July 2019

LESSEE’S LEASE OBLIGATION – BORROWINGS VS. FINANCIAL LIABILITY

Dolphy D'Souza
Chartered Accountant

ISSUE

Ind AS 17 Leases required lessees to classify leases as either finance leases or operating leases, based on certain principles, and to account for these two types of leases differently. The asset and liability arising from finance leases was required to be recognised in the balance sheet, but operating leases could remain off-balance sheet.

 

Information reported about operating leases lacked transparency and did not meet the needs of users of financial statements. Many users adjusted a lessee’s financial statements to capitalise operating leases because, in their view, the financing and assets provided by leases should be reflected on the balance sheet. Some tried to estimate the present value of future lease payments. However, because of the limited information that was available, many used techniques such as multiplying the annual lease expense by eight to estimate, for example, total leverage and the capital employed in operations. Other users were unable to adjust and so they relied on data sources such as data aggregators when screening potential investments or making investment decisions. These different approaches created information asymmetry in the market.

 

The existence of two different accounting models for leases, in which assets and liabilities associated with leases were not recognised for operating leases but were recognised for finance leases, meant that transactions that were economically similar could be accounted for very differently. The differences reduced comparability for users of financial statements and provided opportunities to structure transactions to achieve an accounting outcome.

 

To bridge the problems discussed above, IFRS 16 Leases was issued. Correspondingly, in India the Ministry of Corporate Affairs issued Ind AS 116 – ‘Leases’, which is notified and effective from 1st April, 2019 and replaces Ind AS 17. Ind AS 116 requires lessees to recognise a liability to make lease payments and a corresponding asset representing the right to use the underlying asset during the lease term for all leases, except for short-term leases and leases of low-value assets, if the lessee chooses to apply such exemptions. For lessees, this means that more liabilities and assets are recognised if they have leases, compared to the earlier standard, Ind AS 17.

 

Ind AS 116 requires lease liabilities to be disclosed separately from other liabilities either in the balance sheet or in the notes to accounts. However, Indian companies are also required to comply with the presentation and disclosure requirements of division II – Ind AS Schedule III to the Companies Act, 2013 (Ind AS-compliant Schedule III). As per the Schedule III format, under financial liabilities – borrowings are required to be presented separately. Borrowings need to be further bifurcated and presented in the notes to accounts as follows:

 

Borrowings shall be classified as: (a) Bonds or debentures; (b) Term loans (i) from banks or (ii) from other parties; (c) Deferred payment liabilities; (d) Deposits; (e) Loans from related parties; (f) Long-term maturities of finance lease obligations; (g) Liability component of compound financial instruments; (h) Other loans (specify nature).

 

Neither Schedule III nor the guidance note on Schedule III issued by the Institute of Chartered Accountants of India has been revised to take cognisance of the change in the lease accounting (due to introduction of Ind AS 116), under which there is no classification as finance leases or operating leases for lessees. On implementation of Ind AS 116 w.e.f. 1st April, 2019 lessees will not bifurcate leases into finance leases and operating leases and all leases will be capitalised (subject to a few exemptions). To comply with the disclosure requirement mentioned in the preceding paragraph, there is confusion whether (a) all lease liabilities should be classified as borrowings; or (b) all lease liabilities should be shown as financial liabilities because the requirement to disclose finance lease obligation as borrowings by lessees no longer applies (the lessee does not distinguish between operating and finance lease); or (c) for purposes of disclosure only, the lessee distinguishes the lease as finance and operating and discloses the finance lease obligations as borrowings and operating leases as financial liabilities.

 

If lease obligations are presented as borrowings in the financial statements, it will negatively impact debt covenants, the debt-equity ratio, and will have other significant adverse consequences for lessees. It may be noted that globally, under IFRS, companies will not be subjected to such adverse consequences because they do not have to comply with Schedule III or an equivalent requirement.

 

In summary, the following questions emerge:

 

1. On application of Ind AS 116, whether lessee would disclose the entire lease obligation in its financial statements under financial liabilities or borrowings?

2. Though not required under Ind AS 116, whether lessees need to bifurcate all leases into finance lease and operating lease only for the limited purpose of complying with the disclosure requirements of Ind AS-compliant Schedule III?

 

RESPONSE

The following three views are theoretically possible:

 

OPTIONS AND RATIONALES

 

Options

Rationale

Option 1 –
Present entire lease obligation under financial liabilities as separate line item either on the face of balance sheet or in the notes to accounts

Ind AS 1 deals with the presentation of financial statements and it does not require borrowings to be presented as a minimum line item on the face of the balance sheet. As per para 54(m) – Financial liabilities [excluding amounts shown under 54 (k) – Trade and other payable and 54 (l) – provisions] need to be presented as minimum line item on the face of the balance sheet.

 

Accordingly, in the absence of Schedule III, borrowings would have been presented as financial liabilities in the financial statements. Under IFRS, this is indeed the case and there is no requirement to show borrowings separately from financial liabilities;

 

Ind AS 116 requires lease liabilities to be disclosed separately from other liabilities either in the balance sheet or in the notes to accounts. It does not require such financial liabilities to be termed as borrowings;

 

Schedule III requires finance lease obligation to be disclosed under borrowings. However, under Ind AS 116, there is no finance lease classification for lessees and all leases are capitalised, subject to some exemptions. Since there is no finance lease obligation under Ind AS 116, nothing is required to be presented as borrowings;

 

Further, Schedule III states the following which may be used as the basis to present it separately from borrowings:

 

“Line items, sub-line items and sub-totals shall be presented as an addition or substitution on the face of the Financial Statements when such presentation is relevant to an understanding of the company’s financial position or performance, or to cater to industry or sector-specific disclosure requirements, or when required for compliance with the amendments to the Companies Act, 2013, or under the Indian Accounting Standards.”

 

It may be noted that Option 1 is completely in compliance with the accounting standards.

Option 2 –

Present entire lease obligation as borrowings

As Ind AS 116 does not require bifurcation of leases into finance and operating and requires all leases (other than short-term and low-value leases) to be capitalised, the entire lease liabilities need to be disclosed in borrowings to comply with the spirit of Ind AS-compliant Schedule III requirements;

 

Further, this will also eliminate the difference between the two categories of companies, i.e., Borrow to buy vs. Leasing the assets.

Option 3 –

Bifurcate leases into finance and operating and disclose only finance lease obligations as borrowings. Operating leases will be presented as financial liabilities

Though Ind AS does not require bifurcation but to comply with the Schedule III one may need to do such bifurcation;

 

Accordingly, disclose finance lease obligations as borrowings and operating lease obligations as financial liabilities.

 

 

 

CONCLUSION AND THE WAY FORWARD

The author does not believe that Option 3 is appropriate, because it is not so intended under the Standard or Schedule III. Additionally, this issue has arisen because Schedule III is not amended post -Ind AS 116, to either eliminate the requirement to disclose finance lease obligations as borrowings, or alternatively to require all lease obligations (other than low-value and short-term leases) to be disclosed as borrowings.

 

Between Option 1 and 2, MCA needs to make its position clear, either through a separate notification or by amending Schedule III. In the absence of that, an ITFG clarification will be necessary to ensure consistency in the financial reporting.  

 

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