Why Ind AS 116 Changed Everything for Lessees
Before Ind AS 116, most operating leases were off-balance-sheet — the lessee only disclosed a commitment note and expensed the rent as it fell due. Ind AS 116 fundamentally changed this by requiring lessees to recognise a right-of-use (ROU) asset and a corresponding lease liability for virtually all leases with a term exceeding 12 months.
The practical impact: companies with significant operating leases (office space, factory floors, vehicles, equipment) saw their balance sheets grow substantially, their EBITDA improve (rent expense replaced by depreciation and finance cost), but their profit after tax and EPS often declined in early years of a lease due to the front-loaded nature of finance cost recognition.
At commencement: Dr ROU Asset / Cr Lease Liability (at present value of future lease payments). Each period: Dr Depreciation (ROU asset over lease term) and Dr Finance Cost (unwinding of discount on liability) / Cr Cash (lease payment made).
Step 1 — Identify All Leases
The first challenge is identifying which contracts contain a lease under Ind AS 116. A contract contains a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
- Office space rentals — almost always a lease
- Factory building hire — almost always a lease
- Vehicle hire with a specific vehicle assigned — typically a lease
- Machinery hire where supplier controls substitution — may not be a lease
- IT equipment leases — typically a lease unless short-term exemption applies
- Land leases — need careful analysis; prepaid land leases may be treated as prepayments under certain conditions
Step 2 — Determine the Lease Term
The lease term includes the non-cancellable period plus any renewal options the lessee is reasonably certain to exercise. This "reasonably certain" assessment is judgement-based and requires documentation.
Common error: Using only the initial non-cancellable period and ignoring renewal options that the business has always exercised in practice. This understates the lease liability and ROU asset, and auditors are increasingly challenging this.
Step 3 — Select the Discount Rate
The lease liability is the present value of future lease payments, discounted at the rate implicit in the lease (if determinable) or the lessee's incremental borrowing rate (IBR). Most Indian companies use the IBR since the implicit rate is rarely disclosed by lessors.
The IBR should reflect: the credit risk of the lessee, the term of the lease, the currency of lease payments, and the economic environment at commencement date. A company's IBR for a 3-year office lease should not be the same as for a 10-year factory lease.
Step 4 — Compute and Book the Lease Liability Schedule
| Period | Opening Liability | Finance Cost (IBR %) | Payment Made | Closing Liability |
|---|---|---|---|---|
| Year 1 | ₹10,00,000 | ₹90,000 (9%) | ₹3,00,000 | ₹7,90,000 |
| Year 2 | ₹7,90,000 | ₹71,100 | ₹3,00,000 | ₹5,61,100 |
| Year 3 | ₹5,61,100 | ₹50,499 | ₹3,00,000 | ₹3,11,599 |
Step 5 — Disclosures Required
Ind AS 116 requires extensive disclosures in the notes to accounts, including:
- Maturity analysis of lease liabilities (current vs non-current)
- ROU assets by class (property, plant, equipment)
- Total cash outflow for leases (including short-term and low-value leases)
- Interest expense on lease liabilities and depreciation charge on ROU assets
- Key judgements made (lease term, discount rate selection, variable lease payments)
Short-Term and Low-Value Exemptions
Two practical expedients are available that reduce the compliance burden:
- Short-term lease exemption: Leases with a term of 12 months or less (including renewal options) can be expensed on a straight-line basis rather than capitalised. Must be elected by class of underlying asset.
- Low-value asset exemption: Assets with an underlying value below approximately USD 5,000 when new (e.g., laptops, small printers) can be expensed directly. Individual assessment required — cannot be applied by class.