FAQs on Ind AS 116: The New Lease Accounting Standard

By Vijaylakshmi Agarwal (finserv@vinodkothari.com)

Understanding Impact

  1. What is this new Standard all about, in brief?

The standard provides a new method for lease accounting. Ind AS 116 is largely converged with IFRS 16 Leases. Ind AS is expected to replace Ind AS 17 WEF from its proposed effective date being for annual periods beginning on or after 1st April, 2019. Essentially, lessee accounting undergoes major change, while lessor accounting largely remains unchanged. As for lessee, the existing distinction between financial and operating leases (whereby the former was on the balance sheet, and the latter was off-balance sheet) goes away, and in case of every lease (other than exceptions, discussed below), the lease comes on the balance sheet as a right-to-use (RTU) asset and a corresponding lease liability representing its obligation to make lease payments.

  1. Who will be more affected by the standard – lessors or lessees?

While the standard is primarily meant for lessee accounting, lessors are also likely be impacted, to the extent the potential demand from lessees for an off-balance sheet solution gets impacted.

  1. Is a lease completely on balance sheet now, for the lessee?

Not really. What comes on the balance sheet is an RTU asset, and not the cost of the asset. The RTU asset is to be measured at the present value of the minimum lease payments (“MLPs”) (see below). Therefore, the more the residual value component, the less will be the value of the RTU asset. Hence, the off-balance sheet portion of the leased asset is directly proportionate to the residual exposure of the lessor.

Scope and applicability

  1. When is the standard applicable from?

Ind AS 116 is proposed to be effective from annual periods beginning on or after 1st April, 2019.

  1. Is there any grandfathering of existing lease transactions?

Yes, there is a grandfathering provision in respect of existing lease transaction in respect of existing lease transactions. On the date of initial application of IND AS 116, an entity is not required to reassess whether a contract is, or contains, a lease. The entity is permitted to do the following:

  1. Apply IND AS 116 to contracts that were previously identified as leases applying IND AS 17 Leases. Transition requirements as listed under C5 – C18 of IND AS 116 need to be applied to those leases.
  2. Not to apply IND AS 116 to contracts that were not previously identified as containing a lease basis IND AS 17.

6.  Are there any property types excepted from the Standard?

Para 3 and 4 of IND AS 116 lays down the situations where entities will not be required to apply IND AS 116. The same has been explained as under:

  • leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources – IND AS 106 Exploration for and Evaluation of Mineral Resources lay down the accounting principles in respect of rights to explore for and evaluate mineral resources and hence the same has been excluded from the purview of IND AS 116.
  • leases of  biological  assets  within  the  scope  of  Ind  AS  41 Agriculture, held by a lessee – As per IND AS 41 Agriculture, a biological asset is a living animal or plant. However IND AS 41 applies only to produce from bearer plants while biological assets that are bearer plants are covered by IND AS 16 Property, Plant and Equipment.
  • service concession  arrangements  within  the  scope  of  Appendix  D, Service  Concession  Arrangements,  of  Ind  AS  115,  Revenue  from Contracts with Customer.
  • licences of intellectual property granted by a lessor within the scope of Ind AS 115, Revenue from Contracts with Customers; and
  • rights held by a lessee under licensing agreements within the scope of Ind  AS  38,  Intangible  Assets,  for  such  items  as  motion  picture films, video recordings, plays, manuscripts, patents and copyrights.
  • A lessee  may,  but  is  not  required  to,  apply  this  Standard  to  leases  of intangible assets other than those discussed above.
  1. Are there any de-minimis exceptions?

As per para 5, Ind AS 116 provides recognition exemptions to lessees for the following and specifies alternative requirements for the same:

  • Short term leases – A lease which has a lease term of not more than twelve months on the date of commencement is regarded as a short term lease.
  • Leases for which underlying asset is of low value
  1. In considering the exception for small value assets, assuming several assets (say laptops) are given on lease under a single contract, shall we take them as one asset (bunched together), or as several assets?

As per para 8 of Ind AS 116, the election  for  leases  for  which  the  underlying  asset  is  of  low  value  can  be made on a lease-by-lease basis. Hence where several assets of low value are given on lease under a single contract, each of the asset qualifies to be a low value asset and the entity can elect to apply the low value asset exemption to all of the assets under the contract. It is relevant to refer to para B5 of Ind AS 116 here which lay down the situation as to when the underlying asset can be of low value. As per para B5 an underlying asset can be of low value only if:

  • the lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the lessee; and
  • the underlying  asset  is  not  highly  dependent  on,  or  highly interrelated with, other assets.
  1. Is the Standard applicable to land leases?

    Yes, Ind AS 116 covers long term leases of land.

  2. Is the Standard applicable to short tenure transactions?

Para 5 of Ind AS 116 provides a recognition exemption to lessees in regard to short term leases (a lease which has a lease term of not more than twelve months on the date of commencement) according to which the lease payments in those cases are recognized as expense over the lease term.

What, after all, is a lease?

  1. Does the standard make any significant differences to the definition of a lease?

Yes the standard makes significant differences to the definition of a lease.

Appendix A to Ind AS 116 defines the term lease as “a contract, or part of a contract, that conveys the right  to  use  an  asset  (the  underlying  asset)  for  a period of time in exchange for consideration.”

The new definition of lease captures IFRIC 4 Determining whether an Arrangement contains a Lease, IFRIC 17 Distribution of Non-cash Assets to Owners, SIC 15 Operating Leases Incentives and SIC 27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease.

  1. Can a contract containing a lease and provision of other services be split into (a) lease and (b) other services?

As per para 12 of Ind AS 116, where a contract containing lease comprises a lease and a non-lease component, both of the components need to be accounted for separately unless the entity opts for the practical expedient as per para 15.

The practical expedient permits a lessee to opt for not to separate lease and non-lease components in the contract and instead account for each lease component and any associated non-lease components as a single lease component. This option needs to be exercised by the lessee by class of underlying asset.

When the lessee elects the practical expedient, the lessee is required to account for the combined lease and non-lease component as a lease and not as a service.

Good old financial leases

  1. Does the standard alter the meaning of a financial lease, as opposed to IAS 17/IndAS 17/ AS 19?

Ind AS 116 does not alters the meaning of finance lease as compared to IAS 17, Ind AS 17 or AS 19. A comparative of the definition has been provided as under:

 

AS 19 Ind AS 17 IAS 17 IFRS 16 Ind AS 116
A finance lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset. A finance lease is a lease that transfers substantially all the risks and rewards

Incidental to ownership of an asset.  Title may or may not  eventually  be transferred.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership. A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. A lease is classified as a finance lease if it transfers substantially all the

risks  and  rewards  incidental  to  ownership  of  an  underlying  asset.

 

  1. Does the standard lead to any major difference in accounting for a financial lease in the books of the lessee?

Ind AS 116 does not lead to any major differences in accounting for a financial lease in the books of the lessee. The treatment of financial lease in the books of lessee under AS 19, Ind AS 17 and Ind AS 116 could be summarized as under:

Particulars AS 19 Ind AS 17 Ind AS 116
Initial recognition At the inception of a finance lease, the lessee should recognize the lease as an asset and a liability.  Such recognition should be at an amount equal to the fair value of the leased asset at the inception of the lease. However, if the fair value of the leased asset exceeds the present value of the minimum lease payments from the standpoint of the lessee, the amount recorded as an asset and a liability should be the present value of the minimum lease payments from the standpoint of the lessee. At the commencement of the lease term, lessees shall  recognise finance leases as  assets  and  liabilities  in  their  balance  sheets  at  amounts  equal  to  the  fair value  of the leased property or, if lower, the present value of the  minimum lease payments, each determined at the  inception of the lease. At the commencement date, a lessee shall recognise a right-of-use asset and a lease liability. The right of use asset need to be measured at cost which comprises of the following:

·         the  amount  of  the  initial  measurement  of  the  lease  liability

·         any lease payments made at or before the commencement  date, less 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, unless those costs are incurred to  produce  inventories.

At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date.

Subsequent measurement Lease payments is apportioned between the finance charge and the reduction of the outstanding liability. The finance charge is allocated to periods during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability for each period.

Finance lease also give rise to depreciation expense for the asset. The depreciation policy for the leased asset should be consistent with that of the depreciable assets which are owned and the depreciation recognized should be calculated on the basis set out in AS 10 Property, Plant and Equipment.

Minimum  lease  payments  is apportioned  between  the  finance  charge and  the  reduction  of  the  outstanding  liability.  The  finance  charge  shall  be allocated  to  each  period  during  the  lease  term  so  as  to  produce  a  constant periodic rate  of interest on the remaining balance of the liability.  Contingent rents are charged as expenses in the periods in which they are incurred.

The depreciable amount of a leased asset is allocated to each accounting period during  the  period  of  expected  use  on  a  systematic  basis  consistent  with  the depreciation  policy  the  lessee  adopts  for  depreciable  assets  that  are  owned.  the depreciation recognised shall be calculated in accordance with  Ind  AS  16,  Property,  Plant and Equipment  and  Ind  AS  38, Intangible Assets. If there is reasonable certainty that the lessee will obtain ownership by the end of the lease term, the period of expected use is the useful life of the asset; otherwise the asset is depreciated over the shorter of the lease term and its useful life.

After the commencement date, the right-of-use asset should be measured using a cost model unless it applies either of the measurement models described in para 34 and 35 of IFRS 16. Under the cost model, the right-of-use asset is measured at cost:

·         less any accumulated depreciation and any accumulated impairment losses

·         adjusted for any re-measurement of the lease liability specified in para 36(c) of IFRS 16.

A lessee shall apply the depreciation requirements in Ind AS 16, Property, Plant  and  Equipment,  in  depreciating  the  right-of-use  asset.

After the commencement date, the lease liability is measured by:

·         increasing the carrying amount to reflect interest on the lease liability;

·         reducing the carrying amount to reflect the lease payments made; and

·         re-measuring the carrying amount to reflect any reassessment or lease modifications specified in para 39 to 46 of IFRS 16, or to reflect revised in-substance fixed lease payments.

Interest on the lease liability in each period during the lease term shall be the amount  that  produces  a  constant  periodic  rate  of  interest  on  the  remaining balance of the lease liability.

 

The asset side

  1. How is the RTU asset recognized?

At the date of commencement of lease, RTU asset is measured at cost. Cost of RTU asset will comprise of the following:

  • the amount of the initial measurement of the lease liability, as described in para 26 of Ind AS 116 i.e. on the date of commencement of lease, lease liability is to be measured at present value of the lease payments that are not paid at that date.
  • any lease payments made at or before the commencement date, less any lease incentives received i.e. if the lessee has made payment towards the RTU the underlying assets at any point of time, the same shall form a part of the cost of RTU.
  • any initial direct costs incurred by the lessee. Initial direct costs are the incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained.
  • 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, unless those costs are incurred to  produce    The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period.

A lessee shall recognise the costs described in fourth bullet above as part of the cost of the right-of-use asset when it incurs an obligation for those costs. A lessee  applies  Ind  AS  2,  Inventories,  to  costs  that  are  incurred  during  a particular period as a consequence of having used the right-of-use asset to produce  inventories  during  that  period.  The  obligations  for  such  cost accounted  for  applying  this  Standard  or  Ind  AS  2  are  recognised  and measured  applying  Ind  AS  37,  Provisions,  Contingent  Liabilities  and Contingent Assets.

  1. How is the RTU asset depreciated?

RTU asset is to be depreciated as per the depreciation requirement of Ind AS 16 Property, Plant and Equipment subject to the following:

  • If the lease transfers ownership of the underlying asset to the lessee by the end of the lease term or if the cost of the right-of-use asset reflects that the lessee will exercise a purchase option, the lessee shall depreciate the right-of-use asset from the commencement date to the end of the useful life of the underlying asset.
  • Otherwise, the lessee shall depreciate the right-of-use asset from the commencement date to the earlier of the end of the useful life of the right-of-use asset or the end of the lease term.

The Liability side

  1. How is the lease liability recognized?

At the commencement date, a lessee shall measure the lease liability at the present value of the lease payments that are not paid at that date. The lease payments shall be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee shall use the lessee’s incremental borrowing rate.

At the commencement date, the lease payments included in the measurement of the lease liability comprise the following payments for the right to use the  underlying  asset  during  the  lease  term  that  are  not  paid  at  the commencement date:

  • fixed payments (including in-substance fixed payments i.e. lease  payments  that  may,  in  form, contain  variability  but  that,  in  substance,  are  ), less any lease incentives receivable;
  • variable lease payments that depend on an index or a rate [these include, for example, payments linked to a consumer price index,  payments  linked  to  a  benchmark  interest  rate  (such  as  LIBOR)  or payments that vary to reflect changes in market rental rates.], initially measured  using  the  index  or  rate  as  at  the  commencement  date
  • amounts expected  to  be payable  by  the  lessee  under  residual  value guarantees [A guarantee made to a  lessor  by a party unrelated to the lessor  that the value (or part of the value) of an underlying asset at the end of a lease will be at least a specified amount.]
  • the exercise  price  of  a  purchase  option  if  the  lessee  is  reasonably certain  to  exercise  that  option
  • payments of  penalties  for  terminating  the  lease,  if  the  lease  term reflects the lessee exercising an option to terminate the lease.
  1. How is the liability amortised over time?

After the commencement date, a lessee shall measure the lease liability by:

  1. increasing the  carrying  amount  to  reflect  interest  on  the   lease liability;
  2. reducing the  carrying  amount  to  reflect  the  lease  payments made; and
  3. re-measuring the carrying amount to reflect any reassessment or lease modifications or to reflect revised in-substance fixed lease payments.

Interest on the lease liability in each period during the lease term shall be the amount  that  produces  a  constant  periodic  rate  of  interest  on  the  remaining balance of the lease liability. The periodic rate of interest is the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily  determined,  the  lessee  shall  use  the  lessee’s  incremental borrowing rate,  or  if  applicable,  the  revised  discount  rate.

After  the  commencement  date,  a  lessee  shall  recognise  in  profit  or  loss, unless  the  costs  are  included  in  the  carrying  amount  of  another  asset applying other applicable Standards, both:

  1. interest on the lease liability; and
  2. variable lease payments not included in the measurement of the lease liability in  the  period  in  which  the  event  or  condition  that  triggers those payments occurs.

Balance sheet and Profit and loss impact for lessee

  1. How is the lessee’s balance sheet impacted by the Standard?

Ind AS 116 eliminates the requirement for a lease to be classified as either operating or finance lease for a lessee. All leases are to be treated in a similar way to finance leases applying Ind AS 17. The standard leads to more asset and liabilities being put on the lessee’s balance sheet.

  1. How is the profit and loss account of the lessee impacted by the standard?

The rental expense being debited in case of an operating lease is now replaced by (a) amoritisation of lease liability; and (b) depreciation of the RTU asset. The depreciation charge is even over the life of the asset while interest expense reduces over the lease period as the lease payments are made. The rental was an above-EBITDA item. The amortization of lease liability and depreciation of the RTU asset are now post EBIT items. Hence, the lessee’s EBIT also gets affected.

Minimum lease payments

  1. Is the definition of MLPs under the new standard materially different from the same under the existing lease accounting standards?

The definition of MLPs under the new standard is substantially the same as under the existing lease standards. The same could be shown with the help of the comparative table below:

AS 19 Ind AS 17 Ind AS 116
Minimum lease payments are the payments over the lease term that the lessee is, or can be required, to make excluding contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with:

a.       in the case of the lessee, any residual value guaranteed by or on behalf of the lessee; or

b.      in the case of the lessor, any residual value guaranteed to the lessor:

i.            by or on behalf of the lessee; or

ii.            by an independent third party financially capable of meeting this guarantee.

However, if the lessee has an option to purchase the asset at a price which is expected to be sufficiently lower than the fair value at the date the option becomes exercisable that, at the inception of the lease, is reasonably certain to be exercised, the minimum lease payments comprise minimum payments payable over the lease term and the payment required to exercise this purchase option.

Minimum lease payments  are the payments over the lease term  that the lessee is or can be required to make,  excluding  contingent rent, costs for services and taxes to be paid by and reimbursed to the lessor, together with:

a.       for  a  lessee,  any  amounts  guaranteed  by  the  lessee  or  by  a  party related to the lessee; or

b.      for a lessor, any residual value guaranteed to the lessor by:

i.            the lessee

ii.            a party related to the lessee; or

iii.            a third party unrelated to the lessor that is financially capable  of discharging the obligations under the guarantee.

However, if the lessee has an option to purchase the asset at a price that is expected  to  be  sufficiently  lower  than  fair  value  at  the  date  the  option becomes  exercisable  for  it  to  be  reasonably  certain,  at  the  inception  of  the lease,  that  the  option  will  be  exercised,  the  minimum  lease  payments comprise the minimum payments payable over the lease term to the expected date of exercise of this purchase option and the payment required to exercise it.

As per Ind AS 116, the minimum lease payments is equivalent to the cost at which the RTU asset shall be initially recognized. For lessee the same shall comprise of the following components:

·         the amount of the initial measurement of the lease liability, as described in para 26 of Ind AS 116 i.e. on the date of commencement of lease, lease liability is to be measured at present value of the lease payments that are not paid at that date.

·         any lease payments made at or before the commencement  date, less any lease incentives received i.e. if the lessee has made payment towards the RTU the underlying assets at any point of time, the same shall form a part of the cost of RTU.

·         Any initial direct costs incurred by the lessee. Initial direct costs are the incremental costs of obtaining a lease that would not have been incurred if the lease had not been obtained.

·         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, unless those costs are incurred to  produce  inventories.  The lessee incurs the obligation for those costs either at the commencement date or as a consequence of having used the underlying asset during a particular period.

From the lessor’s point of view, the minimum lease payments comprise of the following:

·         fixed payments, less any lease incentives payable;

·         variable  lease  payments  that  depend  on  an  index  or  a  rate,  initially measured using the index or rate as at the commencement date;

·         any residual value guarantees provided to the lessor by the lessee, a party related to the lessee or a third party unrelated to the lessor that is  financially  capable  of  discharging  the  obligations  under  the guarantee;

·         the  exercise  price  of  a  purchase  option  if  the  lessee  is  reasonably certain  to  exercise  that  option ; and

·         payments  of  penalties  for  terminating  the  lease,  if  the  lease  term reflects the lessee exercising an option to terminate the lease.

Discounting rate

  1. What is the discounting rate to be taken for computing the present value of MLPs?

For computing the present value of MLPs, the following interest rates should be considered:

  1. the interest rate implicit in the lease [The rate of interest that causes the present value of(a) the lease  payments  and (b) the  unguaranteed residual  value  to  equal  the  sum  of  (i)  the  fair value  of the  underlying asset  and (ii) any  initial direct costs of the lessor]; or
  2. if the interest rate implicit in the lease cannot be readily determined, the lessee’s incremental borrowing rate [The rate of interest that a lessee would have to pay to borrow  over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset  in a similar economic environment].

 

  1. Is there a difference between the existing accounting standards and this standard, as regards the discounting rate?

There is no difference between the existing accounting standards and Ind AS 116 as regards the discounting rate. The same could be depicted with the help of the comparative table below:

 

AS 19 Ind AS 17 Ind AS 116
In calculating the present value of the minimum lease payments the discount rate is the:

a.       interest rate implicit in the lease [The interest rate implicit in the lease is the discount rate that, at the inception of the lease, causes the aggregate present value of

i.            the minimum  lease payments under a finance lease from the standpoint of the lessor; and

ii.            any unguaranteed residual value accruing to the lessor, to be equal to the fair value of the leased asset.],

if this is practicable to determine;

b.      if not, the lessee’s incremental borrowing rate [The lessee’s incremental borrowing rate of interest is the rate of interest the lessee would have to pay on a similar lease or, if that is not determinable, the rate that, at the inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset] should be used.

The discount rate  to  be  used  in  calculating  the  present  value  of  the  minimum  lease payments  is  the:

a.       interest  rate  implicit  in  the  lease [The interest rate implicit in the lease  is the discount rate that, at the  inception of  the  lease,  causes  the  aggregate  present  value  of  (a)  the  minimum  lease payments  and (b) the  unguaranteed residual value  to be equal to the sum of (i)  the  fair  value  of  the  leased  asset  and  (ii)  any  initial  direct  costs  of  the lessor.],  if  this  is  practicable  to determine;

 

b.      if not, the lessee’s incremental borrowing rate [The lessee’s incremental borrowing rate of interest is the rate  of interest the lessee would have to pay on a similar  lease  or, if that is not determinable, the rate that, at the  inception of the lease, the lessee would incur to borrow over a similar term, and with a similar security, the funds necessary to purchase the asset. ] shall be used.

For computing the present value of MLPs, the following interest rates should be considered:

a.       the interest rate implicit in the lease [The rate of interest that causes the present value of(a) the  lease  payments  and (b) the  unguaranteed residual  value  to  equal  the  sum  of  (i)  the  fair value  of the  underlying asset  and (ii) any  initial direct costs of the lessor]; or

b.      if the interest rate implicit in the lease cannot be readily determined, the lessee’s incremental borrowing rate [The rate of interest that a lessee  would have to pay to borrow  over a similar term, and with a similar security, the funds necessary to obtain an asset of a similar value to the right-of-use asset  in a similar economic environment].

 

 

Comparative Analysis of changes in Standards on Leasing over time

By Ankit Bhalotia,  (finserv@vinodkothari.com)

 

  1. Introduction

Accounting  for  lease  has  been  a  concern  for  the  leasing  industry  from  very  beginning  of  the industry. Over  the  years,  the  leasing  industry  has  grown  under  the  shadow  of  the  accounting  standards. There has been a revolutionary change taking place in the leasing standards which forms a basis for their records in the books of the parties. Read more

Lease accounting: Operating & Financial Lease distinction set to go from financial year 2019-20

The Accounting standards Board of ICAI, in line with the adopting IFRS for Indian accounting framework, has taken one more step ahead in this direction with the release of the exposure draft[1] on IND AS 116 – Leases. What the said exposure draft has to offer for the leasing industry has been discussed as under: Read more