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December 2014

Ind-AS Carve Outs – Straightlining of leases

By Dolphy D’Souza Chartered Accountant
Reading Time 9 mins
The issue of straight-lining of leases is very important for many enterprises; particularly entities that obtain assets on long-term operating leases; for example, retail entities, multiplexes, telecom towers, etc. Thus, if a telecom tower was leased for nine years on a non-cancellable basis, paying rent of Rs.1,00,000 in the first year, with a 10% escalation each year, the charge in the P&L each year would be Rs.1,50,883 and not the contractual amount to be paid which is the rent for previous year plus 10% escalation. In determining the lease period for straight-lining the possibility of lease extension is also considered, and hence the impact could be much higher than one would normally anticipate.

In a recent discussion organised by an industry association on IFRS adoption, the author was surprised, when the presenter opined that operating leases should not be straight-lined under IFRS and hence a carve-out was required. The reason provided for the carve-out was that IFRS should be pain free. Interestingly, straight-lining is required under Indian GAAP (and is also clarified by an Expert Advisory Committee opinion). Thus, it was absolutely fine to give pain under the Indian GAAP but not under IFRS!

Financial statements should reflect a true and fair view, based on robust accounting standards. Whether the accounting gives pain or is pain free is not relevant. However, what is an appropriate technical approach can sometimes be very debatable. Straight-lining of leases is one such instance where there are strong arguments in favour of and against straight-lining of leases, which one should consider. Let us discuss what those arguments are.

Arguments for and against straight-lining of leases
The primary reason for straight-lining of leases is contained in paragraph 23 of AS-19 which states that “Lease payments under an operating lease should be recognised as an expense in the statement of profit and loss on a straight-line basis over the lease term unless another systematic basis is more representative of the time pattern of the user’s benefit.” In other words, in the above example of telecom towers, the benefit received from the telecom tower over the nine years is absolutely uniform and hence the charge in each of the nine years should be equal. The lessee is expected to derive the same benefit, in physical terms, from the leased asset over the lease term and, accordingly, the scheduled rent increases in the lease rental do not meet the criterion for recognising expense/ income on a basis other than straight-line basis over the lease term.

One view is that the increases in rent in the agreement may only be considered as an adjustment for inflation and hence leases should not be straight-lined. The counter argument is that inflation factor in the agreement may not be representative of the inflation index in the country. Thus, it may so happen that a 10% escalation is built in the rent agreement each year in anticipation of inflation, was not supported by the inflation index, which was expected to be 5%. In reality, it may so happen that in subsequent years rents may fall down drastically, instead of going up. In other words, the cost of operating would be cheaper in future years and hence the assumption that escalations represent future inflation may not be tenable. In India, it may be fair to state that one of the reasons for lease rentals to increase is the inflation factor. Now if the scale up on the rentals in the agreement was based on an inflation index rather than a fixed amount, the scale up would be treated as contingent rentals under AS-19 and accounted for as and when the contingent rentals become due (not on straight-line). However, if the rent increases does not represent an inflation index then straight-lining would be required. This appears to be a fair argument for straightlining leases.

It is understandable that in India people focus on contractual terms and therefore recognising any expense or income that does not represent those contractual terms makes them very uncomfortable. An interesting point would be to look at the standard on depreciation, which permits the straight-line, written down value method and other methods such as unit of production method. A lessee would depreciate an asset obtained on finance lease and capitalised by it using any of the above methods. In other words, the P&L charge would not be based on the contractual terms/payments. Thus, focusing on contractual terms/payments in the case of operating lease would also not be appropriate and would unnecessarily result in structuring possibilities.

Some argue that straight-lining results in recognising future costs. The standard ignores the fact that as time passes, costs go up (or may go down) and so does revenue. The cost of operating in 2007 would always be different from the cost of operating in 2008. The same can be said for the revenue rates; they may go up or down. To try and straight-line the cost (in the case of lessee’s) selectively for leases is a violation of sound accounting principles.

Paragraph 24 of AS-19 states that, “for operating leases, lease payments (excluding costs for services such as insurance and maintenance) are recognised as an expense in the statement of profit and loss on a straight-line basis unless another systematic basis is more representative of the time pattern of the user’s benefit, even if the payments are not on that basis.” This means that if services are provided by lessor to the lessee, for example, maintenance services with a 10% increase each year, those are not required to be straight-lined. Also when a purchaser makes an upfront commitment to purchase goods each year from a seller with a 10% increase over the previous year’s rate, one does not straight-line the cost of purchase over those years. Therefore the point is if straight-lining is not required as a principle in the framework or by other standards, then is it appropriate to apply it selectively in the case of leases?

A point to be noted is that the straight-lining under the standard is an anti-abuse measure arising out of rent-free periods. Thus, if a building is taken on operating lease for three years, with zero rent in the first two years and rent of Rs. 3 lakh for the third year, the standard would require Rs. 1 lakh to be charged each year. This is fair, because in substance there is no such thing as rent-free period. Therefore, some argue that to require straight-lining when there is no indication of deliberate ballooning is unfairly stretching the argument for straight-lining.

The straight-lining of lease rentals would result in a deferred equalisation which may be a liability or an asset. For example, if the operating lease is for two years with rental in year one, of Rs. 100 and rental in year two of Rs. 110; equalisation would result in a deferred liability of Rs. 5 in the first year (which will reverse in the following year). Now the problem with deferred equalisation is that it does not fulfill the definition of an asset or liability under “The Framework For The Preparation And Presentation Of Financial Statements” issued by the Institute of Chartered Accountants of India. Under the framework, asset and liability is defined as follows:

(a) An asset is a resource controlled by the enterprise as a result of past events from which future economic benefits are expected to flow to the enterprise.

(b) A liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying economic benefits.

It begs the question therefore that if deferred equalisation is not an asset or liability as defined under the Framework, then what is it doing in the balance sheet?

Overall, there appears to be good arguments for and against straight-lining of leases. Ultimately, one has to take a decision.

Overall Conclusion
The adoption of Ind-AS will bring India at par with the world (more than 120 countries) at large that has adopted IFRS. To achieve full benefit, it is imperative that Ind-AS’s are notified without any major difference from IASb IFRS. If India were to implement IFRS with too many differences,  it  would  be  akin to moving from one Indian gAAP to another Indian gAAP. This would entail 100% efforts with zero benefits. Moving from Indian GAAP to IASB IFRS would entail 100% efforts but will provide 100% benefits. By adopting IASB IFRS it would become possible  for  Indian companies to state that they are compliant with IASB IFRS, and hence those financial statements can be used globally.

It is well appreciated that accounting is an art, and not   a precise science. Primarily, financial statements should reflect and capture the underlying substance of transactions. The accounting standards are drafted to ensure that underlying transactions are properly accounted for and also aggregated and reflected transparently in the financial statements. But as already pointed out, this is not a precise science, and people may have different views as is evident from the above debate on leases. Sometimes there are no right or wrong answers, and a decision needs to be taken and people need to move ahead.

IASB IFRS is not necessarily the best cut in all cases, and there may be a few instances where the standards could have been better, from another person’s perspective. Nonetheless, the author believes that the standard setters and regulators will have to consider the benefit of these carve outs with the benefits lost as a result of departing from IASB IFRS. ultimately, it is not about one-upmanship but aligning with the world. In my view, full adoption of IASb IFRS is a goal worth pursuing. At the same time the standards setters and regulators should engage with the IASB in resolving the Indian specific issues amicably. As an alternative approach, the author suggests that companies should be allowed an option to adopt IASb IFRS, instead of Ind-AS, if they wish to.

In the long-run, the Indian standard setters and regulators should work closely with the IASB so that any differences that arise are resolved more promptly. A mutually respectable relationship can be built with the IASB, where the IASB and the world can gain from India’s participation in the standard setting process and simultaneously India can also benefit from the process in improving its financial reporting framework.

IASB certainly has a global objective of having one set  of uniform IFRS standards across the world. Therefore, if IFRS are adopted in India without any carve-outs it would be a positive development for IASB. But adopting full IFRS or providing an option to do so, would be a far bigger positive development for India.

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