A closer look at the new leases standard- Ind AS 116 - PowerPoint Presentation

A closer look at the new leases standard- Ind AS 116CA (Dr.) Sanjeev SinghalCA Amit Jain

1 Content Background 2 Scope 3 New Definition of lease 4 Lessee accounting 5 Lessor accounting 6 Transition 7 Key differences

1 Background

BackgroundOn 30 March 2019, MCA has issued Ind AS 116 Leases and is effective from April 01, 2019. Lessees will have a single on-balance sheet accounting model for all leases , with exemptions for short-term leases and leases of low-value assetsLessor accounting is substantially unchanged. Lessees and lessors will have additional disclosure requirements compared to current accounting The new standard could have broad implications for entities’ finances, operations and EBITDAImplementing the standard could require an entity to develop new processes and controls or adjust existing ones to identify and account for leases.

Effect of new leasing Standard Total future minimum payments for off balance sheet leases (undiscounted) US$ 2.86 trillion Present value of future minimum payments for off balance sheet leases (estimated at 5% discount rate) US$ 2.18 trillion Source IASB – New leasing standard effect analysis For Listed Entities Region % North America 62% Europe 47% Asia / Pacific 43% Latin America 23%Africa / Middle East 23% Percentage of US GAAP / IFRS companies who disclose off balance sheet leases :

2 Scope

ScopeThis standard is applicable to all lease arrangements except for the following: Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources ( Ind AS 106) Leases of biological assets (Ind AS 41)Service concession arrangements (Appendix D to Ind AS 115)Licenses of intellectual property granted by lessor (Ind AS 115)Rights held by a lessee under licensing agreements such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights ( Ind AS 38)

3 New Definition of Lease

Ind AS 116 – Lease definition Leases Customer has right to control the use Identified asset Right to direct the use Right to obtain substantially all economic benefits No substantive rights to substitute Explicitly / implicitly specified A contract is, or contains, a lease if the contract conveys the RIGHT TO CONTROL the use of an IDENTIFIED ASSET for a period of time in exchange for consideration. and Ind AS 17: A lease is an agreement whereby the lessor conveys to the lessee in return for a payment or series of payments the right to use an asset for an agreed period of time. Appendix C of Ind AS 17 : Arrangement contains a lease if the arrangement is dependent on the use of a specific asset and arrangement conveys a right to use the asset. A B 1 2 3 4

Identified assetsExplicitly or implicitly specifiedAn asset can be either explicitly specified in a contract or implicitly specified at the time it is made available for use by the lessee. Substantive substitution right: A asset is not a identified asset if the lessor has a substantive right to substitute the asset for an alternative asset throughout the period of use. A lessor's substitution right is 'substantive‘ if the lessor: has the practical ability to substitute the asset throughout the period of use; and would benefit economically from exercising its right to substitute the asset.Evaluation of lessor’s substitution right should be made at the inception of the contract.If the customer cannot readily determine whether the supplier has a substantive substitution right, the customer presumes that any substitution right is not substantive

Right to control To assess whether a contract conveys the right to control the use of an identified asset for a period of time , an entity is required to assess whether, throughout the period of use, the customer has both of the following: 1) Right to economic benefit 2) Right to direct the use

Right to economic benefits To control the use of an identified asset, a customer must have the right to obtain substantially all of the economic benefits f rom use of the asset throughout the period of use . e.g. by having exclusive use of the asset throughout that period. Economic benefits from use of an asset can be obtained by the customer in many ways e.g. by using, holding or sub-leasing the asset. Such economic benefits include the primary output and by-products generated from use of the asset, and other economic benefits from using the asset When assessing customer right to obtain substantially all of the economic benefits from the use of an assets, an entity considers the economic benefits that result from use of the asset within the defined scope of a customer's right to use the asset. Examples: (a) if a contract limits the use of a motor vehicle to only one particular territory during the period of use, an entity considers only the economic benefits from use of the motor vehicle within that territory. (b) if a contract specifies that a customer can drive a motor vehicle only up to a particular number of miles during the period of use, an entity considers only the economic benefits from use of the motor vehicle for the permitted mileage.

Right to economic benefits When assessing whether the customer has the right to direct the use of the identified asset, the key question is which party (customer or supplier) has the right to direct how and for what purpose the identified asset is used throughout the period of use. The standard gives several illustrative examples of relevant decision-making rights: Right to change what type of output is produced. Right to change when the output is produced.Right to change where the output is produced.Right to change how much of the output is produced. Relevance of each of the decision-making rights depends on the underlying asset being considered. Decision-making rights are relevant when they affect the economic benefits to be derived from the use of the asset. If both parties have decision-making rights, an entity considers the rights that are most relevant to changing how and for what purpose the asset is used.

Determining whether an arrangement contains a lease Yes Customer Yes Yes Neither; how and for what purpose the asset will be used is predetermined Yes Supplier No No No No Is there an identified asset? Does the customer, the supplier or neither party have the right to direct how and for what purpose the asset is used throughout the period of use? Does the customer have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use? The contract is or contains a lease The contract is not or does not contain a lease Does the customer have the right to operate the asset throughout the period of use without the supplier having the right to change those operating instructions? Did the customer design the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use?

Ind AS 116 A snap shot # Identified Assets Illustrative factors 1 Lease of trucks / aircraft / rail cars etc. Which goods are transported? When the goods are transported and to where? How often the asset is used? Which route is taken? 2 Retail unit Which goods will be sold? Prices at which the goods will be sold? Where and how the goods are displayed? 3 Power plant How much power will be delivered and when? When to turn the power plant on/off? 4 Fibre-optic cable When and whether to light the fibres? What and how much data the cable will transport? How to run the cable? Which routes will be used to deliver the data? Examples of relevant decision-making rights that grant the right to change how and for what purpose the asset is used :

Case Study Particulars Identified asset? Lessor has substitution rights? Customer has right to control the use of the identified asset? Lease? Right to economic benefits Right to direct the use 1. Contract entered between customer and a freight carrier (Supplier), to provides customer with the use of 10 rail cars of a particular type for five years. Lessor cannot provide alternative rail car. Yes Specific rails cars identified in contract. No Yes Yes Customer has a right to direct when and where the cars are used, and which goods are transported i.e. he is having a right to change how and for what purpose the rail cars are used. Yes 2. Coffee company (Customer) enters into a contract with an airport operator (Supplier) to use a space in the airport to sell its goods for a 3 years period. No Many areas are available for Customer and none are specified in the contract. Yes Supplier has alternative to use its space in most efficient manner. Yes No Supplier selects which space is allocated to Customer and obtains substantially all of the economic benefits from use of the concession space. No

Case Study Particulars Identified asset? Lessor has substitution rights? Customer has right to control the use of the identified asset? Lease? Right to economic benefits Right to direct the use No Supplier can deliver any truck it has available Yes Yes Lessee will enjoy y all the economic benefits No No A has entered a contract to lease 10 trucks for a period of 6 years. The trucks will be used to transport goods across Europe. When not in use these trucks will be kept at A’s premises. If the tucks are damaged or require maintenance then they will be sent back to supplier. The contract also provide for renting of additional trailers on an ad-hoc basis . There trailers will be kept by supplier.

What can be an Identified Assets ? Illustrative examples of an Identified Assets, provided it satisfies lease definition : Specific cars / truck / ship / aircraft to transport the goods as mentioned in the contract. Specific retail unit identified in the contract.Access of premises for installation of telecom equipment on telecom towers.Portion of an asset can be an identified asset if it is physically distinct e.g. a floor of a building. Fibre-optic cable if it represents substantially all of the capacity of the cable.

4 Impact on Lessee accounting

Lessee accounting overview Old standard New standard Finance lease/ operating lease Lease The new on/off-balance sheet test for lessees – a key judgement area ON Lease classification test Ind AS 17 deal with dual accounting approach i.e. both on balance sheet and off balance sheet accounting model. While Ind AS 116 covers only balance sheet accounting model. Ind AS 116 is not applicable on the service component of a combined contract. Example of service contract – cleaning, security services included in a contract for building lease.

Recognition and measurement A lessee applies a single lease accounting model under which it recognises all major leases on-balance sheet Balance sheet Asset = ‘Right-of-use’ of underlying asset Liability = Obligation to make lease payments Profit and Loss Lease expense = Depreciation + Interest

Initial measurement – ROU Lease liability Initial direct costs Estimated costs to dismantle, remove or restore, measured In accordance with Ind AS 37 Prepaid lease payments Lease incentives received Right-of-use-asset

Initial measurement – ROUInitial direct costs Include Exclude Commissions Legal fees* Costs of negotiating lease terms and conditions* Payments made to existing tenants to obtain the lease. * If they are contingent on origination of the lease General overheads Costs to obtain offers for potential leases Typical initial direct costs of a lease :

Initial measurement – Lease liability Initial measurement of lease liability : Lease liability shall be recognised at the PV of the outstanding lease payments*. Such lease payments shall be discounted using the interest rate implicit in the lease. If that rate cannot be readily determined, the lessee shall use its incremental borrowing rate. *Any upfront deposits are not included in the lease payments. Lease liabilities are financial liabilities. Fixed payments less any lease incentives Variable lease payments that depend on an index or a rate Exercise price of a purchase option Penalties for terminating the lease Residual value guarantees by lessee Lease liability include the payments on account of :

Subsequent measurement – Lease liability Measurement basis : Particulars Amount At Costs XXX Less : Accumulated Depreciation XXX Less : Accumulated impairment losses XXX WDV of ROU XXXX If lessee is reasonably certain not to obtain ownership, ROU will be depreciated over (whichever is shorter) The lease term Its useful life If lessee is reasonably certain to obtain the ownership, ROU will be depreciated over the useful life. The ROU is subsequently measured using the cost model. However, it may be revalued if it belongs to a class of assets that are revalued.

Example Example Lessee enters into a three-year lease of equipment. The arrangement provides the following: Lease term Three years Annual payments Year 1 – CU10,000 Year 2 – CU12,000 Year 3 – CU14,000 Discount rate 4.235% Present value (PV) of lease payments CU33,000

Response Example Initial Year 1 Year 2 Year 3 Cash lease payments CU10,000 CU12,000 CU14,000 Lease expense recognised: Interest expense CU1,398 CU1,033 CU569 Amortisation expense 11,000 11,000 11,000 Total periodic expense CU12,398 CU12,033 CU11,569 Balance sheet: ROU asset CU 33,000 CU 22,000 CU 11,000 CU  Lease liability CU (33,000 ) CU (24,398 ) CU (13,431 ) CU 

Example Debit Credit At lease commencement ROU asset CU33,000 Lease liability CU33,000 To initially recognise the ROU asset and lease liability Year 1 journal entries Interest expense CU1,398 Lease liability CU1,398 To record interest expense and accrete the lease liability using the interest method (CU33,000 x 4.235%) Amortisation expense CU11,000 ROU asset CU 11,000 To record amortisation expense on the ROU asset (CU33,000 ÷ 3 years) Lease liability CU10,000 Cash CU 10,000 To record lease payment Response

P&L profile Straight line Depreciation Interest

Impact on financials Companies with operating leases will appear to be more asset-rich, but also more heavily indebted Asset Liability Impact on balance sheet Impact on statement of profit and loss Total lease expense will be front-loaded even when cash rentals are constant Depreciation Interest Cash rental payments

Impact on financials ratios Gearing EBITDA EPS (in early years) Net assets Interest cover Total assets Ratios Profit/loss Balance sheet

Lease term The assessment of the lease term is a critical estimate and a key input to the amount of the lease liability. The lease term can be defined as : Lease term begins at the commencement date and include any rent free period. Termination options held by the lessor are not considered when determining the lease term. Particulars Years Non-cancellable period XXX Optional renewable periods (where lessee is reasonably certain to extend the lease) XXX Periods covered by option to terminate the lease (where lessee is reasonably certain not to terminate early) XXX Total Lease terms XXXX

Exemption Two optional exemptions make the standard easier to apply Leases of low value items Short term leases ≤ 12 months 1. Low value assets 2. Short-term leases Lessees – can use ‘short-term lease’ exemption Not to recognise ROU assets or lease liabilities on the balance sheet Recognise lease expense on a straight-line basis over the lease term or another systematic basis. Applies to leases with a lease term of 12 months or less A lease that contains a purchase option does not qualify. To be applied by class of underlying assets. Lessees – can use ‘low-value asset’ exemption: Not to recognise ROU assets or lease liabilities on the balance sheet. Recognise lease expense on a straight-line basis over the lease term or another systematic basis. Applies to assets that are not dependent on, or highly interrelated with, other assets Can be applied on a Lease by Lease basis.

Case Study : Low value assetsCase study: Lessee B is in the pharmaceutical manufacturing and distribution industry and has the following leases: Leases of real estate: both office building and warehouse; Leases of company cars; Leases of trucks and vans used for delivery; and Leases of office furniture;Leases of IT equipment such as laptops. B determines that the leases of office furniture and laptops are individually of low value.Whether B can apply the exemption to the leases of furniture and laptops.Responses: Yes, B can elects to apply the exemption to these leases i.e. Lease by lease . As a result, it applies the recognition and measurement requirements in Ind AS 16 to its leases of real estate, company cars, trucks and vans.

Exemption1. Case study: An entity that has leased several items of office equipment – some for less than 12 months and some for longer than 12 months, with no purchase options. Items of office equipment are all considered to be of the same class. Can entity avail all the lease exemptions? Responses: Yes, the entity can use the short-term lease exemption for all of the leases with terms of 12 months or less. 2. Case study: A lessee enters into a lease with a nine-month non-cancellable term with an option to extend the lease for four months. At the lease commencement lessee is reasonably certain to exercise the extension option because the monthly lease payments during the extension period are significantly below market rates. Can entity avail all the lease exemptions Responses:No, The lease term is greater than 12 months i.e. 13 months. Lessee can not account for the lease as a short-term lease.

The complexPresentation and disclosure requirements for lessees Balance sheet Income statement Cash flow statement Disclosures ROU asset ROU asset needs to be presented Separately in BS or Disclosed in notes s eparately from other assets (e.g., owned assets) in the corresponding underlying assets and disclose line items in BS containing ROU assets. Depreciation expense (separate from interest expense) - Depreciation of ROU assets by class of underlying asset Lease Liability L ease liability is presented s eparately from other liabilities, or together with other liabilities and disclose line items containing lease liabilities Interest expense (separate from depreciation expense) Principal payments within financing activities. Interest payments consistent with policy election in Ind AS 7 Statement of Cash Flows. Interest on lease liabilities

4 Lessor accounting

Lessor accounting - OverviewLessor accounting remains similar to current practice Lease classification test is essentially unchanged from Ind AS 17 (5 indicators + 3 additional indicators) Lease classification test Finance leases and operating leases A lessor classifies a lease as either a finance lease or an operating lease, as follows: Does the lease transfer substantially all the risks and rewards incidental to ownership of an underlying asset ? Yes Finance lease No Operating lease For a lease of land and buildings in which the amount of the land element is immaterial to the lease, a lessor may treat the land and buildings as a single unit Lease classification is reassessed only if there is a lease modification Changes in estimates do not give rise to the reassessment of lease classification Ownership transfers at end of lease Purchase option Lease for majority of economic life Minimum lease payments Specialised nature

5 Transition

Transition exemption on Lease definition Apply the new definition to all contracts Or Apply practical expedients and ‘grandfather’ assessment for existing contracts and apply the new definition only to new contracts. Practical expedient This exemption must be applied either for all contracts or none i.e. cherry-picking is not permitted . This exemption does not mean that previously identified operating leases can remain off-balance sheet for lessee. (unless qualify for a recognition exemption). It merely saves the entity the costs and effort of reassessing. If the exemption is elected, the new definition of a lease is applied only to contracts entered into or changed on or after initial application . Disclosure is required if a practical expedient is elected.

Transition date – Retrospective Vs Modified approach option Lessees are permitted to choose between two transition approaches applied consistently to all leases Full retrospective Modified retrospective Retrospective application or modified approach? Option 2A – Measure asset as if Ind AS 116 had been applied from lease commencement (but using incremental borrowing rate at date of transition) Option 1 – Retrospective Restate comparatives as if Ind AS 116 always applied. Option 2 – Modified (Do not change comparative FS) Difference between asset and liability recognised in opening RE at transition date. Lease liability : Calculate present value of remaining lease payments for existing operating leases using incremental borrowing rate at date of transition. Choose how to measure ROU asset on lease-by-lease basis: Option 2B – Measure asset at amount equal to liability (adjusted for accruals and prepayments)

5 Key Differences

Key Differences - Ind AS 116 Vs Ind AS 17 Particulars Ind AS 116 Ind AS 17 Lease model Single lease accounting model for Lessee i.e. finance lease. Dual lease accounting model for Lessee i.e. finance / operating lease. ROU Concept of “Right to control the use” has been introduced for Lessee. Concept of “Right to use” exist. Initial direct costs for lessors Added to carrying amount of leased asset and recognised as expense over the lease term. Recognised as expense in the statement of profit and loss in the period in which incurred. Lease definition Control model has been introduced in the lease definition. No such control model exists. Lease expense Lease expenses (interest) will be higher in initial year and will be lower in later years. Lease rental shall be recognised on straight line basis.

Key Differences - IFRS 16 Vs Ind AS 116 Particulars IFRS 16 Ind AS 116 Interest – operating / Financing Cash payments for interest portion of lease liability will be classified as operating or financing activity. No such option is available under Ind AS 116. Such interest shall be classified as financing activities. Investment Property IFRS 16 provides that if lessee applies FV model in IAS 40 to its investment property, it shall apply that FV model to the ROU assets that meet the definition of investment property. Not applicable as Ind AS 40, does not allow the use of fair value model in investment property.

6 What does it mean for the industry

Ind AS 116 has the potential to impact many functions across an entityWe outline here some high-level questions that you may ask when beginning to address Ind AS 116 What should you consider? What impact will 116 have on current business operations and commercial negotiations (e.g., lease vs. buy decisions, sale and lease back transactions, lease negotiation and renewals)? What is the impact on performance targets and KPIs (e.g., EBITDA, solvency rations)? Will enterprise resource planning (ERP) systems require reconfiguration to capture all the necessary financial and operational information, including data needed for transition and disclosures? Is data on leases primarily stored manually? Will the standard create new book or tax differences? Have you prepared for the transition disclosures? Have you considered how to communicate the transition impact to stakeholders? How do your implementation plans compare to those of your competitors? How and when will you communicate the accounting and wider commercial impacts of Ind AS 116 to internal and external stakeholders? Transition Financial Systems and data Organisation What does it mean for the industry? Key questions to consider

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