IND AS 116: A paradigm shift or mere adjustment?
The Indian growth story since 1980 has not only been about rising GDP but also about access to capital for businesses. Economic liberalisation of the 1990s further accelerated this need to acquire technology and scalable operations. Many capital-intensive sectors requiring huge investment gathered momentum, giving rise to the demand for heavy machinery and equipment. Instead of outright purchase of such assets, leasing became a perfect financing tool where companies could use the assets to generate revenue and without owning them and pay lease rentals for their use. These lease rentals were also allowed as an expense for reducing the tax. Companies would use these leased assets year on year till the life of the asset. This made their Balance sheets look asset-light while using the assets to generate income. However, on the other hand, companies that bought these assets as against leasing would do so, taking on huge debts, and make their balance sheets asset and liability heavy. Therefore, this kind of disclosure benefited companies leasing the assets versus companies buying these assets to generate the same income.
So what changed and why?
To address the disparity in lease reporting, particularly concerning operating leases, the Institute of Chartered Accountants of India (ICAI) introduced IND AS 116 in line with the global implementation of IFRS 16 by the International Accounting Standards Board (IASB) in 2019. They made it mandatory for all companies that took the assets on long-term operating lease to show them as ‘ Right of Use ( ROU) Assets’ in the Balance sheet, unlike the earlier years. Correspondingly, the future lease payments were also to be disclosed as liabilities. This marked a significant shift in financial statement disclosures for companies with substantial leased assets, fundamentally altering how leases were reported. Their Balance sheets would now be asset-heavy, their asset turnover ratios would decline, and more importantly, their leverage would increase, showing them more risky than in earlier years. Although the operational aspects of lease arrangements remained largely unaffected, the primary transformation was in the manner of disclosing lease transactions in the financial statements.
It thus became intriguing to observe how shareholders would respond to the announcement mandating greater disclosure of lease obligations in their companies’ financial statements. We tried to analyse their reaction in terms of changes in the stock market prices of companies heavy on leases in sectors like technology, aviation, telecom, oil and gas, and retail using an event study methodology.
Event study methodology is a research technique used to assess the impact of specific events on stock prices by analysing how those prices change around the event date. The actual returns of a company’s stock are compared to a predicted “normal” return to understand any abnormal returns caused by the event.
What was interesting to note was that there was a negative reaction in the stock market for a very short period of around three days when this announcement of the change in reporting was made, indicating investors’ concern over increased leverage and perceived financial risk. Further, companies with stronger negative reactions ultimately did not report ROU assets post-implementation of the standard, showing their likelihood of shifting to short-term leases before the event date to mitigate balance sheet impact. Additionally, companies affiliated with business groups did not show changes in the stock prices, depicting higher resilience to such announcements. For companies with institutional holdings, the evidence was mixed.
Thus, these findings can guide policymakers before steering any regulatory changes in financial reporting. It would also help the companies understand how the investors would react to these changes and how long or to what extent the market would be volatile. Investors will also be able to judge and take a conscious decision with respect to the market volatility due to such changes.
About the faculty
Sapna Malya
Sapna Malya holds a Ph.D. with a research focus on capital markets. She is a qualified Chartered Accountant and holds both a master’s and bachelor’s degree in Commerce, majoring in Auditing and Accounting.
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How should investors look at the financials of companies specially in the retail business? As i am full time small equity investor, i found many small/micro cap companies which are operating in retail space like car dealership, clothing brand, care, grocery, pharmacy retail etc…. many of these have been using lease properties for thier operation and decent/good real easte property is pretty much important for them, my issue is that, these small/micro cap companies can not purchase real easte which extremly high in value and that is way they are taking it on lease. But because of these accounting changes it just distorts the whole income statement as ebitda does not include rent expenses, which is very important to look for thsese business for their performance at the store and company level, plus balace sheet became heavy, which I find it unnecessary for them as it is compulary for them take properties on lease because the prices are too much high as rental yield are too law in india. May be for many other indusries, it is true like you said above oil, gas, telecom, heavy industries; where possible the assets are very specialized in nature and may cases they will not able to resell it if they want, so they are taking these asset on lease to looks good which is not case for many small reatil type business where prperty is extermly important. Still, it is too costly, and these are generalist asset which anyone can easily resell. Yes, good locations are important, but it is not that you will not find another good/decent property. Maybe, for a highly luxurious business, you need an extremely good location; otherwise, it is not the case for a pharmacy shop or clothes shop or a car dealership, etc., anyone will find many decent assets. plus it also distorts the operating cash flow by removing rent cash outflow, which would in many case a very good portion of operating cash flow and at the same time increases the financial cash outflow by repayment of loan/interest on lease liability. So my issue is how one should look at this type of case, as it is not giving me the true picture by introducing unnecessary complexity. I just want your thoughts on this. Is it fundamentally right to use old accounting for this type of business or not?