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LEASES :
Meaning, Types & Accounting treatment

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CA STUDY NOTES

Date : 12th Oct 2024

Short Notes on LEASES : Meaning, Types & Accounting treatment

By CA Sweta Kothari

LEASES

A lease is a legal, binding contract outlining the terms where one party grants a right to use a property or land to another party in return for consideration (periodic payment) and for a specific period of time. Both the parties enter into a lease agreement specifying the terms and conditions of the agreement.

It guarantees the tenant or lessee – the use of the property and guarantees the property owner or landlord – regular payments for a specified period in exchange.

The primary distinction between leasing and renting lies in their commitment and duration. A lease is a fixed-term agreement, providing stability and predictability but limiting flexibility. Renting offers more flexibility but lacks the long-term security of a lease.

Lessee vs. Lessor

A lease agreement is a contractual arrangement between two parties regarding the use of a property or asset. The two parties can be defined as follows:

Lessor:

This is the party that owns the property or asset and grants the right to use or occupy it to another party, known as the lessee, in exchange for certain payments. In simpler terms, the lessor is the landlord or owner of the property who allows someone else to use it for a specified period and under specific terms outlined in the lease agreement. The lessor retains ownership of the property but gives up possession temporarily.

Lessee:

This party receives the right to use or occupy the property or asset owned by the lessor. They are the tenants or users of the property. The lessee agrees to make regular payments (rent) to the lessor for the privilege of using the property according to the terms outlined in the lease agreement. The lessee doesn’t own the property but has the right to use it during the lease term.

Leases differ from rental agreements in many ways but the two most significant are duration and control. Rentals tend to be short-term — typically 30 days, max — while leases skew longer, often measured in years. Short-term leases have a duration of 12 months or less and lease accounting rules do not apply to them. Ultimate control of an asset, as in maintenance or modification, remains with the asset owner for rentals, but leased assets are typically controlled and maintained by the lessee.

Types of Leases

In accounting and finance, leasing is a common way for businesses to acquire assets without having to buy them outright. Under GAAP, leases are classified as either finance leases or operating leases. The primary difference between the two is how they are accounted for on a company’s financial statements.

Finance Leases

Finance leases are long-term leases of expensive assets, where the lessee takes on most ownership risks and rewards. Lessees record the asset on their balance sheet and are responsible for maintenance, insurance, and other costs.

Finance leases are typically used for assets like buildings, machinery, or vehicles.

Features of Financial Lease:

• Long-term Commitment: Financial leases last a long time, often covering most of an asset’s life. This means the lessee gets to use the asset for a significant period.
• Ownership Transfer: Even though the lessor technically owns the asset during the lease, the lessee takes on most ownership responsibilities, like maintenance and risks associated with the asset’s value.
• Fixed Payments: Lessees pay a set amount regularly to the lessor throughout the lease. This makes it easier for businesses to budget and plan their finances.
• Purchase Option: Many financial leases offer the lessee the chance to buy the asset at the end of the lease. This gives them flexibility and a path to eventually owning the asset outright, which can be beneficial for long-term planning and investment.

Operating Leases

Operating leases, on the other hand, are short-term leases of assets with high turnover rates, where lessors retain most ownership risks and rewards. With operating leases, lessees don’t record the asset on their balance sheet, but rather record lease payments as rental expenses on their income statement. Lessors are responsible for maintenance, insurance, and other costs. Operating leases are typically used for assets like office equipment or vehicles.

Features of Operating Lease:

• Short-term Commitment: Operating leases usually involve shorter agreements compared to financial leases, offering flexibility for businesses with evolving needs or uncertain plans.
• Less Ownership Responsibility: In an operating lease, the lessor maintains ownership of the asset, relieving the lessee from responsibilities such as maintenance, insurance, and risks associated with ownership. This arrangement provides convenience and simplicity for the lessee.
• Variable Payments: Operating lease payments are often structured as rental expenses, allowing for flexibility in adjusting payments based on usage or market conditions. Unlike financial leases, which typically involve fixed payments, operating lease payments may vary over time.
• Off-balance Sheet Treatment: Operating leases are treated differently in accounting compared to financial leases. Since the lessee doesn’t take on significant ownership risks and benefits, the obligations from operating leases may not appear as assets and liabilities on the balance sheet.

The choice between finance and operating leases depends on a company’s accounting and tax requirements, as well as its cash flow and operational needs.

Operating and finance lease are the main classifications. However, lease classification can also be done in below types. Classification of leases is important because the accounting treatment for both lessor and lessee is different for each classification. Using the five criteria explained in the accounting standards, leases are classified as follows:

• Sales-type: If a lease meets any one of the five criteria, it is a sales-type lease for the lessor and a finance lease for the lessee.
• Direct financing: If it doesn’t meet any of the five criteria, but the risks and rewards similar to ownership transfer to the lessee and the value of the lease (including the residual) does not trigger profit to the lessor, it’s a direct finance lease for the lessor and a finance lease for the lessee. The technical fine print on measuring whether profit exists is similar to criterion number four, but instead of ―greater than or almost equal to‖ the fair market value of the asset, the present value of the lease payments is

―less than or equal to‖ that value and collectability of any residual value is probable.

• Operating lease: If a lease does not meet any of the criteria, it is an operating lease for both the lessor and the lessee.
• Operating lease vs capital lease: Evaluating whether a lease was operating or capital, a classic test question for accounting 101 students, is now outdated since the new standards no longer include capital leases, which have been replaced by finance leases.

Difference between Finance and Operating Lease

Basis	Financial Lease	Operating Lease
Meaning	A financial lease is a rent agreement where a business leases an asset for a significant portion of its useful life, almost like buying it.	An operating lease is like renting an asset for a short period without the commitment of ownership.
Ownership	In a financial lease, the renter takes on most ownership duties and risks during the lease.	In an operating lease, the owner keeps the asset’s ownership rights, so renters have fewer duties.
Duration	Financial leases usually last a long time, covering most of the asset’s life.	Operating leases are often short, covering only part of the asset’s life, giving more flexibility.
Maintenance & Insurance	Renters in financial leases must look after maintenance, insurance, and other costs.	Owners in operating leases usually handle maintenance, insurance, and other costs.
Purchase Option	Financial leases sometimes let renters buy the asset when the lease ends.	Operating leases usually don’t allow renters to buy the asset at the end of the lease.
Accounting Treatment	Financial leases show up as assets and debts on the renter’s financial records.	Operating leases are just rental expenses on the renter’s financial records, with no big impact on assets and debts.
Payments	Payments in financial leases stay the same for the whole lease, so renters know what to expect.	Payments in operating leases might change, giving renters more flexibility based on how much they use the asset.
Use and Flexibility	Financial leases are perfect for businesses that need to have an asset for a long time and desire to own it eventually.	Operating leases are better for businesses with short-term needs or those that want more flexibility with assets.

Lease Accounting

Lease accounting refers to the set of rules and guidelines used to record and report lease transactions in financial statements. It includes identifying, measuring, and showing leases according to accounting rules like IFRS or GAAP.

Lease accounting is a complex area of accounting that requires an understanding of GAAP. Under GAAP, leases are classified as either finance leases or operating leases

Leasing assets is a common practice for companies of all sizes and industries. Among their many advantages, leases increase businesses’ purchasing power; decrease maintenance costs (if the lessee isn’t responsible for maintenance) and help better manage cash flow. However, accounting for leases has become an issue for many companies due to new accounting rules that began in 2019 for publicly traded companies and took effect at the end of 2021 for private companies.

These changes to lease accounting rules are particularly extensive for lessees, even though the core principle of classifying leases based on how much they’re like an outright sale remains intact. The changes include big philosophical shifts along with many small adjustments, with the primary change being that lessees are now required to carry the operating leases on their balance sheets if they last more than 12 months

• the design is to give investors a better understanding of a company’s long-term liability. Complying with the new rules has proven to be more difficult than anticipated, especially for companies without the right accounting systems in place.

Lease accounting refers to the treatment of lease-related revenues and expenses for financial record keeping and reporting. Accounting standards from several rule-setting organizations, including the Financial Accounting Standards Board (FASB) and Government Accounting Standards Board (GASB) in the U.S., and the International Accounting Standards Board (IASB), govern how leases are classified for accounting purposes.

Lease accounting aims to properly reflect the true nature of the underlying lease agreement for key considerations, including:

• 1. Proper recognition of lease liability on a lessee’s balance sheet.
  2. Recording and properly valuing the asset at inception and as that value changes throughout the duration of the lease.
  3. Recognizing and valuing lease liability at inception and as that liability changes throughout the duration of the lease.
  4. Proper recognition of income statement aspects, such as lease revenue and expenses and profits and losses on leased assets.

Lessee vs. Lessor Accounting:

Lessors have three possible accounting treatments that may be applicable to a given lease while lessees have two. Selecting the appropriate lease accounting treatment begins with determining the classification of a lease, using five tests defined by the accounting standards. Once the designation is determined, the lessor makes certain journal entries and disclosures and the lessee makes others.

Lessors classify leases as either sales-type leases, direct financing leases or operating leases, based on the tests included in the standards. The more the lease resembles an outright asset sale, the more a lessor’s initial accounting mirrors that of a sale.

• For sales-type leases, which are, as you might guess, most like an outright sale, lessors ―derecognize‖ the underlying asset — which simply means they remove it from their balance sheet — and add a new asset to their balance sheet in its place: an investment in the lease. Also, at this point, the lessor would recognize any profit or loss on the asset. Over the duration of a sales-type lease, the lessor records interest income and reduces the balance of the lease investment as they receive payments from the lessee. Sales-type leases are found often in the entertainment business, where movie theater technology is leased to independently owned theaters. Once the technology is installed in the theater, the lessor effectively transfers total control and responsibility for it to the lessee, usually for a 10- to 20-year lease term. At the end of the lease, the technology is likely to be obsolete, and therefore of no remaining value to the lessor. In reality, the lease is very much like a sale, which is why the movie-theater technology asset is removed from the balance sheet and replaced by the lease investment asset.
• For operating leases, which are the least sales-like, lessors retain the asset and related depreciation on their books and simply record lease payments. A straightforward example is a lease for office space in a high-rise building with multiple occupants. Since this is more like a rental than a sale, the lessor retains the building and related accounts, like a depreciation account, on its balance sheet.
• Direct financing leases can be thought of as in between sales-type leases and operating leases, although much closer to sales-type. With this type of lease, the lessor’s accounting works similarly to a sales-type lease but defers any profit or loss on the asset because it’s not quite an outright sale. This is the type of lease used by most financial institutions that acquire assets simply to make money from leasing them to customers.

Lessees can classify leases as either an operating lease or a finance lease, based on tests included in the standards. For lessees, the tests are meant to gauge the relationship with the underlying asset, determining how similar the lease is to true ownership. There are different accounting treatments for the two types of leases in the US version of the new standard, which is known as a ―dual approach.‖

• In the case of finance leases, where the relationship is more like ownership — meaning, the risks and control of the asset lies mostly with the lessee. An open- ended vehicle lease, where there is an obligation to purchase the car at the end of the lease, is an example of a finance lease.
• In an operating lease, the lessee records a ―right-of-use asset‖ and a lease liability on their balance sheet. A right-of-use asset designation distinguishes leased assets from a company-owned assets, which is especially relevant for financial reporting purposes. As lessees make payments over the lease term, they amortize the asset, reduce the lease liability and recognize interest expense on

their income statements. A closed-end vehicle lease, where the car must be returned to the lessor at the end of the lease, is an operating lease.

Five criteria for classifying a lease constitute an important part of the lease accounting standards. The objective of these criteria is to characterize the nature of the lessee business’s relationship with the underlying asset. The more akin to ownership control and an outright purchase, the more comprehensive the accounting will be for both lessor and lessee. The five criteria used to classify a lease are:

1. Does ownership transfer at the end of the lease?
2. Is there a ―bargain purchase option‖ — i.e., a price significantly lower than the expected market value — for the leased asset that is reasonably certain to be exercised?
3. Does the lease term cover the major part of the remaining economic life of the asset?
4. Is the present value of the lease payments (plus any residual value guarantees) greater than or almost equal to the fair value of the asset?
5. Is the asset very specialized, so can’t be used by the lessor at the end of the term?

Example of Lease Accounting

Here is a simplified example to illustrate lease accounting:

Let’s say a company, ABC Corporation, enters into a lease agreement to rent office space for five years. The annual lease payments are $10,000, payable at the end of each year and the lease agreement does not transfer ownership of the property to ABC Corporation when the lease has ended.

Under the lease accounting standards (e.g., IFRS 16 or ASC 842), ABC Corporation needs to determine whether the lease is a finance lease or an operating lease.

If the lease meets any of the following criteria, it is classified as a finance lease:

1. The lease transfers ownership of the property to the lessee by the end of the lease term.
2. The lease grants the lessee an option to purchase the property, and it is reasonably certain that the option will be exercised.
3. The lease term covers a major part of the economic life of the property (e.g., 75% or more).
4. The present value of the lease payments, excluding any costs such as initial direct costs, equals or exceeds substantially all of the fair value of the property.

In this example, assuming none of the above criteria are met, the lease would be classified as an operating lease.

Operating Lease Accounting:

Under the operating lease accounting approach, ABC Corporation would record the annual lease payments as an operating expense on its income statement. The following entry would be made each year:

• • Debit: Operating Lease Expense $10,000
  • Credit: Cash $10,000

Finance Lease Accounting:

Now, let’s consider an alternate scenario where the lease agreement does meet the criteria for a finance lease. In this case, ABC Corporation would recognize the leased office space as an asset and record a corresponding liability for the lease obligation.

Assuming the present value of the lease payments at an appropriate discount rate is

$40,000, the initial lease accounting entry would be:

• • Debit: Right-of-Use Asset (Office Space) $40,000
  • Credit: Lease Liability $40,000

Over the course of the lease term, ABC Corporation would recognize annual depreciation expense on the right-of-use asset and interest expense on the lease liability. Assuming a straight-line depreciation method and a discount rate of 5%, the annual entries for the first year would be:

• • Debit: Depreciation Expense (Office Space) $8,000
  • Debit: Interest Expense $2,000
  • Credit: Right-of-Use Asset (Office Space) $10,000

The same entries would be made for subsequent years, adjusting for any changes in the lease liability due to interest accruals and lease payments.

Scenario 2

A company, ABC Ltd., leases a piece of equipment for a period of 5 years. The lease payments are $10,000 per year, payable at the end of each year. The implicit interest rate in the lease is 8%. The lease term is considered to be the useful life of the asset.

Step-by-Step Calculation:

1. Calculate the present value of lease payments:
   • Using a present value table or financial calculator, calculate the present value of an annuity of $10,000 for 5 periods at an 8% interest rate.
   • The present value of lease payments is $41,646.

Recognize right-of-use asset and lease liability:

• • At the commencement of the lease, ABC Ltd. will recognize:
  • A right-of-use asset on its balance sheet at $41,646.
  • A lease liability on its balance sheet at $41,646.

Depreciation expense:

• • The right-of-use asset will be depreciated over its useful life (5 years).
  • Annual depreciation expense = $41,646 / 5 = $8,329.

Interest expense:

• • Each year, interest expense will be calculated as the lease liability at the beginning of the year multiplied by the implicit interest rate.
  • In the first year, interest expense = $41,646 * 8% = $3,332.

Illustration of the first year’s entries:

• • Income Statement:
    • Lease expense: $10,000 (lease payment)
    • Interest expense: $3,332
    • Depreciation expense: $8,329

Balance Sheet:

o Right-of-use asset: $33,317 ($41,646 – $8,329)

o Lease liability: $38,314 ($41,646 – $3,332)

Key points to remember:

• The lease liability will decrease over time as lease payments are made.
• The right-of-use asset will decrease due to depreciation.
• The difference between the lease payment and interest expense will reduce the lease liability.

*Please note that these examples are simplified for illustrative purposes. In practice, lease accounting involves more detailed calculations, considerations for lease modifications, variable lease payments, and other factors. It’s important to consult the relevant accounting standards and seek professional advice for comprehensive and accurate lease accounting.*

Why is Lease Accounting important?

• Transparency and Accuracy: Proper lease accounting enhances the transparency and accuracy of financial statements. By recording lease obligations on the balance sheet, it provides a more complete and accurate representation of a company’s assets, liabilities, and financial position. This information is vital for investors, creditors, and other stakeholders in making informed decisions.
• Financial Statement Analysis: Lease accounting allows for more accurate financial statement analysis. Investors and analysts can better evaluate a company’s financial health, liquidity, leverage, and profitability when lease obligations are properly recorded and disclosed.
• Comparability: Lease accounting standards provide a consistent framework for companies to record and report leases. This improves the comparability of financial statements across different companies and industries, allowing stakeholders to make meaningful comparisons and assessments.
• Risk Assessment: Lease accounting enables a more comprehensive assessment of a company’s risk exposure. By recognizing lease liabilities on the balance sheet, stakeholders can evaluate the financial impact of lease obligations, such as debt covenants, repayment obligations, and future cash flow requirements.
• Contract Management: Accurate lease accounting facilitates effective contract management. It helps companies monitor lease terms, payment schedules, renewal options, and other critical aspects of lease agreements. This allows businesses to better plan for lease expirations, negotiate favorable terms, and optimize lease portfolios.
• Regulatory Compliance: Lease accounting standards, such as IFRS 16 and ASC 842, are recognized by regulatory bodies and accounting standard-setters. Compliance with these standards ensures that companies meet the requirements set forth by the respective governing bodies, avoiding potential penalties, legal issues, or reputational risks.
• Decision Making: Lease accounting information assists in making strategic decisions. Companies can evaluate the costs and benefits of leasing versus buying assets, assess the financial implications of lease modifications, and consider the impact of leases on profitability and cash flow.

Overall, lease accounting is essential for accurate financial reporting, informed decision-making, risk management, and maintaining compliance with accounting standards. It provides stakeholders with a clearer understanding of a company’s lease- related commitments, financial position, and performance, leading to increased transparency and confidence in the financial statements.

Advantages and Disadvantages of Lease Financing

Lease financing is a popular medium and long-term financing option in which the owner of an asset grant another person the right to use the asset in exchange for a periodic payment. The asset’s owner is known as the lessor, and the user is known as the lessee. A contract is to be made between the lessor and the lessee regarding the terms and conditions of the lease. After the lease period is over, the asset goes back to the lessor (the owner). There can also be a provision in the contract regarding compulsory buying of the asset by the lessee (the user) after the lease period is over.

The lessee is given the right to use the asset, but the lessor retains ownership, and the asset is returned to the lessor at the end of the lease contract, or the lessee is given the option to purchase the asset or renew the lease agreement.

Advantages of Lease Financing

To Lessor:

The following are the benefits of lease financing from the perspective of the lessor:

• • Regularly Assured Income: Lessors receive lease rentals by leasing an asset for the duration of the lease, which is a guaranteed and consistent source of income.
  • Ownership Preservation: In a finance lease, the lessor transfers all risk and rewards associated with ownership to the lessee without transferring asset’s ownership, so the lessor retains ownership.
  • Security: The lessor may take back the leased asset, property, or equipment if the lessee cannot pay the lease rentals; in this way, the lessor’s interest is safeguarded
  • Tax Advantage: Because the lessor owns the asset, the lessor receives a tax benefit in the form of depreciation on the leased asset.
  • Profitability is high: Leasing is a highly profitable business because the rate of return on lease rentals is much higher than the interest paid on the asset’s financing.
  • Growth Possibilities: There is a lot of room for growth here. Because leasing is one of the most cost-effective forms of financing, demand for it is steadily increasing. Even amid a depression, economic growth can be maintained. As a result, leasing has a much higher growth potential than other types of businesses.

To Lessee:

The following are the benefits of lease financing from the perspective of the lessee:

• • Capital Goods Utilization / Liquidity: A business will not have to spend a lot of money to acquire an asset, but it will have to pay small monthly or annual rentals to use it. The business can use its funds for other productive purpose.
  • Convenience: The simplest way to finance fixed assets is by leasing. There is no need for a mortgage or hypothecation. A long-term loan from a financial institution is not subject to restrictions. Leasing involves many fewer formalities than borrowing money from financial institutions.
  • Cheaper: Leasing is a form of financing that is less expensive than almost all other options.
  • Tax Advantages: Lease payments can be deducted as a business expense, allowing a company to benefit from a tax advantage.
  • Zero chance of Obsolescence / Technical Support: Regarding the leased asset, the lessee receives some form of technical support from the lessor. The lessor is liable for the asset’s Obsolescence due to technical developments
  • Friendly to Inflation: Leasing is inflation-friendly because the lessee is required to pay a fixed amount of rent each year, even if the asset’s cost rises.
  • Ownership: After the primary period has expired, the lessor offers the lessee the opportunity to purchase the assets for a small fee.
  • Flexibility: A lease’s conditions are more adaptable. The lessee can change the rental time based on his needs and concerns
  • Less Delay: In general, processing a lease proposal takes less time than term- loan funding. Lease Financing enables the business/lessee to get the right to utilize the asset or property quickly.

Disadvantages of Lease Financing

To Lessor:

The following are the disadvantages of lease financing from the perspective of the lessor:

• • In the event of inflation, it is unprofitable: Every year, the lessee receives a fixed amount of lease rental, which they cannot increase even if the asset’s cost rises. So, it is unprofitable during inflation.
  • Double Taxation: It is possible to be charged sales tax twice: The first is when the asset is purchased, and the second is when the asset is leased.
  • Greater Risk of Asset Damage: As the ownership is not transferred, the lessee treats the asset carelessly, and there is a great chance that it will not be usable after the primary lease period ends.
  • Market Competition: There are now more leasing firms than ever before. The lessor may have to rent out the property at a reduced rental rate due to the increased competition, which might prevent them from realizing the anticipated returns on their investments in the asset or property
  • High risk of Obsolescence: Due to the current condition of rapidly evolving technology, the lessor is also concerned about the danger of technical equipment becoming obsolete (state of being unusable).

To Lessee:

The following are the disadvantages of lease financing from the perspective of the lessee:

• • Compulsion: Finance leases are non-cancelable, and lessees must pay lease rentals even if they do not intend to use the asset.
  • Ownership: Unless the lessee decides to purchase the asset at the end of the lease agreement, the lessee will not become the owner of the asset.
  • Contract restriction: The lessee may not be allowed to change or modify the asset in any way under a lease agreement
  • No Renovation permission: No extensive modifications can be made to the Asset or Property by the lessee because the lessee doesn’t own the Asset or Property.
  • Costly: Lease financing is more expensive than other types of financing because the lessee is responsible for both the lease rental and the expenses associated with asset ownership.
  • Asset Understatement: As the lessee is not the owner of the asset, it cannot be included in the balance sheet, resulting in an understatement of the lessee’s asset.
  • Loss of Asset Salvage Value: The salvage value of an asset is the projected amount of its worth at the end of its usable life. The lessee cannot collect the salvage value of the asset when the lease time expires since he does not have ownership of the asset, which is returned to the lessor.
  • No warning period: Contrarily, if the asset/property is acquired, the buyer can change it to boost usability, modernize it, or for any other purpose, including incorporating his personal décor preference. An asset often takes a long time to produce enough money to repay the loan. The term loan stipulates a defined moratorium time in debt repayments. However, in lease agreements, no such period is permitted.
  • Regular rents: The lessee has to pay regular lease rent to the lessor.

Difference between Hire purchase and Leasing

Hire Purchasing and Leasing are both methods of acquiring assets without the need for an upfront purchase. However, they differ in terms of ownership, payment structure, and the transfer of risk. Hire Purchasing involves acquiring an asset through a series of installment payments over a specified period; whereas, Leasing involves renting an asset from the owner (lessor) for a specified period in exchange for periodic payments.

Basis	Hire Purchasing	Leasing
Meaning	Hire Purchasing involves acquiring an asset through a series of installment payments over a specified period.	Leasing involves renting an asset from the owner (lessor) for a specified period in exchange for periodic payments.
Duration	Duration of hire purchasing are longer months to years.	Duration of leasing are shorter and customizable.
Ownership Transfer	In hire purchasing, the buyer gets ownership of the asset after completing paying installments.	In leasing, the owner remains the same throughout the lease period.
Payment Structure	With hire purchasing, the buyer pays installments until they own the asset.	In leasing, the lessee makes regular payments to use the asset for a set time.
Maintenance and Insurance	In hire purchasing, the buyer is responsible for maintenance & insurance	In leasing, the owner usually handles maintenance and upkeep.
Flexibility	Hire purchasing terms are often fixed once agreed upon, offering less flexibility.	Leasing is more flexible; lessees can often change terms or upgrade assets.
Tax Treatment	Interest portion of hire purchase payments may be eligible for tax deductions as a business expense.	Lease payments may be treated as operating expenses and deducted from taxable income.
End of Term Options	With hire purchasing, ownership is gained, & no more payments are needed.	Leasing allows options like buying, returning, or renewing the lease at the end.
Risk Exposure	In hire purchasing, the buyer takes on the risk of asset depreciation or damage.	In leasing, the owner retains ownership and risk.
Contract Termination	Hirer purchase can terminate before ownership (subject to fees).	Breaking a lease can have legal consequences.

IFRS 16/IND AS 116 ‘Leases’ — snapshot

The new lease accounting standard IFRS 16/Ind AS 116 attempts to bring leasehold assets held under operating lease on balance sheet except assets under short or low value leases. This is in conformity to the concept of asset defined in the Conceptual Framework. It also rationalizes the process of identifying lease since IFRIC 4 was considered to be one of the stumbling blocks in IFRS adoption/ convergence in various countries and also integrates other interpretations (e.g. SIC-15 Operating Leases—Incentives , SIC-27 Evaluating the Substance of Transactions Involving the Legal Form of a Lease ).

Right of Use Asset

Accounting for Leases

Other than short leases and leases of small value in the Books of Lessee

• Both operating and finance lease give rise to a new ‘Right of Use Asset’ in the books of the lessee. There are exemptions for lease interest arising out of short leases or low value leases. At the inception, the lessee would measure ‘Right of Use asset’ at cost which is the value lease liability plus lease payments made at or before the commencement date minus any lease incentives received plus indirect cost and estimated cost of site restoration. This principle is applied to all leasehold assets earlier accounted for as finance lease and operating lease except for short lease having lease term of 12 months or less and low value leases.
• The new lease standard thus brings operating lease assets on Balance Sheet of the lessee. expenses incurred including estimated value of site restoration cost and the lease liability at discounted value of fixed and variable payments

Lease accounting by lessee so far ignored inherent resource under control putting assets under operating lease off-balance sheet . The lessee has simply recognized lease rent as an expense applying straight line method or any other systematic allocation basis that matches the time pattern of benefits arising out of the leasehold asset under the operating lease.

Under IFRS 16/ Ind AS 116 Leases, lease classification (e.g. classification of lease into operating and finance leases) is not applicable to lessee as any leasehold asset creates a right of use in favour of the lessee which satisfies the definition of asset :

“An asset is a present economic resource controlled by the entity as a result of past events. An economic resource is a right that has the potential to produce economic benefits.”

Based on IASB’s Conceptual Framework for Financial Reporting (2019) , it would be logically required that all resources controlled by the entity should be recorded on Balance Sheet for better appreciation of the profitability of an entity with reference to resource utilized and for ensuring fair comparison of performance of entities. So all ‘ Right of Use’ assets should be recognized irrespective of the nature of origination lease contract ( i.e. whether or not it is a financial lease ).

Exemption of short leases and low value leases from the requirement of recognition of ‘right of use’ asset is simply on cost benefit ground. On the basis of a fieldwork, the IASB observed that, in most cases, assets and liabilities arising from leases within the scope of the exemption would not be material, even in aggregate.

The lessee would charge depreciation on ‘Right of Use’ asset. On the other hand, the lessor would continue to classify lease as operating and finance as before. Therefore, a lessor shall continue to recognize assets leased out as operating lease on balance sheet and also follow depreciation policy consistent with the lessor’s normal depreciation policy for similar assets. A lessor would calculate depreciation in accordance with IAS 16/ Ind AS 16 and IAS 38/ Ind AS 38. Thus the asset under operating lease would appear on balance sheet of both the lessor and the lessee which would cause difficulty for business taxation as depreciation benefit cannot be offered twice for the same asset. In all probability amortization of ‘Right of Use’ asset be excluded from the purview of eligible expenses for computing taxable profit.

Process of Identifying Lease

IFRIC4 Determining whether an arrangement contains a lease which contained two primary criteria for classifying an arrangement as a lease i.e. specific asset test and right to use test.

Specific asset test – the arrangement to be satisfied by explicitly or implicitly identified asset.

Right to use test : this test could be satisfied if any one of the following three conditions are satisfied –

1. the lessee has the ability or right to use the asset or direct others to use the asset and controls more than significant amount output /other utility arising out of the asset , or
2. the purchaser has the ability or right to control physical access to the underlying asset while obtaining or controlling more than an insignificant amount of the output or other utility of the asset, or
3. facts and circumstances indicate that it is remote that one or more parties other than the purchaser will take more than an insignificant amount of the output or other utility that will be produced or generated by the asset during the term of the arrangement, and the price that the purchaser will pay for the output is neither contractually fixed per unit of output nor equal to the current market price per unit of output as of the time of delivery of the output.

As per IFRIC 4 arrangements that convey the right to use an asset in return for a payment or series of payments be accounted for as a lease, even if the arrangement does not take the legal form of a lease. Some common examples of such arrangements include power plants built to exclusively supply to the rail network, or a power plant located on the site of an aluminium smelter . Such arrangements have become very common in the renewable energy business as well where all of the output of wind or solar farms or biomass plants is contracted to a single party under a power purchase agreement.

The new lease standard retained the basic criteria of specific asset test and right to use test but inherent conditions are rationalized in Paragraphs B 9-B31 of IFRS 16 / Ind AS 116 as follows:

1. An asset is typically identified by being explicitly specified in a contract or impliedly identified;
2. In addition, the lessee has the right to use the specified asset. This condition is not satisfied if the lessor has the substantive right to substitute the asset through out the period of use or the lessor will economically benefit by substitution of the asset.
3. Thus if the supplier has a right or an obligation to substitute the asset only on or after either a particular date or the occurrence of a specified event, the supplier’s substitution right is not substantive.
4. Of course, the supplier’s right or obligation to substitute the asset for repairs and maintenance, if the asset is not operating properly or if a technical upgrade becomes available does not preclude the customer from having the right to use an identified asset.
5. The lessee shall be able to obtain substantially all of the economic benefits from use of an asset. For this purpose an entity shall consider the economic benefits that result from use of the asset within the defined scope of a customer’s right to use the asset.
6. A customer has the right to direct the use of an identified asset throughout the period of use. A lessee has the decision making right to direct how and for what purpose the asset is used if, within the scope of its right of use defined in the contract, it can change how and for what purpose the asset is used throughout the period of use.
7. The lessor may enjoy protective right – the terms and conditions to protect its interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance with laws or regulations. Such protective right does not negate the existence of lease.

In contrast to restrictive requirements of IFRIC 4 regarding usage and pricing policy of the output as indictors of right to use, IFRS 16/ Ind AS 116 sets out two modified conditions –

• • Right to obtain economic benefit from use ;and
  • Right to direct the use of the identified asset.

Right to obtain economic benefit from use would mean ‘substantially all of the economic benefits from use of the asset’. Also the purchasers should enjoy the right to direct the use of the identified asset. Right to direct the use under the new standard is in no way linked to the process of pricing output. By virtue of this rationalization of the conditions of specified asset test and right to use test, restrictive conditions of the erstwhile IFRIC 4 has been avoided.

Outsourcing arrangements as lease transaction

In contrast to IFRIC 4 , both substantial economic benefit and right to direct use of the identified assets conditions should be satisfied . Accordingly , even if the buyer of output takes 100% unless ‘right to direct use’ is satisfied the arrangement cannot be treated as lease.

However, in outsourcing arrangement when the nature of product, quantity to be produced timing of production is directed by the buyer [Paragraph B24(a) of Ind AS 116] and the buyer enjoys substantial economic benefit arising out the asset [ Paragraphs B21-23, Ind AS 116], then it becomes a lease. Ind AS 116 does not in effect relaxes IFRIC4 requirements.

In outsourcing arrangements, if the customer enjoys exclusive use right the transaction would satisfy to be lease transaction as it is quite obvious that the buyer decides the nature of the product, quantity to be produced and production schedule.

A customer has the right to direct the use of an identified asset throughout the period of use if the customer enjoys the right to direct how and for what purpose the asset is used. It includes right to decide type of output and its quantity, time and place of production / operation. This decision making right although may restricted or interfered because of maintenance of the underlying asset that cannot be construed as barrier to right to direct use.

Alternatively, the right to direct use is also satisfied the relevant decisions about how and for what purpose the asset is used are predetermined and the customer has right

to operate the asset. The supplier cannot change the operating instructions. This test is also satisfied the customer designed the asset (or specific aspects of the asset) in a way that predetermines how and for what purpose the asset will be used throughout the period of use.

Thus conditions for identifying a lease transaction is no longer subjected to the condition pricing but still it remains an issue whether ‘substantially all of the economic benefits from use of the asset’ flow to the customer.

Traditional Power Purchase Agreements

In traditional power purchase agreements, production is carried out by the power plant as

per its own production schedule and the buyer does neither has the right to direct

how and for what purpose the asset is used throughout the period of use nor does the buyer has the right to operate. Also the customer did not design the asset to meet its requirement. Therefore, even though the buyer enjoys 100% output purchase agreement, still the transaction would not satisfy lease conditions.

However, the captive energy plant run by a third party for exclusive supply to the buyer would satisfy the leasing conditions. Right to direct use is impliedly satisfied.

Measurement principle and reassessment of lease liability

Initial measurement of ‘Right of Use’ assets include estimated dismantling cost excluding those costs which relate to inventories. Likewise IAS 16/ Ind AS 16 , in subsequent measurement of ‘ Right of Use’ asset cost model or revaluation model is followed. This integrates accounting principles followed in respect of owned and leasehold assets.

But reassessment of linked financial liability used to finance any PPE or Intangible Asset does not economically affect the value of the underlying asset. Capital market factors would affect valuation of liability and asset market factors in particular the underlying operating cash flows derived from the asset determines the value of the asset. Exception could be the value of the asset that is directly derived from the underlying liability which are offsets.

But IFRS 16/ Ind AS 116 requires to adjust reassessment gain or loss of lease liability to the value of ‘Right of Use’ asset till the asset is value is not brought down to zero – this does not meet economic logic. Revaluation or impairment of ‘Right of Use’ asset should essentially be the outcome of increase/decrease in economic benefit. In particular, measurement of impairment loss of ‘Right of Use’ asset is also guided by the external and internal parameters enshrined in IAS 36/ Ind AS 36. Value in use of the ‘Right of Use’ asset should be measured by discounted cash flows arising out of the asset. Mode of financing of the asset does not determine its value.

Although ‘Right of Use’ asset is initially measured based on value of lease liability which is its cost of acquisition but logically its fair value should be different because of inherent entrepreneurship profit. If the revaluation model is adopted in subsequent measurement, the fair value of ‘Right of Use’ asset can be captured.

Of course, change in market rate of interest that causes change the fair value of lease liability may also affect the value of ‘Right of Use’ asset. But the change in fair value of reassessed lease liability and ‘Right of Use’ not necessarily be the same.

Paragraph BC 192 of Basis of Conclusion , IFRS 16 clarifies reasons for adopting adjustment of gain or loss arising out of reassessment to Right of Use asset:

1. A change in the assessment of extension, termination or purchase options reflects the lessee’s determination that it has acquired more or less of the right to use the underlying asset. Consequently, that change is appropriately reflected as an adjustment to the cost of the right-of- use asset.
2. A change in the estimate of the future lease payments is a revision to the initial estimate of the cost of the right-of-use asset, which should be accounted for in the same manner as the initial estimated cost.
3. The requirement to update the cost of the right-of-use asset is similar to the requirements in IFRIC 1 Changes in Existing Decommissioning, Restoration and Similar Liabilities. IFRIC 1 requires an entity to adjust the cost of the related asset for a change in the estimated timing or amount of the outflow of resources associated with a change in the measurement of an existing decommissioning, restoration or similar liability.

However, ‘Right of Use’ asset is not comparable to the component of cost of PPE that relates to decommissioning liability as that component does not include entrepreneurship profit. Economic benefit arising of the leasehold asset can be assessed independent of the lease liability while decommissioning component of PPE cost arises out of the decommissioning liability.

A change in the future payment of lease liability does not necessarily change the economic benefit of Right of Use asset. Of course , Paragraph 192 (a) of Basis of Conclusion of IFRS 16 affects the original estimate of the cost of Right of Use asset to the extent it results from discounting of revised cash flow at the original discount factor. In other words, movements in fair value of ‘Right of Use’ asset and fair value of leased liability are not correlated.

Exclusions

The following assets are excluded from application of IFRS 16/ Ind AS 116:

• 1. leases to explore for or use minerals, oil, natural gas and similar non- regenerative resources covered under IFRS 6/ Ind AS 106;
  2. leases of biological assets within the scope of IAS 41 / Ind AS 41 Agriculture held by a lessee;
  3. service concession arrangements within the scope of IFRIC 12 Service Concession Arrangements;
  4. licences of intellectual property granted by a lessor within the scope of IFRS 15 Revenue from Contracts with Customers; and
  5. rights held by a lessee under licensing agreements within the scope of IAS 38 Intangible Assets for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.

In effect, there is no logical basis for these exclusions of exploration asset and biological asset. In particular, financial asset or intangible asset recognized under IFRIC 12 is excluded and Paragraph BC 69 issued by the IASB explains that :

‘The IASB decided to exclude from the scope of IFRS 16 service concession arrangements within the scope of IFRIC 12. Consistently with the conclusions in IFRIC 12, any arrangement within its scope (i.e. that meets the conditions in paragraph 5 of the Interpretation) does not meet the definition of a lease. This is because the operator in a service concession arrangement does not have the right to control the use of the underlying asset’.

However, an intangible asset under Paragraphs 15-19 of IFRIC 12 cannot be recognized unless it there is an underlying right :

‘The operator shall recognise an intangible asset to the extent that it receives a right (a licence) to charge users of the public service’.

Economic benefit of intangible asset under service concession arrangement arises out of this right to charge for use of public asset and that right can be leased out.

Concluding remarks

1. Recognition of ‘Right of Use’ is targeted to bring to book the off -balance sheet operating lease assets to improve the information about resources used and liability assumed.
2. Although IFRIC 4 conditions are relaxed still certain assets of outsourced agencies operating under the instructions of the buyer and in which the buyer enjoys exclusive right would fall within the scope of IFRS 16/Ind AS 116. However, transactions which are simply exclusive right to buy the output would not satisfy the conditions of a lease.
3. The IASB should re-examine the accounting principle of adjusting the reassessment gain/ loss on lease liability to ‘Right of Use Asset’. Of course, gain/loss arising out of change in lease term modifies the value of ‘ Right of Use’ and should be adjusted. Otherwise, when the lease liability is changed because of change in the market rate of interest that simply reflects financial market factor while value of the ‘Right of Use’ asset is mostly determined by the asset market factors.
4. Exclusions of certain assets from applicability of lease standard namely, exploration asset and biological asset are contradictory to the integration process. There is no reason why leasing of license should not covered under IFRS16.

All other intangible assets may be accounted for applying IFRS. The IASB deferred this issue for closer scrutiny

Difference between IFRS-16 and INDAs 116

Essentially, both standards are substantially the same, adopting a single model for all leases. They require lessees to recognize both assets and liabilities on their balance sheet for most lease agreements, with a few minor variations in terminology and guidance.

While IFRS 16 and IndAS 116 are largely aligned, there are a few key differences:

Effective Dates:

• • IFRS 16: Became effective for annual periods beginning on or after January 1, 2019.
  • IndAS 116: Became effective for annual periods beginning on or after April 1, 2019.

Terminology

• • IFRS 16: Uses the term “right-of-use asset.”
  • IndAS 116: Uses the term “lease asset.”

Scope and Applicability

• • IND AS 116: Applies to entities in India and may have specific guidelines tailored to Indian regulations.
  • IFRS 16: Applies globally and is used by entities following IFRS.

Recognition Exemptions

• • IND AS 116: Provides an exemption for leases with a term of 12 months or less and low-value assets, similar to IFRS 16.
  • IFRS 16: Also provides these exemptions but may have different interpretations on what constitutes low-value assets.

Transition Approach

• • IND AS 116: Allows for two transition approaches: the full retrospective approach and the modified retrospective approach.
  • IFRS 16: Primarily encourages the modified retrospective approach but allows the full retrospective approach as well.

Transition Requirements:

• • IFRS 16: Provides more guidance on the transition to the new standard, including the option to apply the modified retrospective approach.
  • IndAS 116: Adopts a similar approach but may have some variations in specific guidance.

Disclosure Requirements:

• • IFRS 16: Requires more detailed disclosures about lease incentives, variable lease payments, and contingent rent.
  • IndAS 116: Has slightly less stringent disclosure requirements in these areas.

Interpretation of Certain Provisions:

• • While both standards are generally aligned, there may be slight differences in the interpretation of certain provisions, such as the definition of a lease or the treatment of certain lease modifications.

Overall, the differences between IFRS 16 and IndAS 116 are relatively minor and do not significantly impact the core principles of lease accounting. However, it’s important for entities to be aware of these differences when applying the standards in their specific context.

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