THE IMPACT OF CAPITAL LEASE ON FINANCIAL STATEMENTS

The Impact of Capital Lease on Financial Statements in India

Capital leasing, often referred to as finance leasing, is a significant method by which companies in India can finance their asset purchases. Unlike operating leases, capital leases have a profound impact on a company’s financial statements. This article explores the key aspects and implications of capital leases on financial reporting.

Understanding Capital Lease

A capital lease is a lease agreement where the lessee (the user of the asset) assumes some of the risks and rewards of ownership. In India, as per the Indian Accounting Standards (Ind AS) 116, a lease is classified as a capital lease if it meets one or more of the following criteria:

• The lease transfers ownership of the asset to the lessee by the end of the lease term.
• The lessee has an option to purchase the asset at a price significantly lower than the fair value.
• The lease term covers the major part of the economic life of the asset.
• The present value of lease payments amounts to at least substantially all of the fair value of the leased asset.
• The leased assets are of such a specialized nature that only the lessee can use them without major modifications.

Impact on the Balance Sheet

Recognition of Right-of-Use Asset and Lease Liability

Under a capital lease, the lessee recognizes a right-of-use asset and a corresponding lease liability on the balance sheet. The right-of-use asset represents the lessee’s right to use the leased asset for the lease term, while the lease liability reflects the present value of future lease payments.

Initial Measurement

At the commencement date, the right-of-use asset is measured at cost, which includes:

• The amount of the initial measurement of the lease liability.
• Any lease payments made at or before the commencement date, minus any lease incentives received.
• Any initial direct costs incurred by the lessee.
• An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located, or restoring the underlying asset to the condition required by the terms and conditions of the lease.

The lease liability is measured at the present value of the lease payments that are not paid at that date. Lease payments are discounted using the interest rate implicit in the lease, if that rate can be readily determined; if not, the lessee’s incremental borrowing rate is used.

Impact on the Income Statement

Depreciation and Interest Expense

The right-of-use asset is depreciated over the lease term. Depreciation expense on the right-of-use asset and interest expense on the lease liability are recognized separately in the income statement. This results in a front-loaded expense pattern, as interest expense decreases over time with the reduction of the lease liability.

Effect on Profitability Metrics

The inclusion of interest expense and depreciation in the income statement affects profitability metrics such as EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Since lease payments under operating leases are typically included in operating expenses, transitioning to capital leases can improve EBITDA.

Impact on Cash Flow Statement

Operating vs. Financing Cash Flows

Lease payments under a capital lease are divided into principal repayment and interest payment. In the cash flow statement:

• The interest portion of lease payments is classified under operating activities.
• The principal portion is classified under financing activities.

This classification affects the operating cash flows, potentially improving operating cash flow metrics, which are critical for assessing the liquidity and operational efficiency of the business.

Tax Implications

Deductibility of Lease Payments

In India, the tax treatment of lease payments can influence a company’s decision to enter into a capital lease. While the principal repayment is not deductible for tax purposes, the interest component and depreciation on the right-of-use asset are deductible, thereby providing tax benefits.

Key Considerations for Indian Companies

Impact on Financial Ratios

The inclusion of lease liabilities on the balance sheet increases the company’s debt, affecting leverage ratios such as debt-to-equity and debt-to-asset ratios. Companies need to consider these impacts when planning their capital structure.

Compliance and Disclosure

Indian companies must ensure compliance with Ind AS 116 and adequately disclose their leasing arrangements in their financial statements. This includes providing detailed notes on the nature of lease arrangements, the right-of-use assets, lease liabilities, and the impact on financial performance.

Strategic Financial Planning

Capital leases can be a strategic tool for financial planning, offering benefits such as asset utilization without upfront capital expenditure. However, companies must carefully analyze the long-term financial commitments and the implications on financial statements before entering into such leases.

The impact of capital leases on financial statements in India is profound, affecting various aspects of financial reporting, from the balance sheet and income statement to the cash flow statement. Indian companies must carefully evaluate the benefits and implications of capital leases, ensuring compliance with accounting standards and making informed strategic decisions to optimize their financial health.