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BW Businessworld

Accounting For Lease Arrangements Has Evolved

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Lease arrangements have existed for decades and have evolved over the years. The increase in innovative ways of structuring business arrangements has kept the accounting regulators busy with ensuring that the accounting rules are also updated to reflect the real substance of the arrangement.

Leasing of assets has been a strategy for the user of the asset to avoid blocking of their funds in non-core business assets and has also helped companies to reduce their tax liability. Typically, companies either finance the asset or take them on a lease usually for a period shorter than the total useful life of the asset. Financing is usually done where there is intent to take the ownership of the asset eventually (for example, in case of motor vehicles). However, where the user of the asset does not intend to own the asset, it enters into an operating lease arrangement.

There are lease arrangements which are specific to the use of an asset/class of assets (Dry Lease arrangement) and those that are bundled with the services such as operating and maintenance of asset/class of assets (Wet Lease arrangement). Wet lease arrangements are common in the Airlines industry where the owner of the airline also provides crew, maintenance other services to the operator. Further, companies enter into take of pay arrangements or outsourcing arrangements that may require the vendor to use specific assets for example use of moulds/dies for producing customer specific components, in automotive sector.

With companies getting more innovative in structuring their business arrangement, the classification of a lease arrangement as an operating or finance lease has become less of a challenge as compared to identification of a lease arrangement. Accounting regulators globally recognise the complexity in the business arrangements and continue to provide application guidance to ensure that companies identify, record and measure the lease arrangements appropriately to reflect the true substance.

Companies that have transitioned to IFRS or equivalent framework globally have acknowledged that recording the real substance of a potential lease arrangement directly impacts the valuation of it's business, as it directly affects the EBITDA of their company as well as some of the key ratios such as debt-equity ratio.

We have discussed below some practical business arrangements that may need detailed evaluation and consideration with respect to their potential impact on the company's financial statements and key ratios. This is more relevant for companies in India that have historically not reported under IFRS or USGAAP.

Lessee being involved in the construction of the leased asset:
This arrangement is common in real estate industry as well as infrastructure companies where it is mutually agreed that the lessee would spend significant costs to construct the asset (for example the cost to construct a shopping complex) and subsequentlylease the asset for a lower lease rental, as compared to the market rate. Typically, the lessee may wish to capitalise the construction cost incurred on it's balance sheet, as a leasehold improvementand recognize the lease expense based on the operating or finance lease classification.

However, if we refer to the some of the global accounting principles and practices, it provides practical guidance on such arrangements, particularly where the arrangement is a linked transaction. In case the construction of the asset results in transfer of substantive risk and rewards associated to the construction of the asset (such as financing the construction cost, obligation to complete the construction etc.) to the lessee, he may be able to recognise the construction costs incurred on it's balance sheet only until the construction is complete. Post the completion of construction, the subsequent leasing of the asset may get considered as a sale and leaseback transaction and accounted for as such. This is on the basis rationale that the lessee has incurred the cost to construct the asset in lieu of lower lease rentals and did not have intent to eventually own the constructed asset. As such, the cost incurred by the lessee is recognised over the lease term. The cost incurred could either be considered as prepaid rent or included in the carrying value of the leased asset, depending on the operating or finance lease classification, respectively.

Composite lease arrangement (land and building)
It is common for companies to enter into lease arrangement containing lease of land and building. Under Indian GAAP there is no specific guidance to account for such lease arrangements. Particularly, AS 17 does not include within it's scope, lease of land. However, under IFRS/US GAAP, in case of a composite lease arrangement, operating or finance lease classification needs to be assessed separately for land and building, particularly where the fair value of land is significant part of the lease asset and significant portion of lease payment is towards land. There are multiple approaches provided under the international rules to separate the land and building values and evaluate the lease classification of both the components. Similar requirement is also included in Ind-AS 17 (Indian equivalent to IFRS standard), that shall be applicable once IN-AS is implemented in India. As such, companies may have a situation where land lease is an operating lease and lease of building, a finance lease, particularly where the lease arrangement is for 25-50 years, given land has indefinite economic useful life.

Arrangement containing lease (multiple element arrangements):

Under Indian GAAP, business arrangements such as outsourcing, take or pay supply arrangements are accounted for as a supply of goods or service contract and the amount paid is usually recognized as an expense. However, under international accounting rules (IFRS/US GAAP), in case such arrangements involve use a specific asset and there is adequate evidence to demonstrate that the provider of the service has conveyed the right to use the asset to the customer, the right to use the underlying specific asset would need to beidentified and separated from the service, as a lease arrangement and accounted for as an operating or finance lease, based on it's classification under the relevant leasing standard (IFRS/Ind-AS 17). Companies in India, particularly in the manufacturing, pharmaceutical or Telecom industry may have significant impact on their financial statements,in case the lease assessment results in finance lease of the asset, as it would mean an asset shall be recognized on the balance sheet of the company and amortised, resulting in improving the overall EBITDA.

Lease accounting principles continue to evolve:
Accounting rules around lease arrangements have continuously evolved over time and shall continue to change over time, as the regulator attempt to align the accounting principle with the substance. Even now there are on-going discussions between IASB and FASB, as part of it's joint project to come up with a revised version of the existing standard that would completely change the way operating leases are accounting for by the lessee, when and if the revised standard gets introduced. Under the revised exposure draft, the lessee of an operating lease arrangement may end up capitalizing the asset as a right to use the asset with a corresponding obligation to pay the lease rentals. What impact would it have on the business models for companies shall need detailed consideration, particularly in case it results in  bringing off-balance sheet assets (in case of the lessee of the asset in an operating lease arrangement), on the company's balance sheet.

Given the regulators are likely to introduce IFRS/IND-AS which may get applicable for a lot of Indian companies in it's first phase, CFOs and to an extent CEOs should gear up to understand the potential impact of leasing accounting standard (IFRS/Ind-AS 17) on not only their existing business arrangements, but also on the planned arrangements, to avoid any surprises.

The author, Vishal Seth, is the founder and chief executive at BERC Consulting