Simrat Singh, Executive | finserv@vinodkothari.com

There is an age-old distinction between financial leases and operating leases; this arose from accounting standards, and has had a sunset, from the perspective of the lessee, because of a change in accounting standards. Globally, IFRS 16, replacing the earlier standards IAS 17, became effective from 1st January, 2019. Note that not every country has still adopted IFRS 16 – USA is a prominent exception.

The equivalent of IFRS 16 in India is Ind AS 116. Under Ind AS 116, there is no distinction between operating leases and finance leases from the perspective of a lessee. Instead, the lessee  recognizes a right-of-use (‘ROU’) asset and a corresponding obligation-to-pay (‘lease liability’) on the lessee’s balance sheet, reflecting their right to use the underlying asset and the obligation to make lease payments.

In this write up, we try to briefly discuss the crucial aspects of lease accounting for an Ind AS compliant lessee.

Recognition and valuation of the ROU asset

The value of the ROU asset is essentially the value of the right which the lessee has to pay to the lessor. If the lessee is entitled to only a portion of the asset’s useful life, the value of the ROU asset is proportionally adjusted. However, its value cannot exceed the actual value of the underlying asset—it may be equal to or lower, depending on the lease terms. Essentially, the present value of the lease rentals is recognised as the ROU asset.

Depreciation of the ROU Asset

The ROU asset is depreciated linearly i.e. on SLM basis. The period for depreciation depends on the lease structure:

1. If ownership transfers to the lessee or the purchase option is certain to be exercised, the ROU asset is depreciated over its useful life.
2. If the lease terms do not provide for automatic transfer of ownership, the asset will be depreciated over the lease tenure.

Lease Rentals: Principal & Interest Components

Lease payments are split into two components:

1. Interest Component – Recognized as a finance cost in the income statement. The rate of interest should be the internal rate of return of the lessor or if the same is not available, then the incremental cost of borrowing of the lessee.
2. Principal Component – Adjusted against the lease liability, reducing the obligation over the lease tenure.

Net effect over the lease term

At the inception of a lease transaction, the ROU asset and lease liability are equal. Over time, they reduce at different rates:

1. The ROU asset declines through SLM depreciation (as discussed above).
2. The lease liability is reduced by the principal portion of each lease payment, eventually being zeroed down.

By the end of the lease tenure, both the ROU asset and lease liability reduce to NIL, reflecting the complete settlement of the lease obligation of the lessee. 

Lets understand the above with the help of an illustration in excel [Link to sheet]

Accounting of lease
Asset cost	1000
Tenure	4 years
Interest rate (annual basis)	10%
Rental	₹315.47
NPV	₹1,000.00
Yearly rental payments
Year	Payment
1	₹315.47
2	₹315.47
3	₹315.47
4	₹315.47
Financial statement extract
Balance sheet	Y0	Y1	Y2	Y3	Y4
Assets:
ROU asset	₹1,000.00	₹750.00	₹500.00	₹250.00	₹0.00
Depreciation		-₹250.00	-₹250.00	-₹250.00	-₹250.00
Liabilities:
Lease liability	₹1,000.00	₹784.53	₹547.51	₹286.79	₹0.00
Write-off (amortization during the year)		-₹215.47	-₹237.02	-₹260.72	-₹286.79
Income statement		Y1	Y2	Y3	Y4
Depreciation expenses		₹250.00	₹250.00	₹250.00	₹250.00
Interest expenses		₹100.00	₹78.45	₹54.75	₹28.68
Cash flow statement		Y1	Y2	Y3	Y4
		₹315.47	₹315.47	₹315.47	₹315.47

Lets also understand the journal entries for a lease transaction

Journal entries

1. Creation of asset and corresponding obligation-to-pay 

ROU Asset A/c Dr.

  To Lease liability A/c

2. Charging depreciation on the ROU Asset

P/L A/c Dr.

 To Depreciation A/c

Depreciation A/c Dr. 

To ROU Asset A/c

3. Payment of lease rental

1. Interest component

P/L A/c Dr. 

To interest of lease rental A/c 

(Being interest on lease rental charged to P/L A/c)

Interest of lease rental A/c Dr.

To Cash A/c 

(Being interest of lease rental actually paid in cash)

2. Principal component

Lease liability A/c Dr.

To Cash A/c

Exception from applicability of Ind AS

Note that there are two exceptions w.r.t applicability of IndAS 116 on a lease transaction, i.e. such a transaction may not follow the above set of rules and may be expensed as an ordinary lease transaction. The two exceptions are:

1. Short term leases- Leases of tenure up to 12 months. However, if the renewal of the lease is certain then this exception cannot be claimed.
2. Low value asset – if the underlying asset i.e. the asset which is the subject matter of the lease is of a small value. In such a case, the complexities of IndAS 116 may not apply should the lessee choose not to apply them. 

Our other relevant resources on this topic:

1. PPT on lease accounting
2. Note on the discussion paper on lease accounting
3. Background and international accounting changes on lease accounting
4. IAS 19 on lease accounting
5. Lease Accounting under IFRS 16- A leap towards transparency!
6. Accounting for Leasing Transactions: IndAS 116 and IFRS 9
7. Video – accounting for lease transactions