This article aims at covering most of the concepts of recently issued Ind AS 116 by the ICAI and MCA which will supersede the earlier issued standard Ind AS 17 on leases w.e.f. 01st April 2019.
1. Introduction
Ind-AS 116 Leases brings significant changes in accounting requirements for lease accounting, primarily for lessees. Ind-AS 116 replaces the existing standard on leases i.e. Ind-AS 17, Leases.
This article aims at simplifying the concepts of Ind-AS 116 in relation to the classification of leases from the perspective of lessees majorly and compares those requirements to the previous standard (i.e. Ind-AS 17), as the guidance relating to lessor accounting remains largely same as in Ind-AS 17.
Under Ind AS 116 the lessee is now required to create the “right-to-use asset” and a “lease liability” in the balance sheet which is an entirely new concept unlike the previous standard Ind AS -17 which has no such requirement. The “right-to-use asset” has to be shown under non-financial asset while “lease liability” has to be shown under financial liabilities in the Balance Sheet.
On this right-to-use asset depreciation has to be booked and on lease liability interest has to be charged by the lessee every year.
On the other hand, lessor will continue to classify its leases as operating leases or finance leases, and to account for those two types of leases differently.
2. Out of Scope
The following types of transaction are out of the scope from Ind AS 116 :-
(a) leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources;
(b) leases of biological assets within the scope of Ind AS 41, Agriculture, held by a lessee;
(c) service concession arrangements within the scope of Appendix D, Service Concession Arrangements, of Ind AS 115, Revenue from Contracts with Customer;
(d) licences of intellectual property granted by a lessor within the scope of Ind AS 115, Revenue from Contracts with Customers; and
(e) a lessee is not required to apply this standard to leases of Intangible assets
Further, a lessee is not required to apply this standard to leases which are of:-
1. Short term;
2. Low value
It is important to understand as to what classifies as a short term leases and what constitutes to a low value.
Short term - As per the definition, a lease that, at the commencement date, has a lease term of not more than 12 months is a short term lease. However, if a lease contains a purchase option it will not be considered as a short-term lease.
Lease term has to be viewed keeping in mind not only the initial lease period agreed as per agreement but also the renewal option, if any, available with the lessee. If there is a period specified for which lease can be renewed by the lessee, or by both lessor and lessee, then it has to be considered in determining lease term. It is worth noting that if only lessor has the option to renew the lease, it is not considered in determining the lease term.
If there is also termination option with the lessee it also needs to be considered in determining lease term keeping in mind the likelihood of lessee exercising termination option and its economic effects on the lessee.
Low value - The election for leases for which the underlying asset is of low value can be made on a lease-by-lease basis. The value has to be seen as to how much the underlying asset will cost to the lessee if a new asset has been purchased instead of taking it on lease. The monthly lease payments are not considered in determining low value but the original value of new underlying asset is considered for determination of low value. Further the low value criteria needs to be seen on an absolute basis and not on relative basis to keep the accounting uniform across companies and industries.
3. Separation of lease components in a contract
For a contract that contains both lease and non-lease components, an entity shall account for each lease component within the contract as a lease separately from non-lease components of the contract. However, a lessee may apply a practical expedient by class of underlying asset, and ignore the requirement to separate non-lease components (such as services) from the lease components. Instead it may account for the entire contract as a single lease contract. It is noted that this option is available to lessees only and not to lessors.
For example, in case of commercial building taken on lease, common area maintenance costs is included in the agreement and is a part of monthly payments to be made by lessee and is often separately mentioned in the agreement. Here, the lessee has an option to not exclude such service cost from the lease payments and to consider entire agreement as a single lease contract and not to account for such service payments separately.
4. Identifying a lease
A contract is, or contains, a lease if the contract conveys the right to control the use of an identified asset for a period of time in exchange for consideration.
The first criterion to determine whether a contract is a contract of lease is to determine whether there is an identified asset for which agreement has been made. This is consistent with the requirement that for a lease to exist, the customer must control the asset. Typically, an asset will be explicitly identified in a contract (for example, by specifying the registration or chassis number of a car as well as a description of the manufacturer and model). However, an asset can also be identified by being implicitly specified at the time that the asset is made available for use by the customer.
However, even if the asset is specified in the contract, the customer does not have the right to use that asset if the supplier has the substantive right to substitute the asset throughout the period of use. A supplier’s right to substitute an asset is substantive only if both of the following conditions exist:
(a) the supplier has the practical ability to substitute alternative assets throughout the period of use and
(b) the supplier would benefit economically from the exercise of its right to substitute the asset.
It is to be noted that the right with supplier to substitute shall be throughout the period of use and not only in case of breakdown or other emergency which requires the existing underlying asset to be replaced as it’d neither be economically beneficial and nor a right throughout the period to be classified as substantive right.
The next criterion to analyse in determining if a customer controls the use of an identified asset is whether the customer has the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use. The customer shall obtain substantially all of the economic benefits from use of the asset within the defined scope of a customer’s right to use the asset.
Another criterion is right to direct the use of an asset. A customer has the right to direct the use of an identified asset throughout the period of use only if either:
(a) the customer has the right to direct how and for what purpose the asset is used throughout the period of use; or
(b) the relevant decisions about how and for what purpose the asset is used are predetermined and:
(i) the customer has the right to operate the asset or to direct others to operate the asset throughout the period of use, without the supplier having the right to change those operating instructions; or
(ii) the customer designed the asset in a way that predetermines how and for what purpose the asset will be used throughout the period of use.
In assessing whether a customer has the right to direct the use of an asset, an entity shall consider only rights to make decisions about the use of the asset during the period of use.
Certain decision-making rights are clearly more relevant than others. Those that affect the economic benefits derived from use of the asset are the most relevant in determining the right to direct the use of asset.
This majorly covers the requirement to identify whether a contract contains a lease or not. The next part will discuss about the recognition and measurement of leases, what to do in case of lease modification and accounting for sale and lease back transactions.
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