending on the financial ability of the company, intended period of holding, ease of obtaining the asset, and tax considerations.
The Centre has recently notified a new accounting standard, Ind AS 116- Leases, effective from April 1. This requires a closer look, as it is likely to impact several industries. Companies in the technology and aviation sectors are likely to be significantly impacted as the former mostly uses rented premises for its operations and the latter largely depends on leased aircraft and airport facilities.
According to the new standard, most of the leases should now be taken to balance sheet, showing the leased property as an asset, and the aggregate of lease rents payable as the liability. This not only has a bearing on the operating profits a company reports but may also optically lower the borrowing appetite of entities leasing such assets.
Here’s how.
No off-balance sheet leases
Under the old standard, accounting treatment of a lease for a lessee was dependent on its nature — operating or finance lease.
Leases of short period, where the ownership rights are not transferred to the lessee, were generally considered as operating lease. Financial lease covers those leases where the asset is leased for a period equal to its economic life, and the present value (that considers time value) of all lease payments is equal to fair value (market value) of the asset.
In operating leases, periodical lease rent payments are charged as an expense in the statement of profit and loss (SOPL). But financial leases are considered as a purchase of the asset by showing the present value of all lease payments as both an asset and a liability in the balance sheet.
The new Ind AS 116 has eliminated the distinction between operating and financial leases for lessees.
Therefore, no periodical lease payments will be charged as expense in the SOPL. Instead, lease rentals paid periodically get reduced from liabilities in the balance sheet. Also, as the leased property is considered an asset, depreciation on it will be charged in the statement. An additional interest component also gets charged.
In short, the value of assets and liabilities increases in the balance sheet, while depreciation and interest replace the lease rent charges charged to the P&L statement earlier.
So what do all these complex accounting changes mean for you?
Higher EBITDA
With the new accounting treatment kicking in from the first quarter of FY20, it may be useful to understand the implication of the new rule on the reported numbers of airlines or technology companies.
There will be significant changes in a few of the frequently used financial metrics, such as operating profit or EBITDA (earnings before interest, tax, depreciation and amortisation), debt to equity ratios, and return on capital employed.
Since operating profit, or EBITDA, is calculated before considering interest and depreciation, the new accounting rule will bump up the operating profit. This is because you will no longer charge the lease rentals to your P&L, as before.
According to a report by PwC titled, ‘A study on the impact of lease capitalisation’, the expected average increase in EBITDA for the aviation and telecommunication sectors would be 50.3 per cent and 22.9 per cent respectively.
Increasing debt-equity ratio
Two, the debt-equity ratios would also increase as the lease rent payables are considered as liabilities. The PwC report says an average change in debt after the implementation of Ind AS 116, would be 321 per cent, 55 per cent and 30 per cent for the aviation, technology and telecom sectors respectively. It would result in a higher debt-equity ratio of 321 per cent, 46 per cent and 36 per cent for these three sectors, respectively. An increase in the debt-equity ratio could, notionally at least, discourage entities in these industries to borrow further.
Further, return on capital employed will be impacted as the ratio divides net operating profit with capital employed (assets-current liabilities).
The other significant impact would be seen in the case of foreign currency leases. The liability in the balance sheet has to be re-translated in each reporting period, based on the current exchange rate, with the resultant profit or loss being charged to the P&L account. As many of the lease obligations of Indian airlines are denominated in foreign currencies (such as the dollar), the change in accounting treatment is expected to create significant volatility in the P&L statement of these companies.