Ind AS 116 Leases Accounting Standards

Know All about Ind AS 116 Leases Accounting Standards

The MCA (Ministry of Corporate Affairs) has notified new standards on leases, i.e., Ind AS 116 vide its notification dated 30th March 2019. Lease accounting has undergone significant changes in Ind AS 116, which is fully converged with IFRS 16. This new standard replaced erstwhile Ind AS 17 and is effective from financial periods beginning or after 1st April 2019.

Ind AS 17 was based on a dual classification model of operating and finance leases with different classification and measurement guidance for each of them. The dual classification model did not account for the assets and liabilities associated with the rights and obligations arising from the most “operating” leases.

Under Ind AS 116, leases are accounted for based on a ‘right-of-use model.’ The model usually reflects that, at the commencement date, a lessee can be having a financial obligation for making lease payments to the lessor for its right for using the underlying asset during the term of lease.

The lessor conveys that the right for using the underlying asset at lease commencement, which is when it can make the underlying asset available for use by the lessee. Ind AS 116, Leases, requires most leases to be recognized on the balance sheet and requires enhanced disclosures.

It is believed that this would be resulting in a more faithful representation of lessees assets and liabilities and increase the transparency about the lessee’s obligations and leasing activities. However, Ind AS 116 does not make fundamental changes to the existing lessor accounting model.

OBJECTIVE Ind AS 116 Leases Accounting Standards

The objective of this standard is ensuring that lessees and lessors should provide relevant details in a manner that is faithfully representing those transactions. This information also gives a basis for users of financial statements to assess the effect that leases have on an entity’s financial position, financial performance, and cash flows.

This standard requires an entity to consider the terms and conditions of contracts and all relevant facts and circumstances and apply for the standard consistently to contracts with similar characteristics and in similar cases.

For many reporting entities, leasing is a critical way to obtain access to the property. A leasing arrangement can convey the use of an asset from one party to another without transferring ownership. The leasing arrangement may take various forms.

Some accounts are clearly within the scope of lease accounting, for example, a property lease that is providing an explicit contractual right for using a building for a specified period in exchange for several consideration.  However, the right for using an asset can also be conveyed through arrangements that are not leased in form.  Therefore, it is critical to assess which account contains a lease to evaluate the correct impact on financial position.

Ind AS 116, Leases, identifies arrangements that are to be accounted for as leases. This unit discusses how to determine which structures or components within a collection should be accounted for under Ind AS 116 and sets out the principles for recognizing, measuring, presenting, and disclosing leases.

RECOGNITION EXEMPTIONS Ind AS 116 Leases Accounting Standards.

In addition to the above exclusions scope, a lessee can elect not to apply Ind AS 116’s recognition requirements to:

1. Short-term leases.
2. Low value of leases for which the underlying asset is.

Suppose a lessee elects to apply for the above recognition exemption. In that case, the lessee should be recognizing the lease payments which are associated with those leases as an expense on either on a basis of straight-line over the lease term or another systematic basis if that basis can be more representative of the pattern of the benefits of lessee.

Short term leases:

A short-term lease means a lease that, at the commencement date, it would be having a lease term of 1 year or less and it is not included in an option to purchase the underlying asset. As the determination is made at the date of commencement, a lease can’t be classified as short-term if subsequently the lease term is reduced to less than 12 months.

The exemption in short-term lease can be made by class of underlying asset to which the right of use relates. A type of underlying asset is a grouping of underlying investments of a similar nature and use in an entity’s operations. For example, consider an entity that has leased several office equipment items.

Some of them for less than 1 year and some for more than 1 year, with none containing purchase options. Assuming that the things of office equipment are all considered to be of the same class if the entity wishes to use the short-term lease exemption, it must apply that exemption for all of the leases with terms of 12 months or less. The leases with times longer than 12 months will be accounted for following lessees’ general recognition and measurement requirements.

A lessee that makes this election must make certain quantitative and qualitative disclosures about short-term leases. Once a lessee have established a policy for a class of underlying assets, all future short-term leases for that class must be accounted for according to the lessee’s policy.

WHAT IS A LEASE?

At the contract’s inception, an entity shall assess whether the contract is or contains a lease.  For this purpose, a lease can be defined as a contract or part of an agreement that may be conveying the right to control the use of an identified asset for a while in exchange for consideration.

Ind AS 116 requires customers and suppliers to determine whether a contract is or contains a lease at the contract’s inception.

The inception date is defined as the earlier of the following dates:

• Date of a lease agreement.
• Commitment date by the parties to the principal terms and conditions of the lease.

A period of time may be described as the value of use of an identified asset (for example, the no. of production units that an item of equipment would be used to produce). It includes any non-consecutive periods.

Whether an arrangement contains a lease?

Identified Asset-

An arrangement at most contains a lease if there is an identified asset. Under Ind AS 116, an identified asset can be explicitly specified in a contract or implicitly defined when the investment is made available for use by the customer.

Right to control-

For assessing whether a contract conveys the right to control the use of an identified asset for a while, an entity shall determine whether, throughout use, the customer has both of the following=

(a) The right for obtaining all of the economic benefits from using the identified asset substantially.

(b) The right for directly using of the identified asset.

The right for controlling the use of an asset may not necessarily be documented, in form, as a lease agreement. The right for using an identified asset is often embedded in an arrangement that may appear to be a supply arrangement or service contract. Therefore, a reporting entity should consider all of the terms of an agreement to determine whether it contains a lease.

Further, if the customer has the right to control the use of an identified asset for only a portion of the contract term, the contract contains a lease for that portion of the period.

Separation of Lease and Non-lease components:

Identifying separating lease components of a contract-

Sometimes, some contracts contain rights to use multiple assets (e.g., a building and equipment, multiple pieces of equipment, etc.). The right to use each such purchase is considered as a ‘separate’ lease component ONLY IF BOTH the following conditions are satisfied:

• The lessee can be beneficial from the use of the asset either it can be on its own or together it can be with other resources that are readily available for the lessee (i.e., services or goods that are traded or separately leased, by the lessor or several other suppliers, or that the lessee has already obtained from the lessor or in other transactions or events).

 

• The underlying asset is neither highly dependent nor interrelated highly with the other assets which are underlying in the contract.

In case, if one or both of these criteria are not meeting then, the right to use multiple assets is considered a ‘single’ lease component, i.e., not a ‘separate’ lease component.

Separating lease components from non-lease components-

Many contracts also contains a lease which are coupled with an agreement to purchase or sell other goods or services (i.e., the non-lease components under Ind AS 116). For e.g., a supplier may be leasing a truck and may be operating the leased asset on behalf of a customer.

This service is not related to securing the use of the truck. Only items that are contributed for ensuring the output of the asset are components that are leased. In this example, only the usage of the car can be considered as a lease component.

Similarly, costs which are incurred by a supplier for providing maintenance on an underlying asset and the materials and supplies which have been consumed as a result of the use of the investment do not lease components.

The non-lease components can be identified and even accounted for separately from the lease component following other standards. E.g., the non-lease details may be accounted for as executory arrangements by lessees (customers) or as contracts subject to Ind AS 115  by lessors (suppliers).

Costs which are related to property taxes and insurance do not involve the transfer of a good or service. Consequently, if these costs are fixed in the contract, they should be included in the overall contract allocated to the lease and non-lease components.

Determination and allocation of the consideration in the contract (Lessee)-

Lessees that are not making an accounting policy election (by class of underlying asset) for using the practical expedient, as it is discussed above, to account for each separate component lease of a contract and any which are associated non-lease components as a single lease component.

These are required to allocate the consideration in the agreement to the components that are lease and non-lease on a BASIS RELATIVE STAND-ALONE PRICE.

Lessees are needed for using observable stand-alone prices (i.e., prices at which a customer would be purchasing a component of a contract separately) when available. If visible stand-alone prices are not readily available, lessees estimate stand-alone costs, maximizing the use of visual information.

Determination and allocation of the consideration in the contract (Lessors)-

Lessor is required to issue the reference in the agreement to the lease and any associated non-lease components by applying paragraphs 73 to 90 of Ind AS 115 Revenue from Contracts with Customers.

Contract combinations:

Ind AS 116 requires that contracts that are two or more can be entered into at or near the same period with the same counterparty (or related parties of the counterparty) be considered a ‘single’ contract.

Portfolio Application:

Ind AS 116 is applied to leases of individual. However, entities that are having a large number of leases of same assets (e.g., leases of a group of similar rolling stock) may face practical challenges in applying the leases model on a lease-by-lease basis.

Thus, Ind AS 116 includes a  practical expedient that is allowing entities for using a  portfolio which approaches for leases with same characteristics if the entity is reasonably expecting that the effects on the financial statements wouldn’t differ materially from the application of the standard to the individual leases in that portfolio.

If accounting for a portfolio, an entity uses estimates and assumptions that reflect the size and composition of the portfolio.

This approach is consistent with that under Ind AS 115. Using the portfolio approach would be similar to a decision some entities make today to expense, rather than capitalize, certain assets when the accounting difference is, and would continue to be, immaterial to the financial statements.

KEY CONCEPTS Ind AS 116 Leases Accounting Standards

Inception and Commencement of Lease:

Ind AS 116 requires customers and suppliers to determine whether a contract is or contains a lease at the contract’s inception.

The inception date is defined as the earlier of the following dates:

• Date of a lease agreement.
• Commitment date by the parties to the principal terms and conditions of the lease.

The commencement date is defined as the date on which a lessor makes an underlying asset available for use by a lessee, where the ‘underlying asset’ is an asset that is the subject of a lease, for which a lessor has provided the right to use that asset to a lessee.

In some instances, the commencement date of the lease might be before the date of stipulation in the lease agreement (for example, the date on which rents are becoming due and payable). It often occurs when the leased space is modified by the lessee before commencing all the operations in the leased space (for example, during the period a lessee is using the leased space to construct its leasehold improvements).

Suppose a lessee is taking a possession of or have given control over the usage of the underlying asset before it have begun its operations or making lease payments under the lease terms. In that case, the lease term can be commenced even if the lessee is not required to pay any rent or the lease arrangement that states the lease commencement date is later.

The timing of when lease payments is beginning under the contract does not affect the commencement date of the lease.

As discussed earlier, the inception date is when an entity shall assess if the contract is or contains a lease. While the commencement date is relevant because on that date:

(i)  A lessee (except where the exemption of short-term lease or low-value asset is taken) initially recognizes a lease liability and related Right of Use Asset (from now on referred to as “ROU Asset”) on the commencement date.

(ii)  A lessor (for finance leases) initially recognizes its net investment in the lease on the commencement date.

‘ROU Asset’ is defined as an asset representing a lessee’s right to use an underlying asset for the lease term.

Lease Term:

Determination of lease term is a crucial step before calculating the Lease Liability and the corresponding ROU Asset.

The lease term can begin at the lease commencement date. The lease term starts when the lessor makes the underlying asset available for use by the lessee and includes any rent-free periods provided.

The assessment of whether it is reasonably sure that a lessee will exercise an extension or termination option should be done on the lease commencement date. An entity should be considering all relevant facts and circumstances that create an economic incentive for the lessee for exercise, or not to exercise, the option, including any expected changes in facts and events from the commencement date until the option’s exercise date.

The assessment should not be based solely on the lessee’s intentions, past practices, or estimates. It should focus on the factors that create an economic incentive for the lessee, including contract-, asset-, entity-, or market-based factors.

In some instances, it would be more challenging to determine whether the exercise of the option is reasonably sure where the period from the commencement of the lease to the exercise date of choice is longer. The said difficulty arises from several factors. E.g., a lessee’s estimates of its future needs for the leased asset become less precise for the further future where the forecast is going.

Also, the future fair value of certain assets such as those involving technology is more difficult to predict than the future fair value of a relatively stable asset, such as a fully leased commercial office building located in a prime area.

An artificial short lease term (for example, a lease of a corporate headquarters, distribution facility, manufacturing plant, or other fundamental property with a four-year lease term) may be effective in creating a significant economic incentive for the lessee for exercising a purchase or renewal option.

It may be evidenced by the significance of the underlying asset to the lessee’s continuing operations, and whether absent the opportunity, the lessee would have to enter into such a lease.

Similarly, the significance of the assets which are underlying to the lessee’s operations may affect a lessee’s decisions about whether it is reasonably sure to exercise a purchase or renewal option. E.g., a company that leases a specialized facility (e.g., distribution facility, corporate headquarters, manufacturing plants).

There doesn’t exercise a purchase or renewal option would face a significant economic penalty if an alternative facility is not readily available. It would potentially harm the company while it searched for a replacement asset.

An option for extending or termination of a lease may be combined with one or more other features that are contractual (for e.g., a guarantee of residual value) such that the lessee is guarantying the lessor a minimum or fixed cash return that can be substantially the same which is regardless of whether the option can be exercised.

In such cases, and notwithstanding of the guidance on in-substance fixed payments, an entity shall assume that the lessee is reasonably sure for exercising the option for extending the lease or not for exercising the option for terminating the lease.

The shorter the non-adjustable period of a lease, the more likely a lessee is have to to exercise an option for extending the lease or not to exercise an option to terminate the lease. The costs which have been associated with obtaining a replacement asset are likely to be proportionately higher the shorter the non-cancellable period.

A past practice of lessee which is regarding to the period over which it have been typically used as particular types of assets (whether owned or leased), and its economic reasons for doing so, may provide information that helps assess whether the lessee is reasonably sure for exercising or not to exercise as an option.

For e.g., if a lessee is typically using particular types of assets for a specific period or if the lessee has a practice of frequently exercising options on leases for particular kinds of underlying assets, the lessee shall consider the economic reasons for that past practice in assessing whether it is reasonably sure to exercise an option on leases of those assets.

A lessee may be entering into a lease contract for those periods that are non-consecutive. This is seen that in the retail industry when  retailers are entering into agreements with shopping centers for leasing the same retail space for non-consecutive certain months of the year (e.g., during a holiday period in a year).

Ind AS 116 Leases Accounting Standards the same arrangements also exist when sports teams are leasing a sports stadium for particular years non-consecutive days. These arrangements would be usually meeting the definition of a lease because, during the agreed period of use, the customer can control the right for using the underlying asset. In these arrangements, the lease term is the aggregate of the non-consecutive periods.

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