It will be very interesting to know the know the impact of Ind AS 116 on lease accounting applicable to corporates and alike from April 1, 2019. Early estimates suggests that Indian Accounting Standar Board IASB suggests additional impact of USD 2.18 trillion on operating lease to be recognized as finance lease.
From top of my head I can recollect the Airlines, telecom and retail industry that have significant exposure to operating leases. There will be a negative impact on debt/equity ratio. Higher interest costs and increase depreciation hit. So it seems that EBITDA margins would be positive.
Any other exposure in terms of industry which i may be missing out? Please share your thoughts.
Interesting topic. Your assessment is largely correct. Let me put down what i think would happen to companies acting as lessee’s(say Airtel, Indigo, Jet etc) and as lessors(say Bharti Infratel)
As a lessee:
The primary issue would be that what is considered opex today would be moving to balance sheet(which would make the balance sheet bulky to say the least). My assessment is that if companies can make appropriate adjustments to the useful life of assets and and discounting rates the P&L will not have any significant impact. I think this would largely be a 2 quarter phenomena and the industry will just move on. To summarize - all Airline and Telecom companies having a strong balance sheet will survive in the long run and others will perish irrespective of any change in accounting standard.
As a lessor:
SEC has brought in a practical expedient(ASU 2018-11 issued during June 2018) to ASC 842(US GAAP equivalent to ASC 116) which would help companies(as lessors) to continue accounting for operating lease the way it is today. Considering the track record of standard setters in India - it is highly likely that we would follow the suit.
The crux of this ASU is as below:
“Specifically, an entity should determine whether the nonlease component (or components) associated with the lease component is the predominant component of the combined component. If so, the entity is required to account for the combined component in accordance with ASC 606. Otherwise, the entity must account for the combined component as an operating lease in accordance with ASC 842.” - which simply means that if the objective of the contract is to provide pure service and lease of asset is only used as a tool for delivery of such services then one can directly use the principles under revenue recognition standard(ASC 606/ Ind AS 115) instead of lease standard.
Adoption of this practical expedient would reduce the head ache of telecom industry significantly as service is the larger component of telecom industry.
Anyone interested in the original text of this ASU can refer here
It will also impact logistics , media and hospitality industries
eg Blue dart, Jubilant food, Mahindra holidays , coffee Day Enterprises, PVR, Inox
Profitabilityratio like return on asset/ asset turnover will decrease Balancesheet are going to be significantly stressed . As liabilities increases plus interest coverage ratio decreases companies will have lower debt raising capabilities. How Credit rating agency take this into account is to be seen(Might increase cost of debt for companies???)
Enclosed is a brief note which covers impact in brief manner. Don’t have access to detailed note. Someone could help out on that.
As per me, following impact would happen:
EBITDA Margins could expand while also increasing depreciation expenses. This would increase operating leverage ratios and reflect business fundamentals in much better manner.
Under CAPM, higher leverage would mean higher beta if someone levers and unlevers beta. Also, directly computing effective interest rates would become much more difficult.
Higher asset base could reduce RoCE for retail businesses if significant assets were financed using off-balancesheet financing (long term leases). Further, business on balance sheet face would sound riskier than what it is inherently.
Earnings would be hit for majority of retail businesses given that they have recently expanded and negative drag would be there
No impact on taxation front as tax rules are specific and clear on this matter.
Ind AS 116 on Lease Accounting has significantly impacted financial statements – both P & L and Balance Sheet of Indian companies this year. Under this, operating lease is capitalized as a Right of Use Asset in the Balance Sheet and depreciated over the lease term on a straight line basis. The liability is capitalized at present value of minimum lease payments to be made over the term of the lease. This has impacted all the below the topline metrics such as EBITDA, EBIT, margins, CFO etc. making Y-o-Y comparison difficult.
Does anyone know what is the discount rate used for arriving at the present value of minimum lease payments – is every company using its own rate or has a common rate been prescribed by any body such as the ICAI?
I assume the lease liabilities in the Balance sheet are the remaining lease payments discounted using some rate. Is this correct?
I see that some of these companies have a Right of Use Assets under the Fixed Assets part in BS. And these are depreciated in the P&L. Can someone help me understand why are RoU Assets depreciated if they are leased assets?
How do we apply valuation techniques to these companies who has shifted to the new accounting standard? For e.g let’s say I want a fair comparison of Free Cash Flow across 5 years how can we achieve this?
Apologies if the questions may sound dumb. No finance background
Yes your understanding is correct. The amount of lease liability is the present value of the future lease / rental payments. Usually discounted at cost of borrowing rate.
In the erstwhile accounting standard, operating leases like rental payments, were not brought into the BS, even though he operating lease were bounded by a contract and thereby a definite period. I reader of FS could not predict the fixed lease payments due over the contract period. IFRS 16 now brings in the clarity about your future commitments with regards to operating leases. As the object is leased to you, you have the right to use and control that object, this triggers the asset recognition standard. Thereby you see an asset is recognised by the same amount of lease liability recognized (ideal scenario). This asset is depreciated over the contract period of lease object under straight line method of depreciation.
Just as other asset is recognized, the ROU asset is also subjected to impairment testing. One would need to ascertain the Value in use and compare with WDV of ROU asset.
For retail companies or multiplexes, it appears that operating cash flow is also biased upwards, given that the RTU asset amortization (as part of depreciation expense) and Lease amortization (part of finance costs) is also being added back while computing operating cash flow from PBT.
If I just remove the RTU/Lease amortization portion out of this calculation, will operating cash flow be close to what it would have been prior to the Ind AS 116 regime? Can anyone clear this doubt of mine or point me out to an article/video that explains this? My objective is to go back to the old operating cash flow number which I believe was truly a cash number compared to the post Ind AS 116 OCF which is biased due to the non cash items of RTU/Lease amortization.
