Impact of lease rentals and interest free deposits under Ind AS 116

Background

Indian Accounting Standard 116, Leases which is applicable from period beginning on or after 1 April 2019 sets out principle for recognition, measurement, presentation and disclosure of leases. Ind AS 116 supersedes Ind AS 17, Leases. Ind AS 116 is based on the same principal as mentioned in IFRS 16, which is applicable for period beginning on or after 1 January 2019. Ind AS 116 has replaced the dual classification model of finance lease and operating lease in the books of lessee, however, there is no fundamental changes to existing lessor accounting model.

Ind AS 116 is applicable only for long term leases. Any leases exceeding for a period of 12 months at the time of commencement of lease is considered to be a long-term lease. The entity needs to check lease period at the time of commencement and not remaining useful life on the date of transition.

If a lease contract consists of lease and non-lease component, the standards will be applicable only for lease component and other non-lease component treatment needs to be determined based on other applicable standards.

Recognition

At the commencement date of lease, a lessee shall recognise a right to use asset and a lease liability in the books. Right to use asset shall comprise of:

• Present value of future lease payments
• Any initial direct costs paid
• Any lease payment made before the commencement of lease.

Lease liability shall be calculated by discounting future lease payments using the interest rate implicit in the lease or entity's incremental rate of borrowing.

As per Appendix C of the standard Effective date and transition, the lessee has an option of applying standard retrospective by adjusting cumulative effect of applying this standard to the opening balances of retained earnings.

Impact of interest free rent deposits

As required under para 5.1.1 of Ind AS 109, except for trade receivables an entity is required to measure a financial asset or financial liability at its fair value plus or minus, in the case of a financial asset or financial liability not at fair value through profit or loss, transaction costs that are directly attributable to the acquisition or issue of the financial asset or financial liability.

Accordingly, interest free rent deposits used to be recognised at fair value and balance used to be treated as prepaid rent, which was amortised over the period of lease. However, after introduction of Ind AS 116, the concept of rent has been replaced by the concept of right to use asset. In the current scenario, there will be no change to the accounting treatment of interest free deposits, except for the nomenclature, the amount earlier classified as prepaid rent will now be classified as 'Right to use asset'.

Summarizing, 

Right to use asset = Present value of financial assets (interest free deposits- Ind AS 109) + Present value of future lease payments (Ind AS 116)

Right to use asset

Subsequent measurement

After the commencement date, the lessee should measure the lease liability by:

• Increasing the carrying amount to reflect interest expense on lease liability, and
• Reduce the carrying amount to reflect the lease payments made.

Right to use assets should be measured using cost method. Cost method represents assets at cost less any accumulated depreciation and any re-measurement of lease liability.

Impact on financial statement

New standard is expected to have a significant impact on EBITDA of the entities, leading to increase in profit margins, as rent expense which were earlier part of expenses considered to calculate EBITDA will now be considered after calculation of EBITDA. This may impact the company's performance evaluation and incentives schemes. Also, the new standard will gross-up the balance sheet.

Example: Let us assume, the Company has taken 1 property on lease at rent of Rs.200,000 per annum for 5 years and there is no interest free deposit. Assuming incremental rate of borrowings is 10% p.a.

Accounting treatment under Ind AS 17 Leases, the accounting will be as follows:

Accounting treatment under Ind AS 116 Leases, the accounting will be as follows:

Analysis of impact under Ind AS and Indian GAAP

Annexure 1 - Calculation for lease under Ind AS 116

Note:

For the purpose of understanding the calculation, we have not considered deposits, as there is no impact on accounting treatment of interest free deposits, except for the change in the nomenclature.