Model Answer
0 min readIntroduction
A lease is a contract conveying the right to use an asset for a period of time in exchange for consideration. Historically, leases were categorized as either operating or finance leases, with differing accounting treatments. However, the introduction of Ind AS 116 (in India, aligned with IFRS 16 internationally) in 2019 significantly altered the landscape, requiring almost all leases to be recognized on the lessee’s balance sheet. This framework aims to provide a more transparent and comprehensive view of a company’s lease obligations and their financial impact. Understanding this framework is crucial for lessees to accurately assess the cost of using an asset through a lease versus outright purchase.
Initial Measurement of a Lease by the Lessee
Under Ind AS 116, a lessee recognizes a ‘right-of-use’ (ROU) asset and a lease liability at the commencement date of the lease. The initial measurement involves:
- Lease Liability: Calculated as the present value of the lease payments not yet paid at the commencement date. The discount rate used is the lessee’s incremental borrowing rate (IBR) – the rate the lessee would have to pay to borrow funds over a similar term and with similar security.
- ROU Asset: Measured at cost, which includes the initial amount of the lease liability, any lease payments made at or before the commencement date, initial direct costs incurred by the lessee, and an estimate of any costs the lessee will incur in dismantling and removing the underlying asset.
Subsequent Measurement
Following initial recognition, the lessee accounts for the ROU asset and lease liability differently:
- ROU Asset: Is depreciated over the shorter of the asset’s useful life or the lease term. The depreciation method should reflect the pattern in which the benefit from the asset is consumed.
- Lease Liability: Is increased to reflect interest expense and reduced to reflect lease payments. The interest expense is calculated using the effective interest method.
Impact on Financial Statements
The new lease accounting standard has a significant impact on the lessee’s financial statements:
- Balance Sheet: The ROU asset and lease liability are recognized, increasing both assets and liabilities. This impacts key ratios like debt-to-equity and asset turnover.
- Income Statement: Instead of a single rental expense, the lessee recognizes depreciation expense on the ROU asset and interest expense on the lease liability.
- Cash Flow Statement: Lease payments are split into principal (financing activities) and interest (operating activities) components.
Exceptions and Simplifications
Ind AS 116 provides certain exceptions and simplifications:
- Short-term Leases: Leases with a term of 12 months or less. Lessees can elect to not recognize a ROU asset or lease liability for these.
- Low-Value Assets: Leases of assets with a low value (typically below INR 50,000). Similar to short-term leases, lessees can elect not to recognize a ROU asset or lease liability.
Financial Framework Evaluation – Key Considerations for Lessees
From a financial evaluation perspective, lessees need to consider:
- Incremental Borrowing Rate (IBR): Accurately determining the IBR is crucial as it directly impacts the lease liability and subsequent interest expense.
- Lease Term: Understanding the lease term, including any options to extend or terminate, is vital for accurate calculations.
- Residual Value: Estimating the residual value of the asset at the end of the lease term can affect the ROU asset’s carrying amount.
| Aspect | Impact on Lessee |
|---|---|
| Balance Sheet | Increased assets (ROU asset) and liabilities (Lease Liability) |
| Income Statement | Depreciation expense & Interest expense instead of single rental expense |
| Cash Flow Statement | Separation of principal and interest payments |
Conclusion
The financial framework for lease evaluation under Ind AS 116/IFRS 16 represents a significant shift in lease accounting, demanding a more comprehensive and transparent approach from lessees. Accurate measurement of the lease liability and ROU asset, coupled with a thorough understanding of the standard’s requirements, is essential for lessees to present a true and fair view of their financial position and performance. Ongoing monitoring and reassessment of lease terms and conditions are crucial to ensure continued compliance and accurate financial reporting.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.