Leases: implemented with ease or expertise?
Implementation of IndAS 116 – the story so far!
IndAS 116 on leases became applicable from 1st April 2019. By now, we have understood that the new standard requires lessees to recognise nearly all leases on the balance sheet which reflect their right to use an asset for a specified period of time and the associated liability for payments.
This article is to share my views on how the implementation went so far, some of the challenges that were addressed, and some challenges that continue to exist.
While the implementation of this standard has impacted most companies, aviation, retail, technology, telecom, hospitality, healthcare, automotive and such ‘lease-heavy’ industries have been significantly impacted. There has been a considerable increase in the size of balance sheets, and in some instances, liabilities have gone up a staggering 25% to 50%, depending on the industry. Also key financial ratios such as gearing, EPS, ROE, etc., have been adversely impacted and, in some cases triggered breach of loan covenants.
According to a recent survey conducted on certain large listed companies, it was noted that the debt-equity ratios have worsened by 30% to 300% and EBITDA has increased by 20% to 50% depending on how heavily the entities are dependent on leases. Such is the significance of this standard, which raises the question of whether companies have done a thorough exercise and spent adequate time and effort in implementing it, and in gathering and analyzing the underlying data.
In my view, the story of implementation of this standard has been one of ensuring compliance in a hurried manner, to adhere to reporting timelines. Many companies had resource constraints and inadequate IT processes, which ultimately resulted in a compressed timeframe for compliance. Several unexpected challenges were encountered during the process of implementation such as expired leases, inadequately detailed lease agreements, inability to locate old lease contracts, technical challenges in respect of interpretation of the standard and overall, very limited past implementation experience to fall back on.
This may have resulted in diversity in implementation of the standard across companies and industries. With the compliance deadline behind, it is a good time to reassess these aspects and set the house in order.
Opportunities in the future
1. Analysis of benefits beyond compliance:
Implementing IndAS 116 has suddenly brought out a whole lot of data on leases, both in respect of Company’s own leases and those of other companies. Enhanced disclosures around leases are now publicly available information. In this context there is significant opportunity to analyse and address some of the following questions:
Leases: implemented with ease or expertise?`
- is there a need to re-negotiate any of the terms and conditions of the leases?;
- are there cost saving opportunities?;
- should the lease vs. buy decisions be re-assessed?;
- should a bench-marking exercise be carried out?;
- are there some risks that need to be better managed?
2. Revisit technical interpretations – improve implementation
As the standard was being implemented for the first time, there were several technical challenges that companies faced. There was very little implementation experience available globally that one could refer to. Some areas of significant interpretative challenges were:
- Determination of lease term: How does one look at the renewable period beyond the principal lease term, under what circumstances do we include them within the lease term and when do we ignore them? Most importantly, do we need to change some of the terms of the contract to get the desired outcomes?
- Interest rate implicit in the lease: How to determine the discount rate on a case to case basis. Depending on various factors, could the discount rates be different for each lease within the same company?
- Deferred Tax: Did we correctly assess the impact of current and deferred taxes on the right of use assets and lease liabilities?
- Lease modifications: Many a times lease periods are amended, lease amounts are changed, and more so in this pandemic environment, several changes are being made to the lease agreements. How do we account for such lease modifications?
- Impairment of right of use assets: This is particularly important in the current economic environment. Have we appropriately assessed whether any of the right of use assets are impaired? This could have a significant impact on the financial statements of some companies.
With more than a year since the implementation, there is a lot more clarity now in terms of technical interpretations and there is also sufficient global and local experience available that can be referred to. Companies should consider revisiting their technical positions where necessary, in order to improve the implementation.
Leases: implemented with ease or expertise?`
3. Optimization of processes and better IT integration
In most companies, implementation of the standard was a manual or a semi-manual process largely depending on excel spreadsheets. Companies where there are multiple leases with varying lease terms, manual processes could easily result in errors in computing and financial reporting. Considerable opportunities exist to optimise systems and processes with further integration of IT solutions and automation of lease accounting. Obviously, companies will have to do a cost benefit analysis and then make the decision in this regard.
4. Stakeholder communication
Many stakeholders are grappling with understanding the change in the financial statements on account of IndAS 116 implementation, especially for companies with large lease portfolios. Banks have started including lease liabilities in the computation of covenants and companies will need to be very careful when signing up for any covenants. Internal and external stakeholders will expect more detailed explanations to understand the impact of this standard and the steps that the management is taking to address any issues arising therefrom. Companies should come up with transparent disclosures and proactively engage with stakeholders.
In summary
Lease is not just a matter of accounting, it is a business decision. Depending on the facts of a case, one may decide to buy an asset rather than lease it. The buy vs. lease decision could significantly impact the business operations and also the financial results of the company. Therefore, for companies with large lease portfolios, it is a great opportunity to take a fresh look, re-assess the terms and conditions of their leases and the accounting thereof to be confident that they have got this right!
