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
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Options
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Rationale
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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
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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;
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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.
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Option 2 –
Present entire lease obligation as borrowings
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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.
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Option 3 –
Bifurcate leases into finance and operating and
disclose only finance lease obligations as borrowings. Operating leases will
be presented as financial liabilities
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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.
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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.
