Ind AS 116

Understanding Ind AS 116: The Lease Accounting Game Changer

Ind AS 116, Leases, is an Indian Accounting Standard that prescribes the accounting treatment for leases. It represents a significant shift in lease accounting, primarily for lessees, by requiring nearly all leases to be recognized on the balance sheet. This standard aims to provide a more faithful representation of a company’s assets and liabilities, enhancing transparency and comparability across businesses.

Why a New Lease Standard? Tracing Its Origins

Ind AS 116 is the Indian equivalent of IFRS 16 Leases, issued by the International Accounting Standards Board (IASB) in January 2016. Its development was driven by a long-standing concern that traditional lease accounting, particularly for operating leases, kept substantial amounts of leased assets and associated liabilities off companies’ balance sheets. This “off-balance-sheet financing” obscured the true financial leverage and asset base of many entities, making it difficult for investors and other stakeholders to compare companies that owned assets versus those that leased them extensively.

The Ministry of Corporate Affairs (MCA) in India notified Ind AS 116 on 30 March 2019, making it mandatory for companies adopting Ind AS for accounting periods beginning on or after 1 April 2019. It superseded the old Indian Accounting Standard (AS) 19, Leases, bringing India’s lease accounting practices in line with global standards.

The Heart of Ind AS 116: How Leases Are Now Recognized

The core of Ind AS 116 lies in its single lessee accounting model. Under this model, a lessee is required to recognize a ‘right-of-use’ (ROU) asset and a corresponding lease liability for virtually all leases, eliminating the previous distinction between operating and finance leases for lessees. This fundamentally changes how leases impact a company’s financial statements.

• Right-of-Use (ROU) Asset

  The ROU asset represents the lessee’s right to use an underlying asset for the lease term. It is initially measured at cost, which typically includes the initial amount of the lease liability, any lease payments made at or before the commencement date, initial direct costs incurred by the lessee, and an estimate of costs to dismantle and remove the underlying asset or restore the site. Subsequently, the ROU asset is depreciated over the shorter of the lease term or the useful life of the underlying asset, similar to property, plant, and equipment.

• Lease Liability

  The lease liability represents the lessee’s obligation to make lease payments. It is initially measured at the present value of the lease payments that are unpaid at the commencement date, discounted using the interest rate implicit in the lease or, if that cannot be readily determined, the lessee’s incremental borrowing rate. Subsequent measurement involves increasing the liability to reflect interest on the lease liability and reducing it to reflect lease payments made. The lease liability is essentially treated like a financial liability.

• Exemptions for Lessees

  Ind AS 116 provides practical expedients that allow lessees to opt out of recognizing ROU assets and lease liabilities for:

  • Short-term leases: Leases with a lease term of 12 months or less and no option to purchase the underlying asset.
  • Leases of low-value assets: Assets whose value, when new, is considered low (e.g., typically below USD 5,000, though this is a qualitative judgment rather than a strict monetary threshold).

  For these exemptions, lease payments are recognized as an expense on a straight-line basis over the lease term or another systematic basis.

• Lessor Accounting

  Lessor accounting under Ind AS 116 largely remains unchanged from the previous standard (AS 19). Lessors continue to classify leases as either operating or finance leases, applying similar classification criteria. This means the significant balance sheet impact is primarily on the lessee side.

The Business Impact: Why Ind AS 116 Matters to Your Bottom Line

The adoption of Ind AS 116 has profound implications for businesses, extending beyond just the accounting department:

• Altered Financial Statements: The most direct impact is on the balance sheet, which now shows higher assets (ROU assets) and higher liabilities (lease liabilities). This can significantly change key financial ratios.
• Impact on Key Financial Ratios:
  • Debt-to-equity ratio: Increases due to higher lease liabilities.
  • Gearing ratio: Increases, potentially affecting borrowing capacity and covenants.
  • Return on Assets (ROA): May decrease due to higher asset base.
  • EBITDA: Operating lease expenses previously reduced EBITDA. Now, with depreciation of ROU assets and interest on lease liabilities recognized below EBITDA, EBITDA will typically be higher. This can be a double-edged sword, making companies appear more profitable at the operating level but with higher financing costs.
• Debt Covenants: Companies with existing debt covenants tied to financial ratios (e.g., debt-to-equity, interest cover) may find themselves in breach, necessitating renegotiations with lenders.
• Tax Implications: The timing and nature of deductions for lease payments may change, potentially impacting deferred tax calculations.
• Comparability and Transparency: While challenging for individual entities, the standard significantly improves the comparability of financial statements across entities, particularly for those with extensive leasing activities, and provides greater transparency into a company’s true financial obligations.

Real-World Scenarios: Where Ind AS 116 Comes into Play

Ind AS 116 affects a wide range of industries and business activities, particularly those that rely heavily on leased assets:

• Real Estate: Companies leasing office spaces, retail outlets, warehouses, or factory premises will now bring these leases onto their balance sheets. This has a massive impact on sectors like retail, hospitality, and logistics.
• Equipment Leasing: Businesses leasing machinery, vehicles (cars, trucks, construction equipment), IT hardware, and specialized equipment will recognize ROU assets and lease liabilities.
• Aviation and Shipping: Airlines and shipping companies extensively lease aircraft and vessels. These significant assets and liabilities will now be reflected on their balance sheets.
• Telecommunications: Leasing of network equipment, towers, and fibre optic lines will fall under Ind AS 116.
• Fleet Management: Companies managing large fleets of vehicles, whether for transportation, delivery, or employee use, will see a substantial change in their financial reporting.

Navigating the Terminology: Key Concepts Around Ind AS 116

• IFRS 16 Leases: The international standard upon which Ind AS 116 is based.
• AS 19 Leases: The superseded Indian accounting standard for leases.
• Right-of-Use (ROU) Asset: An asset representing a lessee’s right to use an underlying asset for the lease term.
• Lease Liability: A liability representing a lessee’s obligation to make lease payments.
• Discount Rate (Incremental Borrowing Rate): The rate of interest that a lessee would have to pay to borrow funds over a similar term, with a similar security, to obtain an asset of a similar value to the right-of-use asset in a similar economic environment. Used to calculate the present value of lease payments.
• Lease Term: The non-cancellable period for which a lessee has the right to use an underlying asset, together with options to extend or terminate the lease if the lessee is reasonably certain to exercise those options.
• Sale and Leaseback: A transaction where an entity sells an asset and then leases that same asset back from the buyer. Ind AS 116 provides specific guidance on accounting for such arrangements.
• Operating Lease vs. Finance Lease: While this distinction is largely removed for lessees under Ind AS 116, it remains crucial for lessors. Under the old standards, operating leases were off-balance sheet, and finance leases were on-balance sheet for lessees.

Staying Current: Recent Developments and Practical Insights

Since its implementation, entities have been navigating the complexities of Ind AS 116. Key developments and insights include:

• COVID-19 Related Rent Concessions: The IASB (and subsequently the MCA for Ind AS) introduced practical expedients for lessees accounting for rent concessions as a direct consequence of the COVID-19 pandemic. These expedients allowed lessees to treat such concessions as variable lease payments, avoiding complex lease modification accounting.
• Interpretation Challenges: Companies continue to grapple with specific interpretations, particularly around determining the lease term (especially with renewal/termination options), identifying components within a contract (lease vs. non-lease components), and calculating the incremental borrowing rate.
• Technology Solutions: Many businesses have invested in specialized lease accounting software to manage the voluminous data and complex calculations required by Ind AS 116.

Who Needs to Know? Departments Affected by Ind AS 116

The widespread impact of Ind AS 116 means that knowledge of this standard is crucial across several business functions:

• Finance & Accounting: Directly responsible for implementation, calculations, reporting, and disclosures.
• Treasury: Affected by changes in debt covenants, borrowing capacity, and cash flow reporting.
• Procurement & Sourcing: Needs to understand the accounting implications of leasing decisions and contract terms.
• Legal Department: Involved in reviewing lease contracts and ensuring compliance with accounting requirements.
• Real Estate & Facilities Management: Manages lease portfolios, directly impacted by the new balance sheet recognition.
• IT Department: Responsible for implementing and maintaining systems for lease management and accounting.
• Senior Management & Board of Directors: Needs to understand the strategic financial implications and impacts on business performance metrics.

Looking Ahead: The Future Landscape of Lease Accounting

The core principles of Ind AS 116 are expected to remain stable, but future trends might include:

• Further Interpretations and Guidance: As companies encounter new scenarios, specific interpretations or amendments may be issued to clarify complex areas.
• Digital Transformation of Lease Management: Continued adoption of advanced analytics and AI-powered solutions for lease abstraction, calculation, and reporting, reducing manual effort and errors.
• Convergence/Divergence with US GAAP (ASC 842): While both IFRS 16 and ASC 842 (US GAAP lease standard) aim for on-balance-sheet recognition, subtle differences exist. Future discussions might explore greater convergence or specific clarifications on these differences.
• Increased Scrutiny on Disclosures: Regulators and investors will likely place increasing emphasis on the quality and completeness of lease-related disclosures, ensuring transparency of future lease commitments and associated risks.