Lease accounting turns cash flows incomparable
Divergence witnessed in operating & financing cash flows
* The implementation of Ind-AS 116 ‘Lease accounting’ has brought about a significant impact on the reported financials of companies in FY20. This has turned the reported financials incomparable with earlier years.
* Throughout FY20, investors tried comprehending the impact and adjusted their reported earnings (operating and net) to the changes brought by the new accounting standard in order to understand the impact on business (on like-to-like basis).
* As companies now disclose year-end cash flow statements, investors are currently finding reported cash flows (within internal heads changed) also incomparable.
* We note that this is primarily due to lease rental outflows now being excluded from operating activities in cash flows. Instead, lease rental outflows are being recognized under the heads of (a) interest payable toward lease liabilities, and (b) principal repayment of lease liability – in the financing cash flows.
* Thus, due to the change in accounting system, while overall cash flows of companies have remained unchanged, reported operating cash flows and FCF of companies are overstated at the expense of higher outflows in financing activities.
* On an aggregate basis, our analysis of BSE 200 companies (excl. BFSI for which data is disclosed) suggests that reported OCF/FCF for companies are higher by 7%/38%. This increase primarily has higher impact for Retail, Hotel, Aviation, Hospital and Telecom sectors where the usage of operating lease was higher.
New lease accounting introduced material changes in FY20
* The new accounting standard Ind-AS 116 ‘Leases’ came into effect from 1st Apr’19, replacing the existing Ind-AS 17. The new standard required long-term liability toward operating lease payment (erstwhile off balance sheet) to be recognized in the balance sheet with corresponding intangible asset in the form of right-to-use the asset, thus replacing the dual classification model (Operating v/s Finance lease) of the erstwhile Ind-AS 17 to a single measurement method.
* While this helped in improving comparability in financials of players with different asset ownership/lease strategy within the same sector, the financial statement of many companies on a sequential basis have turned incomparable.
Impact on reported earnings/balance sheet felt through the year
* The new changes brought about a paradigm change in the reported financial matrix for companies. While EBIDTA for all companies (impacted with the change) increased, reported earnings were adversely impacted. During transition to the new accounting standard, all impacted companies witnessed an increase in leverage with an adverse impact on their net worth.
* During the year, investors, specifically focused on certain sectors – Retail, Hotel, Aviation, Hospitals and Telecom, which were highly dependent on long-term operating leases – grappled with the new accounting standard to understand the impact of lease accounting on the (a) earnings statement, (b) balance sheet, and (c) real business matrix by making adjustments to the financial number and comparing on a like-to-like basis (excluding the impact of lease accounting).
Reported cash flow impacted: OCF to rise, financing cash flows decline
* As annual reports of companies are getting released, investors (especially those who draw the valuation on DCF basis) are trying to understand the impact of the lease accounting standard on the cash flow statement.
* As generally understood, the change in accounting standard will not impact the amount of cash transferred from the lessee to the lessor. Hence, total cash outflow of the lessee would remain the same.
* However, since the lease accounting standard has brought a change in the nature of long-term operating lease transactions (by treating them at par with the financing leases), the reporting/ presentation of the cash flows has witnessed a material change.
* The lease rentals paid by the lessee are now not treated as part of operating expenses. It is treated as partially for the interest on the financial liability recognized on capitalizing of the lease and the balance toward principal repayment of the lease liability obligations.
* This leads to the reported operating cash flows being higher at the expense of higher outflows reported on the financing activities.
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