Ind AS 116 - Leases
1. Introduction & Core Objective
Ind AS 116 brings about significant changes in the accounting treatment of leases, particularly for lessees, as it eliminates the traditional operating lease off-balance-sheet treatment. The standard aims to provide more transparency in financial reporting by recognizing leases on the balance sheet and providing users of financial statements with a more accurate representation of an entity’s financial position and performance.
The adoption of Ind AS 116 has a significant impact on key financial metrics such as leverage ratios (Debt-to-Equity), return on assets (ROA), and interest coverage ratios. Operating lease rental expenses are replaced by depreciation on the right-of-use asset and finance costs on the lease liability, significantly increasing EBITDA. Investors and analysts need to be aware of these changes to make accurate assessments of a company’s financial performance and risk profile.
2. Key Concepts & The Lease Identification Model
A lease is defined as a contract, or part of a contract, that conveys the right to use an underlying asset for a period of time in exchange for consideration. The arrangement can be written, oral, or implied by the parties’ actions. The agreement must grant the lessee the right to control the use of an identified asset (tangible, such as property or equipment, or intangible).
To comply with the definition of a lease under Ind AS 116, the following four conditions must be simultaneously satisfied:
1. Explicit / Implicit Specification
The asset is explicitly specified in the contract or implicitly identified when made available to the customer.
2. No Substantive Substitution Rights
The supplier does not have the practical ability to substitute alternative assets throughout the period of use.
3. Substantially All Economic Benefits
The customer has the right to obtain substantially all economic benefits from use of the asset throughout the period.
4. Right to Direct the Use
The customer has the right to direct how and for what purpose the asset is used throughout the period of use.
Ind AS 116 eliminates the distinction between finance leases and operating leases for lessees and introduces a single accounting model. However, the classification criteria for lessors remain largely consistent with the previous standard, Ind AS 17 (bifurcated into finance and operating leases).
3. Lessee Recognition and Measurement
At the commencement date, a lessee recognizes a Right-of-Use (ROU) Asset and a Lease Liability:
| Component | Initial Measurement (At Commencement Date) | Subsequent Measurement (Carrying Value) |
|---|---|---|
| Lease Liability | Measured at the Present Value (PV) of unpaid lease payments discounted using the interest rate implicit in the lease or the lessee's Incremental Borrowing Rate (IBR): • Fixed payments (including in-substance fixed) • Variable lease payments linked to an index or rate • Exercise price of a purchase option (if reasonably certain) • Penalties for terminating the lease • Amounts expected to be payable under residual value guarantees Note: Upfront refundable security deposits are excluded from lease payments. | Amortized Cost Model: Initial Carrying Liability Add: Interest accrued at Effective Interest Rate (EIR) Less: Repayment of lease liabilities (principal and interest) Lessees cannot choose to measure lease liabilities subsequently at fair value. |
| Right-of-Use (ROU) Asset | Measured at Cost, which comprises: • Initial measurement amount of the Lease Liability • Add: Any initial direct costs incurred by the lessee • Add: Present value of dismantling and site restoration costs • Add: Prepaid lease payments made at or before commencement • Less: Any lease incentives received from the lessor | Cost Model (Default): Initial Cost Less: Accumulated Depreciation (straight-line basis) Less: Accumulated Impairment Losses (Ind AS 36) The ROU asset may be revalued only if it belongs to a class of property, plant, and equipment revalued under Ind AS 16. |
4. Recognition and Measurement for Lessors
| Particulars | Finance Lease | Operating Lease |
|---|---|---|
| Balance Sheet | Derecognize the underlying asset. Recognize a finance lease receivable equal to the net investment in the lease (PV of lease payments + unguaranteed residual value). | Continue to present the underlying asset on the balance sheet. Add initial direct costs incurred to the carrying amount of the leased asset. |
| Statement of Profit & Loss | Apportion lease receipts between finance income and reduction of lease receivable, reflecting a constant periodic rate of return. | Recognize lease income over the lease term on a straight-line basis (or another systematic basis). Recognize depreciation expense on the underlying asset. |
5. Determining the Lease Term & Recognition Exemptions
Determining the Lease Term
The lease term is the non-cancellable period for which a lessee has the right to use an underlying asset, together with:
- Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option; and
- Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.
The lease term begins at commencement date and includes any rent-free periods. Termination options held exclusively by the lessor are not considered when determining the lease term. The lessee must reassess the lease term upon the occurrence of a significant event or change in circumstances within its control.
Recognition Exemptions
A lessee may elect not to apply the ROU asset and lease liability recognition requirements to:
- Short-Term Leases: Leases with a term of 12 months or less that do not contain a purchase option. The election is made by class of underlying asset.
- Low-Value Assets: Leases where the underlying asset is of low value when new (e.g., personal computers, small office furniture). The election can be made on a lease-by-lease basis. Intermediate lessors cannot claim this exemption.
For exempt leases, lease payments are recognized as an expense on a straight-line basis over the lease term.
6. Presentation & Disclosure Mandates
Balance Sheet Presentation: Lessees must present ROU assets separately from other assets, or include them within the same line item as corresponding owned assets with note disclosures. Lease liabilities must be presented separately from other liabilities.
Statement of Profit and Loss: A lessee presents interest expense on lease liabilities under finance costs (Ind AS 1, paragraph 82(b)) separately from depreciation on ROU assets.
Required Notes Disclosures: Additions to ROU assets; carrying amounts by class; maturity analysis of lease liabilities; depreciation by class; interest expense; short-term and low-value lease expenses; variable lease payments; and total cash outflows for leases.
7. Transition Options: Full Retrospective vs. Modified Retrospective
When transitioning from Ind AS 17 to Ind AS 116, entities could select one of three transition paths:
| Transition Criteria | Full Retrospective Approach | Modified Retrospective: Option A | Modified Retrospective: Option B |
|---|---|---|---|
| Core Accounting Approach | Standard applied retrospectively to each prior reporting period presented in accordance with Ind AS 8. | Lease liability measured at PV of remaining payments using IBR at initial application. ROU asset measured as if standard applied since inception, using IBR at initial application. | Lease liability measured at PV of remaining payments using IBR at transition date. ROU asset equals lease liability adjusted for prepaid/accrued rentals. |
| Data Requirement | Extensive historical contract data, original discount rates, initial direct costs, and modifications since commencement. | Comprehensive lease contract history required, but discount rate determined only at initial application date. Practical expedients permitted. | Requires contract details from transition date onwards only. Significant reduction in administrative effort. |
| Complexity of Quantification | High complexity; every historical modification requires remeasurement of lease liability. | Moderate complexity; historical modification adjustments required, but without multi-period liability remeasurement. | Low complexity; prospective approach eliminates need for historical modification analysis. |
| Impact on Opening Net Worth | Difference between ROU asset and liability adjusted against opening retained earnings (impacts net worth). | Difference between ROU asset and liability adjusted against opening retained earnings (impacts net worth). | Neutral for Net Worth: ROU asset equals adjusted lease liability, resulting in zero opening net worth impact. |
| Impact on Future PBT | Future P&L charge is lower as ROU asset is already heavily depreciated. | Future P&L charge is generally lower compared to Option B. | Future P&L charge is higher (higher depreciation and interest charges). |
| Prior Year Restatement | Mandatory restatement of prior comparative periods. | No restatement of comparative prior years. | No restatement of comparative prior years. |
8. Contentious Practical Application Issues
A. Interest-Free Refundable Security Deposits
Ind AS 116 does not provide specific guidance on security deposits. However, under Ind AS 109, a refundable deposit qualifies as a financial asset. If the time value of money is material, the deposit must be discounted to present value at initial recognition. The difference between the nominal transaction amount and its present value is recognized as prepaid lease rent and added to the ROU Asset, which is depreciated over the lease term. If payable in installments, future tranches are recognized as financial liabilities.
B. Goods and Services Tax (GST) Treatment
GST is a destination-based consumption tax. Even though the lessee pays GST to the lessor, it does not form part of the lease consideration because the lessor acts merely as a collection agent for the government. Consequently, GST should not be included in measuring lease liabilities or ROU assets. If eligible for input tax credit (ITC), it is recorded as a balance with tax authorities; if ineligible, it is expensed in P&L.
C. Reimbursed Property Taxes
The legal obligation to pay municipal property taxes rests on the lessor as legal owner. When a lessee reimburses property taxes, it compensates the lessor for asset utilization. Therefore, reimbursing property tax aligns with the definition of a lease payment. Since property tax levies vary based on municipal assessments and are not tied to an index or interest rate, they constitute variable lease payments recognized in P&L as and when incurred.
D. Operating Lease Escalations Linked to Inflation
In the books of a lessor, regardless of whether contractual lease escalations are structured to match general inflation indices, the lessor must recognize lease income on a straight-line basis over the lease term.
9. Comparison Between Ind AS 116 and AS 19
| Head | Ind AS 116 | AS 19 |
|---|---|---|
| Lease Model | Single lease accounting model for lessees. | Dual lease accounting model for lessees (finance vs. operating lease). |
| Lease Definition | Control model introduced into lease definition. | No control model exists (risks and rewards model). |
| Lease Expense | Front-loaded: interest expense higher in initial years, lower in later years. | Straight-line recognition of lease rentals over lease term. |
| Lessor Initial Direct Costs | Added to carrying amount of leased asset; expensed over lease term. | Recognized immediately as an expense in P&L when incurred. |
| Right-of-Use (ROU) | Concept of "Right to control the use" introduced for lessees. | The concept of "Right to use" does not exist. |
10. Conclusion
Ind AS 116 is a comprehensive standard that brings about a fundamental change in lease accounting, aligning it more closely with economic reality. It aims to enhance comparability and transparency in financial reporting by requiring entities to recognize and measure leases on the balance sheet. With a clearer picture of lease-related obligations and assets, stakeholders—including investors, creditors, and analysts—can make more informed decisions regarding an entity’s financial health, true leverage, risk exposure, and overall operational performance.