Ind AS 116 - Leases

Under Ind AS 116, lessees are required to recognize a Right-of-Use (ROU) asset and a corresponding lease liability at the commencement date of the lease, effectively bringing most leases on-balance sheet. The ROU asset is depreciated, and interest is charged on the lease liability.

A sale and leaseback transaction involves an entity (seller-lessee) transferring an asset to another entity (buyer-lessor) and then leasing that same asset back. The accounting treatment depends on whether the transfer of the asset qualifies as a sale under Ind AS 115, 'Revenue from Contracts with Customers'.

1. Transfer Qualifies as a Sale (under Ind AS 115):
* Seller-lessee: The seller-lessee measures the Right-of-Use (ROU) asset arising from the leaseback at the proportion of the previous carrying amount of the asset that relates to the right of use retained by the seller-lessee. It recognises only the amount of any gain or loss that relates to the rights transferred to the buyer-lessor.
* Buyer-lessor: The buyer-lessor accounts for the purchase of the asset applying applicable standards and accounts for the lease applying the lessor accounting requirements in Ind AS 116.

2. Transfer Does Not Qualify as a Sale (under Ind AS 115):
* Seller-lessee: The seller-lessee continues to recognise the transferred asset and recognises a financial liability equal to the transfer proceeds. It accounts for the financial liability applying Ind AS 109, 'Financial Instruments'.
* Buyer-lessor: The buyer-lessor does not recognise the transferred asset and recognises a financial asset equal to the transfer proceeds. It accounts for the financial asset applying Ind AS 109.

From a lessor's perspective, Ind AS 116 retains the classification of leases as either finance leases or operating leases. This classification is critical because it dictates the accounting treatment for the lessor, significantly impacting their financial statements.

Finance Lease: A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. Indicators that individually or in combination would normally lead to a lease being classified as a finance lease include:

1. The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2. The lessee has the option to purchase the underlying asset at a price that is expected to be significantly lower than the fair value at the date the option becomes exercisable, making it reasonably certain that the option will be exercised.
3. The lease term is for the major part of the economic life of the underlying asset, even if title is not transferred.
4. At the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset.
5. The underlying asset is of a specialised nature such that only the lessee can use it without major modifications.

Operating Lease: A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset. For operating leases, the lessor recognises lease payments as income on a straight-line basis or another systematic basis over the lease term.

The lease liability is initially measured at the present value of the lease payments that are not paid at that date. The lease payments are discounted using the interest rate implicit in the lease, or if that rate cannot be readily determined, the lessee's incremental borrowing rate.

A lease modification is a change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and conditions. Ind AS 116 requires a lessee to account for a lease modification as follows:

1. Modification as a Separate Lease:
A lessee accounts for a lease modification as a separate lease if both of the following conditions are met:
* The modification increases the scope of the lease by adding the right to use one or more underlying assets.
* The consideration for the lease increases by an amount commensurate with the standalone price for the increased scope, adjusted for the circumstances of the particular contract.

If these conditions are met, the lessee accounts for the new, separate lease independently, without affecting the original lease accounting.

2. Modification Not Accounted for as a Separate Lease:
If the modification does not meet the criteria for a separate lease, the lessee remeasures the lease liability by discounting the revised lease payments using a revised discount rate at the effective date of the modification. The revised discount rate is determined as the incremental borrowing rate at the effective date of the modification.

The corresponding adjustment is generally made to the right-of-use (ROU) asset. However, if the ROU asset is reduced to zero, any remaining reduction in the lease liability is recognised in profit or loss. Specific scenarios include:
* Decrease in Scope: When the modification decreases the scope of the lease (e.g., reducing the leased space), the lessee decreases the carrying amount of the ROU asset to reflect the partial or full termination of the lease. The lessee recognises a gain or loss relating to the partial or full termination in profit or loss.
* Other Modifications (e.g., change in consideration, term): For other modifications, the lessee adjusts the carrying amount of the ROU asset to reflect the remeasurement of the lease liability.

This approach ensures that the financial statements reflect the economic substance of the modified lease arrangement.

Under Ind AS 116, a lease is defined as a contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. To determine if a contract contains a lease, two primary criteria must be met:

1. Identified Asset: There must be an explicitly or implicitly identified asset. A capacity portion of an asset can be an identified asset if it is physically distinct. Even if a supplier has a substantive right to substitute the asset, it prevents the customer from having the right to use an identified asset.
2. Right to Control the Use: The customer must have the right to control the use of the identified asset. This implies the customer has both:
   • The right to obtain substantially all of the economic benefits from the use of the identified asset throughout the period of use.
   • The right to direct the use of the identified asset, meaning the customer can decide how and for what purpose the asset is used. This is crucial for identifying embedded leases where the right to use an asset might not be explicitly stated but is inherent in the service provided. For example, in a contract for transportation services, if the customer dictates the specific vehicle, route, and schedule, it might contain an embedded lease of the vehicle.

Under Ind AS 116, a lease modification is accounted for differently based on whether it creates a separate lease or modifies an existing one.

1. Modification as a Separate Lease: A lessee accounts for a lease modification as a separate lease if both of the following conditions are met:
* The modification increases the scope of the lease by adding the right to use one or more underlying assets.
* The consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope, adjusted for the circumstances of the particular contract.
If these conditions are met, the new lease is accounted for prospectively as a new, separate lease.

2. Modification Not Accounted for as a Separate Lease: If a lease modification does not meet the criteria for a separate lease, the lessee remeasures the lease liability by discounting the revised lease payments using a revised discount rate at the effective date of the modification. The corresponding adjustment is generally made to the carrying amount of the ROU asset. However, if the carrying amount of the ROU asset is reduced to zero and there is a further reduction in the lease liability, the remaining amount is recognised in profit or loss.

For lessees, the discount rate is a crucial element in measuring the lease liability under Ind AS 116.

Rate Implicit in the Lease: This is 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. It effectively represents the return the lessor expects to earn on the lease.

Lessee's Incremental Borrowing Rate (IBR): This is 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 (ROU) asset in a similar economic environment.

When to use which rate:

• A lessee shall use the interest rate implicit in the lease if that rate can be readily determined.
• If the interest rate implicit in the lease cannot be readily determined, the lessee shall use its incremental borrowing rate.

The rate implicit in the lease is often difficult for a lessee to determine because it requires knowledge of the fair value of the underlying asset and the unguaranteed residual value, which may not be readily available to the lessee. Therefore, in practice, lessees frequently use their incremental borrowing rate.

Yes, lessees may elect not to apply the standard model (ROU asset and liability) for short-term leases (12 months or less) and leases for which the underlying asset is of low value. In these cases, lease payments are recognized as an expense on a straight-line basis over the lease term.

The incremental borrowing rate (IBR) is a critical component for lessees under Ind AS 116, used to discount lease payments when the interest rate implicit in the lease cannot be readily determined. Ind AS 116 defines IBR as the rate of interest that a lessee would have to pay to borrow funds necessary to obtain an asset of a similar value to the right-of-use asset, over a similar term, and with a similar collateral in a similar economic environment.

When a readily observable rate is not available, a lessee must estimate its IBR by considering several factors:

1. Reference Rate: Start with a publicly available interest rate for a similar term, such as a government bond rate or a corporate bond yield for a company with a similar credit rating.
2. Adjustments for Collateral: Adjust the reference rate to reflect the fact that the lease liability is effectively secured by the underlying asset (the right-of-use asset).
3. Entity-Specific Credit Risk: Adjust for the lessee's specific credit risk, considering its financial health and creditworthiness. This might involve benchmarking against companies with similar risk profiles that have publicly traded debt.
4. Lease Term and Currency: Ensure the rate reflects the term of the lease and the currency in which lease payments are made.
5. Economic Environment: The rate should reflect the economic conditions prevalent at the commencement date of the lease.

Techniques for estimation may include adjusting a risk-free rate for credit risk, using observable lending rates for similar assets, or building a rate from a company's existing debt portfolio, adjusted for lease-specific factors. The estimation requires significant judgment and should be consistently applied.

Ind AS 116 provides practical expedients for lessees regarding short-term leases and leases of low-value assets, allowing them not to apply the full recognition requirements of the standard.

1. Short-term Leases: A short-term lease is defined as a lease that, at the commencement date, has a lease term of 12 months or less and does not contain a purchase option. If a lessee elects this expedient, they recognise lease payments as an expense on a straight-line basis over the lease term or another systematic basis if that basis is more representative of the pattern of the lessee's benefit. This election is made by class of underlying asset.

2. Leases of Low-Value Assets: This expedient can be applied to leases where the underlying asset is of low value (e.g., personal computers, office furniture, small office equipment). The standard does not specify a monetary threshold for 'low value,' but it generally refers to assets that are low in value when new. If a lessee elects this expedient, they recognise lease payments as an expense on a straight-line basis over the lease term or another systematic basis. This election can be made on a lease-by-lease basis.

Both expedients are optional and, if chosen, must be applied consistently.

Under Ind AS 116, if a transfer of an asset by a seller-lessee satisfies the requirements of Ind AS 115, 'Revenue from Contracts with Customers,' to be accounted for as a sale, the seller-lessee and the buyer-lessor must account for the transaction as follows:

Seller-Lessee's Accounting:

1. Right-of-Use (ROU) Asset: The seller-lessee measures the ROU asset arising from the leaseback at the proportion of the previous carrying amount of the asset that relates to the right of use retained by the seller-lessee. This means the ROU asset is measured at (Carrying Amount of Asset * Present Value of Lease Payments) / Fair Value of Asset.
2. Gain or Loss on Sale: The seller-lessee recognises only the amount of any gain or loss that relates to the rights transferred to the buyer-lessor. Any gain or loss relating to the rights retained (i.e., the ROU asset) is deferred and amortised over the lease term or adjusted against the ROU asset.

Buyer-Lessor's Accounting:

1. Purchase of Asset: The buyer-lessor accounts for the purchase of the asset in accordance with applicable Ind AS (e.g., Ind AS 16 for Property, Plant and Equipment).
2. Lease Classification: The buyer-lessor then accounts for the leaseback in accordance with the lessor accounting requirements in Ind AS 116, classifying it as either an operating lease or a finance lease based on the principles of Ind AS 116.

This approach ensures that the seller-lessee does not recognise a full gain or loss on the portion of the asset it continues to use, aligning with the principle that a sale has not occurred for the retained right of use.

Ind AS 116 defines a lease as a contract, or part of a contract, that conveys the right to control the use of an identified asset for a period of time in exchange for consideration. To determine if a contract contains a lease, an entity must assess whether:

1. An identified asset exists: The asset must be explicitly or implicitly specified in the contract, and the supplier must not have a substantive right to substitute the asset throughout the period of use.
2. The customer has the right to obtain substantially all of the economic benefits from use of the identified asset: This means the customer has the right to use the asset throughout the period of use.
3. The customer has the right to direct the use of the identified asset: This involves determining who has the right to direct 'how and for what purpose' the asset is used. If the customer has the right to operate the asset or direct others to operate it, or if the relevant decisions about how and for what purpose the asset is used are predetermined and the customer has the right to operate the asset, then the customer controls the use.

Under Ind AS 116, a lessor classifies each lease as either a finance lease or an operating lease. 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 an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership.

Ind AS 116 provides several indicators that individually or in combination would normally lead to a lease being classified as a finance lease:

1. Transfer of Ownership: The lease transfers ownership of the underlying asset to the lessee by the end of the lease term.
2. Purchase Option: The lessee has an option to purchase the underlying asset at a price that is expected to be significantly lower than the fair value at the date the option becomes exercisable, making it reasonably certain that the option will be exercised.
3. Lease Term: The lease term is for the major part of the economic life of the underlying asset, even if title is not transferred. While no specific percentage is prescribed, a common rule of thumb often used is 75% or more.
4. Present Value of Lease Payments: At the inception date, the present value of the lease payments amounts to at least substantially all of the fair value of the underlying asset. Again, a common rule of thumb often used is 90% or more.
5. Specialised Nature: The underlying asset is of a specialised nature such that only the lessee can use it without major modifications.

Other indicators that could also result in finance lease classification include if the lessee can cancel the lease, the lessor's losses associated with the cancellation fall on the lessee, or if the lessee has the ability to continue the lease for a secondary period at a rent substantially lower than market rent.

These indicators are not exhaustive, and the classification ultimately depends on the substance of the transaction rather than merely its legal form.

Under Ind AS 116, a lessee is required to recognise a Right-of-Use (ROU) asset and a lease liability at the commencement date of the lease.

Initial Measurement of Lease Liability: The lease liability is initially measured at the present value of the lease payments that are not paid at the commencement date. The 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 should be used.

Initial Measurement of Right-of-Use (ROU) Asset: The ROU asset is initially measured at cost, which comprises:

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