15 April 2019

Lease Accounting

Expert Speak

Decoding the new lease accounting standard

We hosted a conference call with Mr Sandip Khetan, Partner and National Leader of Financial

Accounting Advisory Services (FAAS), EY India to decode the new lease accounting standard –

Ind-AS 116. Mr Khetan believes that the impact from the new standard will be fairly broad

and significant. His analysis on the BSE-100 companies suggests that the potential impact on

the balance sheet, excluding banks, will be to the tune of ~INR1.4t. This new change will bring

in consistency between companies that have different finance strategies and asset models

(such as high lease asset v/s owned asset).

Key Highlights:

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Ind-AS 116 – which has become effective from 1

st

Apr’19 – will bring in a significant

change in the financial statements of all companies. The standard will primarily

Mr Sandip is a Chartered

impact the lessee, while lessor accounting will remain largely unchanged, except

Accountant with over 20

for the need to comply with the additional disclosure requirement.

years’ experience. He is a

subject matter expert in

The new standard is doing away with the distinction between operating lease and

Indian GAAP, IND AS, IFRS

finance lease. Thus, all leases will have to be recorded on the balance sheet.

and US GAAP. Sandip has

It requires companies to capitalize long-term liability toward operating lease

extensive experience in

providing various assurance

payment (currently off balance sheet) in the balance sheet with a corresponding

and advisory related services

intangible asset in the form of right to use asset.

to clients across multiple

This will eliminate income statement distortion between companies that used to

industry segments like

manufacturing, power,

own asset by financing it from banks and companies that used to lease assets to

financial services, e-

keep themselves asset-light.

commerce, infrastructure

and software. He is a special

Operating lease expense shall no longer be charged to the income statement, and

invitee to the Ind-AS

thus, EBITDA of all companies shall increase throughout the lease tenure.

implementation group of

Depreciation on right to use asset and interest on lease liability shall now be

Institute of Chartered

Accountants of India.

charged in the income statement. On the other hand, (a) depreciation shall be

charged using the straight line method over the life of the asset and (b) interest

Over the years, Sandip has

expense due to the unwinding of lease liability shall be higher in the initial period

been a trusted advisor to

clients and has served as

of the lease.

engagement partner for

Therefore, the impact on PAT shall be adverse in the initial phase of the lease due

multiple client initiatives.

to front-loading of interest expense. It will be followed by a positive impact in the

latter half of the lease. Overall impact on the income statement over the life of the lease term shall remain

unchanged.

Operating cash flow may improve, while correspondingly investing/financial cash flows may be impacted. Also,

as this is an accounting change, the overall impact on cash flow shall remain neutral.

Mr Sandip Khetan —

Partner & National Leader,

FAAS, EY India

Other highlights:

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Lease rental commitment denominated in foreign currency

is monetary liability and companies are required to

fair value this lease liability at each reporting date. Any mark-to-market income/loss due to foreign currency

fluctuations shall be routed through the income statement, which may heighten volatility. The extent of

volatility shall depend upon the quantum of lease liability denominated in foreign currency.

Sandeep Gu

pta

– Research Analyst

(S.Gupta@MotilalOswal.com); +91 22 6129 1551

Research Analyst

Umesh Jain

(Umesh.Jain@MotilalOswal.com); +91 22 7193 4221;

Mohit Baheti

(Mohit.Baheti@MotilalOswal.com); +91 22 6129 1525

Investors are advised to refer through important disclosures made at the last page of the Research Report

Motilal Oswal research is available on

www.motilaloswal.com/Institutional-Equities,

Bloomberg, Thomson Reuters, Factset and S&P Capital.

Expert Speak

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Additional direct charges such as maintenance expense

in lease agreement can be capitalized based on the

accounting choice provided under the new lease accounting standard. Accordingly, maintenance cost can be

amortized in the income statement, unlike as recorded up-front under the erstwhile accounting standard.

Control of renewal option

would decide the tenure of the capitalized operating lease. Following are possible

scenarios:

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If the lessee controls the renewal option, then the lessee shall determine the lease term based on

management prudent judgment about whether or not the renewal option shall be exercised.

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If the lessor controls the renewal option, then the lessee has to capitalize the lease rental over the entire life

of the lease term, including the renewable term.

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If renewal option is based on mutual agreement, then (a) for the initial period of the lease term, the lessee

should capitalize, as it does not have the option to renew or avoid the renewal and (b) for the remaining

lease term, capitalization would depend on the exercise of the renewal option.

Embedded lease

is structured as a service arrangement, but in substance it has underlying tangible asset for

fulfillment of service obligation. Companies have the option to (a) split accounting and capitalize qualifying lease

rental or (b) capitalize the entire embedded lease, including service arrangements.

Transitional approach

can materially change the impact of the standard. Following are the three transitional

approaches:

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Prospective approach:

Lease asset and lease liability shall be recognized based on the remaining lease term

at the time of transition. The impact on income statement shall be adverse in the initial year, followed by a

positive impact in the subsequent year. On the other hand, net equity shall remain unaffected on the date

of transition.

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Full retrospective approach and Modified retrospective approach:

Depreciation and interest shall be

recomputed from the date of initial origination of lease till the transition date to arrive at right to use asset

and lease liability. Key difference between these two methods is the incremental borrowing rate used.

Under the full retrospective approach,

the borrowing rate as on the lease origination date

is used for

capitalization. Separately, under the modified retrospective approach,

the borrowing rate as on the

transition date

is used for capitalization. Difference between right to use asset and lease liability on the

date of transition shall be charged to networth. These methods (full retrospective and modified

retrospective) are likely to have a positive impact on the income statement.

Please refer our detailed

note

on ‘Lease accounting’ which highlights the possible impact on the financial

statements of companies.

15 April 2019

2

Expert Speak

NOTES

15 April 2019

3

Explanation of Investment Rating

Investment Rating

BUY

SELL

NEUTRAL

UNDER REVIEW

NOT RATED

Expected return (over 12-month)

>=15%

< - 10%

> - 10 % to 15%

Rating may undergo a change

We have forward looking estimates for the stock but we refrain from assigning recommendation

Expert Speak

* In case the recommendation given by the Research Analyst is inconsistent with the investment rating legend for a continuous period of 30 days, the Research Analyst shall within following 30 days take appropriate measures to make the recommendation consistent with the investment rating legend.

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Disclosure of Interest Statement



Analyst ownership of the stock

Companies where there is interest

No

15 April 2019

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