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Lease accounting is changing — An insight with sectoral impacts | I

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February 2019

KPMG.com/in

Lease accounting is changing — An insight with sectoral impacts

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Foreword

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The International Accounting Standards Board (IASB) issued IFRS 16, Leases in January 2016. It took 10 years of discussions and deliberations for IASB to realise its long standing goal to bring leases on-balance sheet for lessees. In India, this standard is expected to be applicable from 1 April 2019.

The new standard has major impact for lessees. It eliminates the classification of leases as either finance leases or operating leases as required by Ind AS 17, Leases. It introduces a single on-balance sheet accounting model that is similar to current finance lease accounting model. Therefore, majority of operating leases will be on-balance sheet as if the entity has borrowed funds to purchase an interest in the leased asset. This accounting will make entities look asset-rich but at the same time heavily indebted too.

The standard will impact the statement of profit and loss of the lessees as well. Currently, operating lease expenses are charged to statement of profit and loss on a straight-line basis over the life of a lease. Entities will now recognise a front-loaded pattern of expense for most leases even when they pay constant annual rentals.

Lessor accounting would remain similar to the current practice i.e. lessors would continue to classify leases as finance lease or operating lease.

Under the new standard, assessment of whether an arrangement is, or contains, a lease is the biggest practical issue. It introduces elaborate guidance to explain what ‘the right to direct the use of an asset’ means along with examples for identifying arrangements as a lease.

We have worked with many entities across sectors who have started to analyse the impact of the new lease standard on their balance sheet, statement of profit and loss and statement of cash flows. Leveraging this experience, our publication ‘Lease accounting is changing – An insight with sectoral impacts’ captures the significant impact of the new leases standard on various sectors. We have also explained the important concepts in the standard in a practical way, with the help of flowcharts and examples.

The application of the new leases standard would be more than just an accounting change. It will have an impact on systems and processes including substantial effort required to identify all lease arrangements and extract all relevant lease data necessary to apply the standard.

The change in the classification of lease in the balance sheet and statement of profit and loss will also affect key financial metrics of the lessees. This could impact debt covenants, tax balances and ability to pay dividends.

Need for judgement

This publication intends to highlight some of the practical application issues with the help of certain facts and circumstances detailed in the examples used. In practice, transactions or arrangements involving the lease arrangements may involve exercise of judgements. Therefore, interpretation and assessment of facts and circumstances of the individual transactions would be required. Further, some information contained in this publication may change as practice and implementation guidance continue to develop. Users are advised to read this publication in conjunction with the actual text of the standards and implementation guidance issued, and to consult their professional advisors before concluding on accounting treatments for their transactions.

References

References to relevant guidance and abbreviations, when used, are defined within the text of this publication.

Sai VenkateshwaranPartner and HeadCFO AdvisoryKPMG in India

Ruchi RastogiPartnerAssuranceKPMG in India

Table of contents

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• Introduction 01

• Scope of ED of Ind AS 116 02

• Lease definition 03

- Identified asset 04 - Substantive substitution rights 05 - Right to control the use of an identified asset 07 - Protective rights 09 - Lease definition - Exemptions 10 - Lease and non-lease components 11

• Accounting by lessee 13

- Initial measurement of lease liability 13 - Subsequent measurement of lease liability 15 - Reassessment of lease liability 15 - Initial measurement of the right-of-use asset 16 - Subsequent measurement of the right-of-use asset 16 - Impact on financial reporting 16

• Accounting by lessor 19• Lease modification 20• Presentation in financial statements 23• Disclosures 24• Transition 26• Others 28

• Sale-and-leaseback transactions 28• Sub-leases 28

• Potential sector impacts 29 - Property leases 29 - Transport, logistics and leisure 32 - Automotive 36 - Telecom 38 - Media and entertainment 40 - Financial services 44 - Consumer market and retail 46 - Information technology 48 - Healthcare 50 - Life sciences 51

- Education 53

• Matters to consider 55

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The Ministry of Corporate Affairs (MCA) requires corporates and Non-Banking Financial Companies (NBFCs) to apply Indian Accounting Standards (Ind AS) when they meet certain thresholds. Currently, 39 Ind AS standards are effective including Ind AS 17, Leases. Ind AS standards are converged with International Financial Reporting Standards (IFRS).

Internationally, the International Accounting Standards Board (IASB) issued a new standard on leases i.e. IFRS 16, Leases on 13 January 2016. IFRS 16 replaces International Accounting Standard (IAS) 17, Leases. IFRS 16 is effective from 1 January 2019, with early application being permitted (as long as IFRS 15, Revenue from Contracts with Customers is also applied).

On 18 July 2017, the Accounting Standards Board (ASB) of the Institute of Chartered Accountants of India (ICAI) issued an Exposure Draft (ED) on Ind AS 116, Leases. The new standard once notified would supersede Ind AS 17.

Ind AS 116 is expected to be effective for annual periods beginning on or after 1 April 2019. As per the IFRS convergence status issued by ICAI as on 19 December 2018, Ind AS 116 has been cleared by the National Advisory Committee on Accounting Standards (NACAS) and submitted to the MCA for notification.

The new standard on leases sets out the principles for the recognition, measurement, presentation and disclosure of leases. The core objective of the standard is to ensure that lessees and lessors provide relevant information in a manner that faithfully represents those transactions. This information is likely to provide a basis to users of financial statements to assess the effect that leases will have on the financial position, financial performance and cash flows of the company.

Introduction

Scope of ED of Ind AS 116

The new standard would be applicable to all leases including leases of right-of-use assets in a sub-lease. However, ED of Ind AS 116 is not applicable to the following types of leases/arrangements:

• Leases to explore for or use minerals, oil, natural gas and similar non-regenerative resources

• Leases of biological assets within the scope of Ind AS 41, Agriculture, held by a lessee

• Service concession arrangements within the scope of Appendix D, Service Concession Arrangements, of Ind AS 115, Revenue from Contracts with Customers

• Licences of intellectual property granted by a lessor within the scope of Ind AS 115

• Rights held by a lessee under licensing agreements within the scope of Ind AS 38, Intangible Assets, for such items as motion picture films, video recordings, plays, manuscripts, patents and copyrights.

A lessee has an option of not applying the standard to leases of intangible assets (other than the rights held under licensing agreements within the scope of Ind AS 38).

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Lease accounting is changing — An insight with sectoral impacts | 4

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Assessment of whether an arrangement is, or contains, a lease will be one of the biggest practical issues when applying the new standard. Lease definition is the test that will determine whether an arrangement is on-or off-balance sheet for a lessee.

A lease is ‘a contract or part of a contract that conveys the right to control the use of an identified asset (the

underlying asset1) for a period of time2 in exchange for a consideration’.

Accordingly, the key elements of the definition of lease to be considered are explained in the diagram below.

Is there an identified asset?

Does the customer obtains substantially all of the economic benefits?

Who has the right to direct the use of the asset – i.e. who takes the ‘how and for what purpose’ decisions?

Lessee

Contract is or contains a lease

Predetermined Lessor

Further analysis is required

Contract does not contain a lease

Yes

Yes

No

No

{Control over the use of the identified asset

Source: KPMG IFRG publication ‘First Impressions: IFRS 16, Leases’, January 2016

1. An underlying asset has been defined to mean an asset that is the subject of lease, for which the right to use that asset has been provided by a lessor or lessee.

2. A period of time may be described in terms of the amount of use of an identified asset (for instance, number of production units that an item of an equipment will be used to produce).

Lease definition


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Identified asset A contract contains a lease only if it relates to an identified asset. An identified asset could be determined as follows:

An asset could be explicitly identified in a contract (for instance, fifth floor in a building) or implicitly specified at the time that the asset is made available for use by the customer.

An asset could be implicitly specified if the facts and circumstances indicate that the lessor can fulfil its obligations only by using a specific asset. For example, a power plant may be an implicitly specified asset in a power purchase contract if the customer’s facility is in remote location with no access to the grid, such that the customer cannot buy the required energy in the market or generate it from alternative power plants.

Portion of assets

A portion of an asset’s capacity could be an identified asset if:

• It is physically distinct (for instance, specified strand of a fibre optic cable) or

• It is not physically distinct but the customer has the right to obtain substantially all of the economic benefits from use of the asset (for instance, capacity portion of a fibre optic cable representing substantially all of the capacity of the cable).

No

Is the asset specified? (explicitly or implicitly)

Is the asset physically distinct or does the customer have the right to obtain

substantially all of the economic benefits from use of the asset?

Does the supplier has substantive substitution

rights?

Contract does not contain a lease

Yes

Yes

Yes

Contract does not contain a

lease

There is an identified

asset.

No

No

Source: KPMG IFRG publication ‘Lease definition’, April 2017

Example: Customer A enters into an agreement with supplier B for the right to store its gas in a specified storage tank that has no separate compartments. At inception of the contract, A has storage rights that permit it to use up to 60 per cent of the capacity of the storage tank throughout the term of the contract. B can use the other 40 per cent of the storage tank as it sees fit.

B has no substitution rights. However, the arrangement allows B to store gas from other customers in the same storage tank.

AnalysisIn the given case, there is no identified asset on account of the following reasons:• A only has rights to 60 per cent of the storage

tank’s capacity and that capacity portion is not physically distinct from remainder of the tank.

• A does not have the right to obtain substantially all of the economic benefits from use of the tank.

Modifying the example, if the storage tank has separate compartment specifically identified for A’s use and cannot be used by any other customer, then the arrangement includes an identified asset.

Storage rights of customer A - 60 per cent

Storage rights of other customers - 40 per cent



Lease accounting is changing — An insight with sectoral impacts | 65 | Lease accounting is changing — An insight with sectoral impacts

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Substantive substitution rightsEven if an asset is specified, a lessee would not have control over the use of an identified asset if the lessor has a substantive right to substitute the asset throughout the period of use.

A lessor’s substitution right is considered to be substantive if throughout the period of use, the lessor:

a. Has the practical ability to substitute the asset, and

b. Would benefit economically from exercising its right to substitute the asset.

Practical ability to substitute the asset throughout the

period of use?

Supplier benefits economically from

substitution?

No identified asset

Could be an identified

asset.Yes

Yes

No

No


Example: A coffee company (customer) enters into a contract with an airport operator (supplier) to use a space in the airport to sell its goods for a three-year period. The contract states the amount of space and that the space may be located at any one of several boarding areas within the airport. Supplier has the right to change the location of the space allocated to customer at any time during the period of use. There are minimal costs to supplier associated with changing the space for the customer: customer uses a kiosk (that it owns) that can be moved easily to sell its goods. There are many areas in the airport that are available and that would meet the specifications for the space in the contract.

AnalysisThe contract does not contain a lease. Although the amount of space customer uses is specified in the contract, there is no identified asset. Customer controls its owned kiosk. However, the contract is for space at the airport, and this space can change at the discretion of supplier. Supplier has the substantive right to substitute the space customer uses because:

a. Supplier has the practical ability to change the space used by customer throughout the period of use. There are many areas in the airport that meet the specifications for the space in the contract, and supplier has the right to change the location of the space to other space that meets the specifications at any time without customer’s approval.

b. Supplier would benefit economically from substituting the space. There would be minimal cost associated with changing the space used by customer because the kiosk can be moved easily. Supplier benefits from substituting the space in the airport because substitution allows supplier to make the most effective use of the space at boarding areas in the airport to meet changing circumstances.

Source: IFRS 16 issued by the IASB - Illustrative example 2


Example: Customer enters into a contract with a property owner (supplier) to use retail unit A for a five-year period. Retail unit A is part of a larger retail space with many retail units.

Customer is granted the right to use retail unit A. Supplier can require customer to relocate to another retail unit. In that case, supplier is required to provide customer with a retail unit of similar quality and specifications to retail unit A and to pay for customer’s relocation costs. Supplier would benefit economically from relocating customer only if a major new tenant were to decide to occupy a large amount of retail space at a rate sufficiently favourable to cover the costs of relocating customer and other tenants in the retail space. However, although it is possible that those circumstances may arise, but at inception of the contract, it is not likely that those circumstances will arise.

The contract requires customer to use retail unit A to operate its well-known store brand to sell its goods during the hours that the larger retail space is open. Customer makes all of the decisions about the use of the retail unit during the period of use. For example, customer decides on the mix of goods sold from the unit, the pricing of the goods sold and the quantities of inventory held. Customer also controls physical access to the unit throughout the five-year period of use.

The contract requires customer to make fixed payments to supplier as well as variable payments that are a percentage of sales from retail unit A.

Supplier provides cleaning and security services, as well as advertising services, as part of the contract.

AnalysisThe contract contains a lease of retail space. Customer has the right to use retail unit A for five years.

Retail unit A is an identified asset. It is explicitly specified in the contract. Supplier has the practical ability to substitute the retail unit, but could benefit economically from substitution only in specific circumstances. Supplier’s substitution right is not substantive because, at inception of the contract, those circumstances are not considered likely to arise.

Customer has the right to control the use of retail unit A throughout the five-year period of use because:

a. Customer has the right to obtain substantially all of the economic benefits from use of retail unit A over the five-year period of use. Customer has exclusive use of retail unit A throughout the period of use. Although a portion of the cash flows derived from sales from retail unit A will flow from customer to supplier, this represents consideration that customer pays supplier for the right to use the retail unit. It does not prevent customer from having the right to obtain substantially all of the economic benefits from use of retail unit A.

b. Customer has the right to direct the use of retail unit A because it meets the specified condition. The contractual restrictions on the goods that can be sold from retail unit A, and when retail unit A is open, define the scope of customer’s right-of-use retail unit A. Within the scope of its right-of-use defined in the contract, customer makes the relevant decisions about how and for what purpose retail unit A is used by being able to decide, for example, the mix of products that will be sold in the retail unit and the sale price for those products. Customer has the right to change these decisions during the five-year period of use.

Although cleaning, security, and advertising services are essential to the efficient use of retail unit A, supplier’s decisions in this regard do not give it the right to direct how and for what purpose retail unit A is used. Consequently, supplier does not control the use of retail unit A during the period of use and supplier’s decisions do not affect customer’s control of the use of retail unit A.

Source: IFRS 16 issued by IASB in January 2016, Illustrative example 4

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Right to control the use of an identified asset

A customer has the right to control the use of an identified asset, if it has:

a. Right to obtain economic benefits from use: A customer is required to have the right to obtain substantially all of the economic benefits from use of the asset throughout the period of use in order to control the use of an identified asset. Such an economic benefit could be obtained from the use of an asset directly or indirectly, such as by using, holding or sub-leasing the asset.

The economic benefits from use of an asset include its primary output and by-products (including potential cash flows derived from these items), and other economic benefits from using the asset that could be realised from a commercial transaction with a third party.

When assessing the right to obtain substantially all of the economic benefits from use of an asset, an entity should consider the economic benefits that result from use of the asset within the defined scope of a customer’s right to use the asset. For example:

i. If a contract limits the use of a motor vehicle to only one particular territory during the period of use, an entity shall consider only the economic benefits from use of the motor vehicle within that territory, and not beyond.

ii. If a contract specifies that a customer can drive a motor vehicle only up to a particular number of miles during the period of use, an entity shall consider only the economic benefits from use of the motor vehicle for the permitted mileage, and not beyond.

If a contract requires a customer to pay the supplier or another party a portion of the cash flows derived from use of an asset as consideration, those cash flows paid as consideration should be considered to be part of the economic benefits that the customer obtains from use of the asset. For example, if the customer is required to pay the supplier a percentage of sales from use of retail space as consideration for that use, that requirement does not prevent the customer from having the right to obtain substantially all of the economic benefits from use of the retail space. This is because the cash flows arising from those sales are considered to be economic benefits that the customer obtains from use of the retail space, a portion of which it then pays to the supplier as consideration for the right to use that space.

b. 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 it meets any of the given criteria:

i. The customer has the right to direct how and for what purpose the asset is used throughout the period of use.

While making this assessment, an entity considers the decision-making rights that are most relevant to changing how and for what purpose the asset is used throughout the period of use. Decision-making rights are relevant when they affect the economic benefits to be derived from use.

Examples of decision-making rights that, depending on the circumstances, grant the right to change how and for what purpose the asset is used include:

- Rights to change the type of output that is produced by the asset (for example, to decide whether to use a shipping container to transport goods or for storage, or to decide upon the mix of products sold from retail space)

- Rights to change when the output is produced (for example, to decide when an item of machinery or a power plant will be used)

- Rights to change where the output is produced (for example, to decide upon the destination of a truck or a ship, or to decide where an item of equipment is used) and

- Rights to change whether the output is produced, and the quantity of that output (for example, to decide whether to produce energy from a power plant and how much energy to produce from that power plant).

Examples of decision-making rights that do not grant the right to change how and for what purpose the asset is used include rights that are limited to operating or maintaining the asset. Such rights can be held by the customer or the supplier.


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ii. The relevant decisions about how and for what purpose the asset is used are predetermined and:

- The customer has the right to operate the asset (or to direct others to operate the asset in a manner that it determines) throughout the period of use, without the supplier having the right to change those operating instructions, or

- 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.

Example: A utility entity (customer) enters into a contract with a power entity (supplier) to purchase all of the electricity produced by a new solar farm for 20 years. The solar farm is explicitly specified in the contract and supplier has no substitution rights. The solar farm is owned by supplier and the energy cannot be provided to customer from another asset. Customer designed the solar farm before it was constructed - customer hired experts in solar energy to assist in determining the location of the farm and the engineering of the equipment to be used. Supplier is responsible for building the solar farm to customer’s specifications, and then operating and maintaining it. There are no decisions to be made about whether, when or how much electricity will be produced because the design of the asset has predetermined those decisions. Supplier will receive tax credits relating to the construction and ownership of the solar farm, while customer receives renewable energy credits that accrue from use of the solar farm.

AnalysisThe contract contains a lease. Customer has the right to use the solar farm for 20 years.

There is an identified asset because the solar farm is explicitly specified in the contract, and supplier does not have the right to substitute the specified solar farm.

Customer has the right to control the use of the solar farm throughout the 20-year period of use because:

a. Customer has the right to obtain substantially all of the economic benefits from use of the

solar farm over the 20-year period of use. Customer has exclusive use of the solar farm as it takes all of the electricity produced by the farm over the 20-year period of use as well as the renewable energy credits that are a by-product from use of the solar farm. Although supplier will receive economic benefits from the solar farm in the form of tax credits, those economic benefits relate to the ownership of the solar farm rather than the use of the solar farm and, thus, are not considered in this assessment.

b. Customer has the right to direct the use of the solar farm because it meets the specified conditions. Neither customer, nor supplier, decides how and for what purpose the solar farm is used during the period of use because those decisions are predetermined by the design of the asset (i.e. the design of the solar farm has, in effect, programmed into the asset any relevant decision-making rights about how and for what purpose the solar farm is used throughout the period of use). Customer does not operate the solar farm, supplier makes the decisions about the operation of the solar farm. However, customer’s design of the solar farm has given it the right to direct the use of the farm. Because the design of the solar farm has predetermined how and for what purpose the asset will be used throughout the period of use, customer’s control over that design is substantively no different from customer controlling those decisions.

Source: IFRS 16 issued by IASB in January 2016, Illustrative example 9A


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Example: Customer enters into a contract with a ship owner (supplier) for the transportation of cargo from Rotterdam to Sydney on a specified ship. The ship is explicitly specified in the contract and supplier does not have substitution rights. The cargo will occupy substantially all of the capacity of the ship. The contract specifies the cargo to be transported on the ship and the dates of pickup and delivery.

Supplier operates and maintains the ship and is responsible for the safe passage of the cargo on board the ship. Customer is prohibited from hiring another operator for the ship or operating the ship itself during the term of the contract.

AnalysisThe contract does not contain a lease.

There is an identified asset. The ship is explicitly specified in the contract and supplier does not have the right to substitute that specified ship.

Customer has the right to obtain substantially all of the economic benefits from use of the ship over

the period of use. Its cargo will occupy substantially all of the capacity of the ship, thereby preventing other parties from obtaining economic benefits from use of the ship.

However, customer does not have the right to control the use of the ship because it does not have the right to direct its use. Customer does not have the right to direct how and for what purpose the ship is used. How and for what purpose the ship will be used (i.e. the transportation of specified cargo from Rotterdam to Sydney within a specified timeframe) is predetermined in the contract. Customer has no right to change how and for what purpose the ship is used during the period of use. Customer has no other decision-making rights about the use of the ship during the period of use (for example, it does not have the right to operate the ship) and did not design the ship. Customer has the same rights regarding the use of ship as if it were one of many customers transporting cargo on the ship.

Source: IFRS 16 issued by the IASB in January 2016, Illustrative example 6

Protective rightsA contract may include terms and conditions designed to protect the supplier’s interest in the asset or other assets, to protect its personnel, or to ensure the supplier’s compliance with laws or regulations. For example, a contract may:

a. Specify the maximum amount of use of an asset or limit where or when the customer can use the asset

b. Require a customer to follow particular operating practices, or

c. Require a customer to inform the supplier of changes in how an asset will be used.

The new standard increases the focus on which party controls the use of an identified asset. Under Ind AS 17, an arrangement may be a lease when the customer obtains substantially all of the output or other utility of the asset even if the customer does not control the use of the asset. Under the new standard, a lease can exist if, and only if, the customer has the right to both control the use of an identified asset and obtain substantially all of the economic benefits from the use of that asset. This is in contrast to a further aspect of Ind AS 17 under which an arrangement is a lease when the customer has the right to control the use of an identified asset and obtains more than an insignificant amount of the output or other utility of the asset.

This is likely to mean that some agreements that are currently treated as leases may fall outside the new lease accounting.


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Example: A contract between a customer and a freight carrier (supplier) provides customer with the use of 10 rail cars of a particular type for five years. The contract specifies the rail cars; the cars are owned by supplier. Customer determines when, where and which goods are to be transported using the cars.

When the cars are not in use, they are kept at customer’s premises. Customer can use the cars for another purpose (for example, storage) if it so chooses. However, the contract specifies that customer cannot transport particular types of cargo (for example, explosives). If a particular car needs to be serviced or repaired, supplier is required to substitute a car of the same type. Otherwise, and other than on default by customer, supplier cannot retrieve the cars during the five-year period.

AnalysisThe contract contains leases of rail cars which are explicitly specified in the contract. Customer has the right to control the use of 10 rail cars throughout the period of five years because:

a. Customer has the right to obtain substantially all of the economic benefits from use of the cars over the five-year period of use. Customer has exclusive use of the cars throughout the period of use, including when they are not being used to transport customer’s goods.

b. Customer has the right to direct the use of the cars because it meets the specified conditions. The contractual restrictions on the cargo that can be transported by the cars are protective rights of supplier and define the scope of customer’s right to use the cars. Within the scope of its right of use defined in the contract, customer makes the relevant decisions about how and for what purpose the cars are used by being able to decide when and where the rail cars will be used and which goods are transported using the cars. Customer also determines whether and how the cars will be used when not being used to transport its goods (for example, whether and when they will be used for storage). Customer has the right to change these decisions during the five-year period of use.

Source: IFRS 16 issued by the IASB in January 2016, Illustrative example 1A

Lease definition – ExemptionsA lessee may elect not to apply the lessee accounting model to:

The election for short-term leases is made by class of underlying asset, whereas the election for leases of low-value assets can be made on a lease-by-lease basis.

If a lessee elects either of these recognition exemptions, then it recognises the related lease payments as an expense on either a straight-line basis over the lease term or another systematic basis if that basis is more representative of the pattern of the lessee’s benefit.

If a lessee elects the short-term recognition exemption and there are any changes to the lease term - e.g. the lessee exercises an option not previously included in its determination of the lease term - or the lease is modified, then the lessee accounts for the lease as a new lease.

A lessee should assess the value of an underlying asset based on the value of the asset when it is new, regardless of the age of the asset being leased.

The assessment of whether an underlying asset is of low value is performed on an absolute basis. Leases of low-value assets qualify for exemption under the new standard regardless of whether those leases are material to the lessee. The assessment is not affected by the size, nature or circumstances of the lessee.

Leases with a lease term of 12 months or less that do not contain a purchase option i.e. short term leases.

Leases for which the underlying asset is of low value when it is new – even if the effect is material in aggregate.


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Accordingly, different lessees are expected to reach the same conclusions about whether a particular underlying asset is of low value.

An underlying asset can be of low value only if:

a. The lessee can benefit from use of the underlying asset on its own or together with other resources that are readily available to the lessee and

b. The underlying asset is not highly dependent on, or highly interrelated with, other assets.

A lease of an underlying asset does not qualify as a lease of a low-value asset if the nature of the asset is such that, when new, the asset is typically not of low value. For example, leases of cars would not qualify as leases of low-value assets because a new car would typically not be of low value.

If a lessee subleases an asset, or expects to sublease an asset, the head lease does not qualify as a lease of a low-value asset.

Examples of low-value underlying assets can include tablet and personal computers, small items of office furniture and telephones.

Lease and non-lease componentsIf a contract is, or contains, a lease, then the entity is required to account for each lease component within the contract as lease separately from non-lease components of the contract.

The steps involved in the determination and accounting of non-lease components are as follows:

• Step 1 - Identification of a separate lease component: A lessee considers the right to use an underlying asset as a separate lease component if it meets both the following crtieria:

Separate lease

component

=

Lessee benefit from the use of underlying asset on

its own or together

with other resources that

are readily available

Asset is neither highly

dependent on, nor highly inter-related

with, the other assets in the

contract

+

Source: KPMG in India’s analysis, 2019

Fees for activities or costs that do not transfer goods or services to the lessee, for example, maintenance, utilities costs, etc. are considered non-lease components and need to be identified and excluded from the lease.

Charges for administrative tasks or other costs associated with the lease that do not transfer a good or service do not give rise to a separate component. However, they are part of the total consideration that the lessee allocates to the identified components.

• Step 2 - Accounting of the components: In a contract with a lease and one or more non-lease components, a lessee should allocate the consideration in the contract to each lease component on the basis of the relative stand-alone3 price of the lease component and the aggregate stand-alone price of the non-lease components.

As a practical expedient, the standard permits the lessee to elect, by class of the underlying asset, not to separate non-lease components from lease components, and instead account for each lease component and any associated non-lease components as a single lease component.

3. The relative stand-alone price of lease and non-lease components should be determined on the basis of the price the lessor or a similar supplier, would charge an entity for that component, or a similar component, separately.

If an observable stand-alone price is not readily available, the lessee should estimate the stand-alone price, maximising the use of observable information.


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Particulars Bulldozer Truck Long-reach excavator Total

Lease 170,000 102,000 224,000 496,000

Non-lease 104,000

Total fixed consideration 600,000

Example: Lessor leases a bulldozer, a truck and a long-reach excavator to lessee to be used in lessee’s mining operations for four years. Lessor also agrees to maintain each item of equipment throughout the lease term. The total consideration in the contract is INR600,000, payable in annual instalments of INR150,000, and a variable amount that depends on the hours of work performed in maintaining the long-reach excavator. The variable payment is capped at two per cent of the replacement cost of the long-reach excavator. The consideration includes the cost of maintenance services for each item of equipment.

AnalysisLessee accounts for the non-lease components (maintenance services) separately from each lease of equipment applying requirements of the new standard. Lessee does not elect the practical expedient of not to separate non-lease components from the lease components. Lessee considers the requirements of the new standard and concludes that the lease of the bulldozer, the lease of the truck and the lease of the long-reach excavator are each separate lease components. This is because:

a. Lessee can benefit from use of each of the three items of equipment on its own or together with other readily available resources (for example, lessee could readily lease or purchase an alternative truck or excavator to use in its operations) and

b. Although lessee is leasing all three items of equipment for one purpose (i.e. to engage in mining operations), the machines are neither highly dependent on, nor highly interrelated with, each other. Lessee’s ability to derive benefit from the lease of each item of equipment is not significantly affected by its decision to lease, or not lease, the other equipment from lessor.

Consequently, lessee concludes that there are three lease components and three non-lease components (maintenance services) in the contract. Lessee applies the guidance of the new standard to allocate the consideration in the contract to the three lease components and the non-lease components.

Several suppliers provide maintenance services for a similar bulldozer and a similar truck. Accordingly, there are observable stand-alone prices for the maintenance services for those two items of leased equipment. Lessee is able to establish observable stand-alone prices for the maintenance of the bulldozer and the truck of INR32,000 and INR16,000, respectively, assuming similar payment terms to those in the contract with lessor. The long-reach excavator is highly specialised and, accordingly, other suppliers do not lease or provide maintenance services for similar excavators.

Nonetheless, lessor provides four-year maintenance service contracts to customers that purchase similar long-reach excavators from lessor. The observable consideration for those four-year maintenance service contracts is a fixed amount of INR56,000, payable over four years, and a variable amount that depends on the hours of work performed in maintaining the long-reach excavator. That variable payment is capped at two per cent of the replacement cost of the long-reach excavator. Consequently, lessee estimates the stand-alone price of the maintenance services for the long-reach excavator to be INR56,000 plus any variable amounts. Lessee is able to establish observable stand-alone prices for the leases of the bulldozer, the truck and the long-reach excavator of INR170,000, INR102,000 and INR224,000, respectively.

Lessee allocates the fixed consideration in the contract (INR600,000) to the lease and non-lease components as follows:

Lessee allocates all of the variable consideration to the maintenance of the long-reach excavator, and, thus, to the non-lease components of the contract. Lessee then accounts for each lease

component applying the guidance in the new standard, treating the allocated consideration as the lease payments.

Source: IFRS 16 issued by IASB in January 2016, Illustrative example 12


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Asset

= ‘Right-of-use’ of underlying asset

Liability

= Obligation to make lease payments

Lease expense

Depreciation

+ Interest

= Front-loaded total lease expense

Balance sheet Profit/loss


The new standard introduces a single lease accounting model and requires a lessee to recognise assets and liabilities for all leases with a term of more than 12 months, unless the underlying asset is of low value on the balance sheet. A lessee would be required to recognise a right-of-use asset representing

its right to use the underlying leased asset and a lease liability representing its obligation to make lease payments. As a result, there is likely to be an increase in reported assets and liabilities by lessees, with resultant impacts on key financial ratios and compliance with existing debt covenants.

Accounting by lessee


Initial measurement of lease liability

A lessee would be required to measure the lease liability, initially, at the present value of the lease payments that are not paid at that date.

The lease payments would be discounted using the interest rate implicit in the lease, if that rate can be readily determined. If that rate cannot be readily determined, the lessee should use the lessee’s incremental borrowing rate.

Therefore, the key inputs to the calculation of lease liability are:

• Lease term: The lease term is the non-cancellable period of a lease for which a lessee has the right to use the underlying asset, together with both:

a. Periods covered by an option to extend the lease if the lessee is reasonably certain to exercise that option and

b. Periods covered by an option to terminate the lease if the lessee is reasonably certain not to exercise that option.

The lease term begins at the commencement date and includes any rent-free periods provided to the lessee by the lessor.

If only a lessee has the right to terminate a lease, that right is considered to be an option to terminate the lease available to the lessee that an entity considers when determining the lease term. If only a lessor has the right to terminate a lease, the non-cancellable period of the lease includes the period covered by the option to terminate the lease.

Lease liability = Present value of lease rentals

Present value of expected payments at

end of lease+


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Termination options held by the lessor only are not considered when determining the lease term because, in this situation, the lessee has an unconditional obligation to pay for the right-to-use the asset for the period of the lease, unless the lessor decides to terminate the lease.

A lessee is required to consider all relevant facts and circumstances that create an economic incentive to exercise or forfeit options to renew and terminate early. Some of the examples of relevant facts and circumstances are as follows:

a. Contractual terms and conditions for the optional periods compared with market rates, such as:

i. Amount of payments for the lease in any optional period

ii. Amount of any variable payments for the lease or other contingent payments, such as payments resulting from termination penalties and residual value guarantees and

iii. Terms and conditions of any options that are exercisable after initial optional periods (for example, a purchase option that is exercisable at the end of an extension period at a rate that is currently below market rates).

b. Significant leasehold improvements undertaken (or expected to be undertaken) over the term of the contract that are expected to have significant economic benefit for the lessee when the option to extend or terminate the lease, or to purchase the underlying asset, becomes exercisable

c. Costs relating to the termination of the lease, such as negotiation costs, relocation costs, costs of identifying another underlying asset suitable for the lessee’s needs, costs of integrating a new asset into the lessee’s operations, or termination penalties and similar costs, including costs associated with returning the underlying asset in a contractually specified condition or to a contractually specified location

d. The importance of that underlying asset to the lessee’s operations, considering, for example, whether the underlying asset is a specialised asset, the location of the underlying asset and the availability of suitable alternatives

e. Conditionality associated with exercising the option (i.e. when the option can be exercised only if one or more conditions are met), and the likelihood that those conditions will exist.

The shorter the non-cancellable period of a lease, the more likely a lessee is to exercise an option to extend the lease or not to exercise an option to terminate the lease. This is because the costs associated with obtaining a replacement asset are likely to be proportionately higher, the shorter the non-cancellable period.

A lessee should reassess whether it is reasonably certain to exercise an extension option, or not to exercise a termination option, upon the occurrence of either a significant event or a significant change in circumstances that:

a. Is within the control of the lessee and

b. Affects whether the lessee is reasonably certain to exercise an option not previously included in its determination of the lease term, or not to exercise an option previously included in its determination of the lease term.

Examples of significant events or changes in circumstances include the following:

a. Significant leasehold improvements not anticipated at the commencement date that are expected to have significant economic benefit for the lessee when the option to extend or terminate the lease, or to purchase the underlying asset, becomes exercisable

b. A significant modification to, or customisation of, the underlying asset that was not anticipated at the commencement date

c. The inception of a sub-lease of the underlying asset for a period beyond the end of the previously determined lease term and

d. A business decision of the lessee that is directly relevant to exercising, or not exercising, an option (for example, a decision to extend the lease of a complementary asset, to dispose of an alternative asset or to dispose of a business unit within which the right-of-use asset is employed).


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• Lease payments: The lease liability comprises the following payments relating to the right to use the underlying asset during the lease term:

a. Fixed payments (including in-substance fixed payments), less any lease incentives receivable

b. Variable lease payments that depend on an index or a rate as at the commencement date, for instance, payments linked to a consumer price index, payments linked to a benchmark interest rate (such as LIBOR) or payments that vary to reflect changes in market rental rates

c. Amounts expected to be payable by the lessee under residual value guarantees

d. The exercise price of a purchase option if the lessee is reasonably certain to exercise that option and

e. Payments of penalties for terminating the lease, if the lease term reflects the lessee exercising an option to terminate the lease.

In-substance fixed lease payments are payments that may, in form, contain variability but that, in substance, are unavoidable. In-substance fixed lease payments exist, for example, if:

a. Payments are structured as variable lease payments, but there is no genuine variability in those payments. Those payments contain variable clauses that do not have real economic substance.

b. There is more than one set of payments that a lessee could make, but only one of those sets of payments is realistic.

c. There is more than one realistic set of payments that a lessee could make, but it must make at least one of those sets of payments.

Example: Company W leases a production line. The lease payments depend on the number of operating hours of the production line i.e. W has to pay INR1,000 per hour of use. The annual minimum lease payment is INR1,000,000. The expected usage per year is 1,500 hours.

This lease contains in-substance fixed payments of INR1,000,000 per year, which are included in the initial measurement of the lease liability. The additional INR5,00,000 that W expects to pay per year are variable payments that do not depend on an index or rate and, therefore, are not included in the initial measurement of the lease liability but are to be expensed as the over-use occurs.


Subsequent measurement of lease liability

Measurement basis

After initial recognition, the lease liability is measured at amortised cost using the effective interest method.

Lease liability of an asset that is denominated in foreign currency is a monetary item. This liability would need to be translated at the closing exchange rate at each reporting date as per Ind AS 21, The Effects of Changes in Foreign Exchange Rates. However, the right-of-use asset would not be restated.

Reassessment of lease liability

A lessee is required to remeasure the lease liability by discounting the revised lease payments based on either unchanged discount rate or a revised rate depending upon the facts and circumstances of a case.

A revised discount rate would be used in the following cases:

a. There is a change in the lease term

b. There is a change in the assessment of an option to purchase the underlying asset

c. Future lease payments change as a result of a change in floating interest rates.

An unchanged discount rate would be used in following cases:

a. There is a change in the amounts expected to be payable under a residual value guarantee

b. There is a change in future lease payments resulting from a change in an index or a rate used to determine those payments, including for example a change to reflect changes in market rental rates following a market rent review. A lessee should determine the revised lease payments for the remainder of the lease term based on the revised contractual payments

c. The variability of payments is resolved so that they become in-substance fixed payments.

A lessee would recognise the amount of the remeasurement of the lease liability as an adjustment to the right-of-use asset. However, if the carrying amount of the right-of-use asset is reduced to zero and there is a further reduction in the measurement of the lease liability, then a lessee should recognise any remaining amount of the remeasurement in the statement of profit and loss.


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Initial measurement of the right-of-use asset

A lessee should measure the right-of-use asset at cost at the commencement of the lease. The cost of the right-of-use asset should comprise of the following:

a. Amount of the lease liability initially measured

b. Any lease payments made at or before the lease commencement date, less any lease incentives received

c. Any initial direct costs incurred by the lessee and

d. An estimate of costs to be incurred by the lessee in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the condition required by the terms and conditions of the lease, unless those costs are incurred to produce inventories (which are to be recognised as per Ind AS 2, Inventories).

These costs are to be recognised when the lessee incurs an obligation towards them.

Subsequent measurement of the right-of-use asset

A lessee would be required to subsequently measure right-of-use assets similar to other non-financial assets (such as property, plant and equipment) by applying a cost model4.Therefore, a lessee would measure right-to-use assets at cost less accumulated depreciation and accumulated impairment.

Impact on financial reporting

The new standard primarily impacts operating leases in the books of lessee. It has minimal impact on the lessor accounting. Essentially in an operating lease arrangement, the lessee would now be required to record the lease on the balance sheet as a right-of-use asset with the corresponding lease liability. Consequently, the erstwhile lease expense would be bifurcated as an amortisation of the right-of-use asset and interest expense on the liability. This is a significant change and has a direct positive bearing on the operating profits of the entities.

Refer the example given below.

Example:

Lease commencement date 1 January 2018

Lease payment INR1 million per month at the commencement

Lease escalation 10 per cent after every five years

Lock in period Three years

Discount rate 8.5 per cent (assumed)

Lease expiration date 31 December 2022 (Five years - primary period)

The lease would auto-renew after the primary period for five years i.e. up to 31 December 2027.

4. If right-of-use assets relate to a class of property, plant and equipment to which the lessee applies revaluation model in Ind AS 16, then a lessee may elect to apply that revaluation model to all the right-of-use assets that relate to that class of property, plant and equipment.


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82 82 82 82 82 82 82 82 82 82

70 65 61 56 50 44 37 29 20 10

0 20 40 60 80

100 120 140 160

1 2 3 4 5 6 7 8 9 10

En

tity

's e

xpen

ses

Year

Lease accounting - Profit or loss impact

Depreciation expenses under Ind AS 116 Interest expenses under Ind AS 116 Total expenses under Ind AS 17

Particulars InceptionYear

1Year

2Year

3Year

4Year

5Year

6Year

7Year

8Year

9Year 10

Total

Balance Sheet under Ind AS 17

Assets - - - - - - - - - -

Liabilities - - - - - - - - - -

Balance Sheet under Ind AS 116

Right-of-use asset 819 737 655 573 491 409 328 246 164 82 -

Lease liability (819) (768) (714) (654) (590) (520) (432) (337) (234) (122) -

Net equity - (31) (59) (81) (99) (111) (104) (91) (70) (40) -

Particulars InceptionYear

1Year

2Year

3Year

4Year

5Year

6Year

7Year

8Year

9Year 10

Total

Statement of profit and loss under Ind AS 17

Operating lease expenses (A)

126 126 126 126 126 126 126 126 126 126 1,260

Statement of profit and loss under Ind AS 116

Amortisation expenses 82 82 82 82 82 82 82 82 82 82 820

Interest expense 70 65 61 56 50 44 37 29 20 10 442

Total expense(B)

152 147 143 138 132 126 119 111 102 92 1,262

Difference (A-B)

(25) (21) (17) (12) (6) - 7 15 24 34 -

Impact on balance sheet and statement of profit and loss under Ind AS 17 and Ind AS 116

Impact on financial position and financial performance if lease term is considered as 10 years

Rental expenses under Ind AS 17



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To summarise, a lessee would now recognise:

• Depreciation expense on the right-of-use asset

• Interest expense on the lease liability

• Lease payments would be classified into a principal portion and an interest portion and would be required to be presented in the statement of cash flows applying Ind AS 7, Statement of Cash Flows.

Interest on the lease liability in each period during the lease term should be the amount that produces a constant periodic rate of interest on the remaining balance of the lease liability.

This is expected to result in a front-loaded pattern of expenses for most leases despite constant rentals.

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Accounting by lessor

A lessor would classify each of its leases either as an operating lease or a finance lease.

A lease is classified as a finance lease if it transfers substantially all the risks and rewards incidental to ownership of an underlying asset. A lease is classified as an operating lease if it does not transfer substantially all the risks and rewards incidental to ownership of an underlying asset.

The lease classification test is based on Ind AS 17 classification criteria.

Under Ind AS 17, lease income from operating leases (excluding amounts for services such as insurance and maintenance) should be recognised in income on a straight-line basis over the lease term, unless the payments to the lessor are structured to increase in line with expected general inflation to compensate for the lessor’s expected inflationary cost increases. If payments to the lessor vary according to factors other than inflation, then this condition is not met.

However, the new standard on leases does not include any exemption from recognising income on a straight-line basis over the lease term in relation to general inflation.

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Lease modification

A lease modification is a change in the scope of a lease, or the consideration for a lease, that was not part of the original terms and conditions of the lease (for instance, adding or terminating the right-to-use one or more underlying assets, or extending or shortening the contractual lease term).

Separate lease a. The modification increases the scope of the lease by adding the right to use one or more underlying assets, and

b. The consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope and any appropriate adjustments to that stand-alone price to reflect the circumstances of the particular contract.

Not a separate lease

A lease modification that is not a separate lease, at the effective date of lease modification, a lessee would:

a. Allocate the consideration in the modified contract

b. Determine the lease term of the modified lease

c. Remeasure the lease liability.

A lessee would remeasure the lease liability by discounting the revised lease payments using a revised discount rate5 and:

a. For lease modifications that decrease the scope of the lease: The lessee decreases the carrying amount of the right-of-use asset to reflect the partial or full termination of the lease.

Also, the lessee should recognise, in the statement of profit and loss, any gain or loss relating to the partial or full termination of the lease.

b. For other lease modifications: The lessee is required to make a corresponding adjustment to the right-of-use asset.

Lessee

A lessee should account for a lease modification as follows:

5. The revised discount rate is determined as the interest rate implicit in the lease for the remainder of the lease term, if that rate can be readily determined, or the lessee’s incremental borrowing rate at the effective date of the modification, if the interest rate implicit in the lease cannot be readily determined.


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Separate lease a. The modification increases the scope of the lease by adding the right-to-use one or more underlying assets, and

b. The consideration for the lease increases by an amount commensurate with the stand-alone price for the increase in scope and any appropriate adjustments to that stand-alone price to reflect the circumstances of the particular contract.

Not a separate lease

a. If the lease would have been classified as an operating lease had the modification been in effect at the inception date, the lessor should:

i. Account for the lease modification as a new lease from the effective date of the modification, and

ii. Measure the carrying amount of the underlying asset as the net investment in the original lease immediately before the effective date of the lease modification.

b. Otherwise, the lessor should apply the requirements of Ind AS 109, Financial Instruments.

Change to the contractual terms and conditions (excludes exercise of option included in original lease contract)

Increase in scope of lease by adding the right-of-use asset for one or

more underlying assets

At stand-alone price for increase

Separate lease Adjust right-of-use asset Adjust right-of-use asset/gain or loss

Not at stand-alone price

All other lease modifications

Decrease in the scope


Lessor

Finance lease

A lessor should account for a modification to a finance lease as follows:


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Operating lease

A lessor should account for a modification to an operating lease as a new lease from the effective date of the modification, considering any prepaid or accrued lease payments relating to the original lease as part of the lease payments for the new lease.

Change to the contractual terms and conditions (excludes exercise of option included in original lease contract)

Increase in scope of lease by adding the right-of-use asset

for one or more underlying assets

At stand-alone price for increase

Separate lease

All other contract modifications


Operating lease(at inception)

Finance lease (at inception)

Apply Ind AS 109

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Presentation in financial statementsLessee

• Balance sheet: A lessee should either present in the balance sheet, or disclose in the notes:

a. Right-of-use assets separately from other assets

b. Lease liabilities separately from other liabilities.

However, right-of-use assets that meet the definition of investment property should be presented as an investment property.

• Statement of profit and loss: Interest expense on the lease liability should be presented separately from the depreciation charge for the right-of-use asset. Interest expense on the lease liability is a component of finance costs.

• Statement of cash flows: A lessee should classify:

a. Cash payments for the principal portion of the lease liability within financing activities

b. Cash payments for the interest portion of the lease liability within financing activities, applying the requirements in Ind AS 7 for interest paid, and

c. Short-term lease payments, payments for leases of low-value assets and variable lease payments not included in the measurement of the lease liability within operating activities.

Lessor

The presentation in the financial statements would be as follows:

Finance lease Operating lease

Balance sheet

• Derecognise the underlying asset

• Recognise a finance lease receivable.

• Continue to present the underlying asset

• Add any initial direct costs incurred in connection with obtaining the lease to the carrying amount of the underlying asset.

Statement of profit and loss

• Recognise finance income on the receivable based on the effective interest method

In addition, manufacturer or dealer lessors recognise for finance leases:

• Revenue based on the lower of the fair value of the underlying asset and the present value of the lease payments

• Cost of sales based on cost or carrying amount of the underlying asset, less the present value of any unguaranteed residual value

• Costs incurred in connection with obtaining the lease as an expense.

• Recognise lease income over the lease term, typically on straight-line basis

• Expense costs related to underlying asset – e.g. depreciation.

Source: KPMG IFRG publication ‘First Impressions: IFRS 16, Leases, January 2016

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Disclosures

Lessee

A lessee would be required to disclose at least the following information:

Quantitative information

Relating to the balance sheet

• Additions to the right-of-use assets

• Carrying amount of right-of-use assets at the end of the reporting period by class of underlying asset

• Lease liabilities

• Maturity analysis for lease liabilities.

Relating to the statement of profit and loss and Other Comprehensive Income (OCI)

• Depreciation charge for right-of-use assets by class of underlying asset

• Interest expense on lease liabilities

• Expense relating to short-term leases for which the recognition exemption is applied

• Expense relating to leases of low-value assets for which the recognition exemption is applied

• Expense relating to variable lease payments not included in measurement of lease liabilities

• Income from subleasing right-of-use assets

• Gains or losses arising from sale-and-leaseback transactions.

Relating to the statement of cash flows

• Total cash outflow for leases.

Other

• Amount of short-term commitments if current sale-and-leaseback expense is not representative for the following year.

Qualitative disclosures

• Description of how liquidity risk related to lease liabilities is managed

• Use of exemption for short-term and/or low-value item leases

• Nature of the lessee’s leasing activities

• Future cash outflows to which the lessee is potentially exposed that are not reflected in the measurement of lease liabilities. This includes exposure arising from:

- Variable lease payments

- Extension options and termination options

- Residual value guarantees and

- Leases not yet commenced to which the lessee is committed

• Restrictions or covenants imposed by leases and

• Sale-and-leaseback transactions.

Disclosures

25 | Lease accounting is changing — An insight with sectoral impacts

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Lessor

A lessor would be required to disclose at least the following information:

A lessor should also disclose quantitative and qualitative information about its leasing activities such as:

• Nature of its leasing activities

• How it manages the risk associated with any

rights it retains in underlying assets. In particular, disclose, risk management strategy for the rights it retains in underlying assets, including any means by which the lessor reduces that risk.

Additional disclosures (when applicable)

• If right-of-use assets meet the definition of investment property, a lessee should apply the disclosure requirements specified in Ind AS 40, Investment Property.

• If the revaluation model of Ind AS 16, Property, Plant and Equipment is applied for right-of-use assets then:

- Effective date of the revaluation

- Whether an independent valuer was involved

- Carrying amount that would have been recognised had the assets been carried under the cost model and

- Revaluation surplus, indicating the change for the period and any restrictions on the distribution of the balance to shareholders.

Finance lease Operating lease

Quantitative information

• Selling profit or loss

• Finance income on the net investments in the lease

• Income relating to variable lease payments not included in the measurement of the net investment in the lease

• Significant changes in the carrying amount of the net investment in the lease

• Detailed maturity analysis of the lease payments receivable.

• Lease income relating to variable lease payments that do not depend on an index or a rate

• Other lease income

• Detailed maturity analysis of lease payments receivables

• If applicable, disclosures in accordance with Ind AS 16 (separately from other assets), Ind AS 36, Impairment of Assets, Ind AS 38, and Ind AS 41.

Qualitative information

• Significant changes in the carrying amount of the net investment in the lease.

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Transition

The standard is expected to be effective for annual reporting periods beginning on or after 1 April 2019.

Lease definition

On transition, the new standard permits a company to:

a. Apply the new definition of lease to contracts that were previously identified as leases (as per Ind AS 17)

b. Not to apply the definition to the contracts that were not previously identified as containing a lease (as per Ind AS 17).

Approach 31 March 2019 31 March 2020 Date of equity adjustment

Full retrospective (no practical expedients)

Ind AS 116

Modified retrospective (with practical expedients)

Ind AS 116

Ind AS 116*

Ind AS 17*

Ind AS 17*

1 April 2018

1 April 2019


(*The company will apply Ind AS 17 in preparing its financial statements for 31 March 2019. It will then apply Ind AS 116 to prepare comparative financial information to be included in its 2019-20 financial statements.)

Transition options

The new standard provides two optional approaches to transition. They are as follows:

a. Full retrospective approach: Under this approach, the lessee applies the new standard retrospectively in accordance with Ind AS 8, Accounting Policies, Changes in Accounting Estimates and Errors. For this purpose, the lessee:

- Applies the new standard to all leases in which it is a lessee

- Applies the standard retrospectively to each prior period presented

- Recognises an adjustment in equity at the beginning of the earliest period presented and

- Makes the disclosures required by Ind AS 8 on a change in accounting policy.

27 | Lease accounting is changing — An insight with sectoral impacts

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b. Modified retrospective approach: Under this approach, a lessee applies the new standard from the beginning of the current period. For this purpose, the lessee:

- Calculates lease assets and lease liabilities as at the beginning of the current period

- Does not restate its prior period financial information

- Recognises an adjustment in equity at the beginning of the current period and

- Makes additional disclosures specified in the standard.

A modified retrospective approach would be applied as follows:

Right-of-use asset

As if Ind AS 116 had always applied or based on lease

liability

Lease liability

Present value of remaining lease

payments

Right-of-use asset

Previous carrying amount of finance

lease asset

Lease liability

Previous carrying amount of finance

lease liability

Source: KPMG IFRG publication ‘Leases transition options – What is the best option for your business?, November 2018

Finance leaseOperating lease

A lessee is required to apply the election (out of the two approaches) consistently to all of its leases in which it is a lessee.

In case of leases previously classified as operating leases, a lessee could apply the following practical expedients on a lease-by-lease basis:

– Apply a single discount rate to a portfolio of leases with reasonably similar characteristics (such as leases with a similar remaining lease term for a similar class of underlying asset in a similar economic environment).

– Rely on its assessment of whether leases are onerous applying Ind AS 37, Provisions, Contingent Liabilities and Contingent Assets, immediately before the date of initial application as an

alternative to performing an impairment review. If a lessee chooses this practical expedient, the lessee should adjust the right-of-use asset at the date of initial application by the amount of any provision for onerous leases recognised in the balance sheet immediately before the date of initial application.

– Account for leases for which the lease term ends within 12 months of the date of initial application as short-term leases.

– Exclude initial direct costs from the measurement of the right-of-use asset at the date of initial application.

– Use hindsight, such as in determining the lease term if the contract contains options to extend or terminate the lease.

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Others

Sale-and-leaseback transactions: ED of Ind AS 116 contains specific guidance on accounting of a sale-and-leaseback transaction. In a sale-and-leaseback transaction, an entity (the seller-lessee) transfers an underlying asset to another entity (the buyer-lessor) and leases that asset back from the buyer-lessor. In such a transaction, the seller is initially required to determine whether such a transfer is a sale under Ind AS 115. Accordingly, it would be accounted for as follows:

Sub-leases: Under a sub-lease transaction, a lessee grants right-to-use the underlying asset to a third party, and the lease (head lease) between the original lessor and lessee remains in effect. The intermediate lessor (lessee in the head lease) accounts for the head lease and the sub-lease as two different contracts.

An intermediate lessor classifies the sub-lease as a finance lease or as an operating lease with reference to the right-of-use asset arising from the head lease, and not the item of property, plant and equipment that it leases from the head lessor.

In a sub-lease, the intermediate lessor treats the right-of-use asset as the underlying asset and not the item of property, plant and equipment that it leases from the lessor (in the head lease).

In case, the head lease has been exempted from recognition as lease on account of being short-term in

nature, then the sub-lease has to be accounted as an operating lease by the intermediate lessor.

In case of a sub-lease classified as a finance lease, at the commencement date, the intermediate lessor will account the sub-lease transaction as follows:

• Derecognise the right-of-use asset relating to the head lease and recognise the net investment in the sub-lease

• Recognise any difference between the carrying amounts of the right-of-use asset and the net investment in the sub-lease in the statement of profit and loss and

• Continues to recognise the lease liability relating to the head lease which represents the lease payments owed to the lessor (in the head lease).

Particulars Lessee (seller) Lessor (buyer)

Transfer to buyer-lessor is a sale

• Derecognise the underlying asset and apply the lease accounting model to the leaseback*

• Measure the right-to-use asset at the retained portion of the previous carrying amount (i.e. at cost)*

• Recognise the gain or loss related to the rights transferred to the lessor*.

• Recognise the underlying asset and apply the lessor accounting model to the leaseback*.

Transfer to buyer-lessor is not a sale

• Continue to recognise the underlying asset

• Recognise a financial liability under Ind AS 109 for any amount received from the buyer-lessor.

• Do not recognise the underlying asset

• Recognise a financial asset under Ind AS 109 for any amount paid to the lessee.

(*Adjustments are required if sale is not at fair value or lease payments are off-market.)


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Potential sector impacts

Property leases

Real estate leases are varied in nature and generally comprise lease of land, building, or both and could also include lease of premises with interiors and furnishings (fully furnished leases). Accordingly, various types of properties in real estate lease based on the use can be broadly categorised as:

• Lease of commercial or office space

• Lease of retail or warehouse space

• Lease of residential premises

• Lease of hotel rooms or service apartments

• Lease of car parking space.

The components of a leasing arrangement in a real estate sector generally include rent payments for lease of land, building, interiors and furnishings, payments towards maintenance, common area costs and utilities. Further, the lease rent charged can be fixed in nature, variable, or variable subject

to minimum guarantee payment. The variable components are normally linked to revenue or profits earned by tenants.

Real estate leases, generally pose many practical accounting challenges for lessees - the underlying asset has a high value, lease terms can be long, discount rates can be complex to determine, the leases often contain multiple options and rent adjustment mechanisms, and the contracts may contain lease and non-lease components.

Following are the key considerations while leasing real estate:

• Identification of a lease arrangement: A lessee will need to identify various leasing arrangements, and evaluate applicability under the new standard. While applying the lease definition to real estate arrangements, key factors to consider are as follows:

Criteria Evaluation of criteria in property leases

Specified asset Most real estate leases will meet this criteria as the address or particular component of a property (for instance, numbered floors of a building or units in a shopping mall) are generally identified in an agreement of such leases.

Capacity portions A lessee is required to identify whether it has exclusive use of the leased asset or a defined portion of that property is physically distinct (for instance, floor of a building).

For example, entity A has taken two floors in a commercial building on lease and has been allotted 10 parking spots along with the lease. The area for parking is identified, though this can be modified by the owner based on the availability at the premises. The 10 parking spots approximate 25 per cent of the total car parking spots (i.e. 40 parking spots in the given case).

Since the assets in the given case - two floors and car parking spots are physically distinct and can be used independently of each other, these will be evaluated separately. Whilst the floors are identified, the spots in car park are not identified assets. The 10 parking spots represent part of the capacity of the total car parking area, and not substantially all of the capacity. Further, the owners’ right of substitution could be substantive in the given case. The lessee will need to evaluate whether it obtains substantially all of the economic benefits from use of the 10 parking spots and also who has the right to direct the use of them to determine whether the arrangement will meet the criterion for lease.

Substantive substitution rights

Evaluate whether the lessor have any substantive substitution rights with respect to the leased asset, for instance, the lessor may relocate the lessee to another place during the lease term.


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Substantial economic benefits

Assessment is required as to whether the lessee is getting all the benefits from the property under lease. This will hold good under sub-lease as well.

Right to direct the use of asset

Evaluate whether the lessee possesses the right to direct the use of the leased asset. It may be noted that the requirement to follow a particular operating practice or to use the property for the agreed purpose, could be protective right in nature. However, the nature of the property need to be evaluated.

• Separating components of a contract: In practice, a lease may contain one or more lease components such as right to use the land and building and one or more non-lease components, such as charges for administrative tasks (cleaning, maintenance, etc.) or other costs associated with the lease. A lessee is required to account for each lease component, separately from non-lease components.

Fees for activities or costs that do not transfer goods or services to the lessee, for example, maintenance, utilities costs, etc. are considered non-lease components and need to be identified and excluded from the lease.

Charges for administrative tasks or other costs associated with the lease that do not transfer a good or service do not give rise to a separate component. However, they are part of the total consideration that the lessee allocates to the identified components.

Adoption of practical expedient to not to separate the non-lease components from the lease component is expected to have a significant accounting impact, for instance, lessee may end up recognising a liability for a service contract which would have otherwise remained off-balance sheet. Similarly, it may also impact the presentation in the statement of profit and loss and key ratios. For instance, if a lessee accounts for CAM as part of lease liability instead of recognising as an expense, then the recognition of resultant depreciation and interest expense will increase the amount of Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA).

• Assessment of lease term: Determination of lease term is a key judgement area which requires careful consideration of the options and facts and circumstances surrounding each lease. Some of the relevant facts and circumstances to be considered by a lessee in a real estate are as following:

a. Level of rentals in any secondary period compared with market rates

b. Contingent payments

c. Renewal and purchase options

d. Cost relating to termination of the lease and the signing of a new replacement lease

e. Existence of significant leasehold improvements.

Additionally, a lessee is required to reassess the lease term if lessee opts to renew its lease. For instance, at the commencement of the lease, lessee determines that the lease term was non-cancellable period of five years, considering that it was not reasonably certain to exercise the renewal option for an additional five years. However, at the end of the fourth year, the lessee exercised the renewal option for an additional five years by formal notification to the lessor. In that case, lessee has to revise the lease term to six years to reflect the new non-cancellable period. Also, it will be required to remeasure the lease liability and make corresponding adjustment to the right-of-use asset on the basis of the revised discount rate.

Example: Lessee A enters into an agreement for lease of premises from lessor B for an annual rent of INR50 per square feet for a term of five years. The contract includes charges for Common Area Maintenance (CAM) of INR5 per square feet and charges for recoveries of water and electricity based on actual consumption. If lessee A elects to use the practical expedient of not separating the non-lease component of CAM charges and utilities of water and electricity, the lease is accounted as a single lease component. The fixed charges of CAM would be included for determining the lease liability, and the payments for water and electricity will be excluded since these are variable in nature and cannot be determined at inception. Water and electricity charges will be recognised in the statement of profit and loss as and when incurred.

If lessee A does not elect the practical expedient, then the payments towards CAM and water and electricity, would be recognised in the statement of profit and loss as operating expenses, as and when incurred.



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• Determination of discount rates: In order to determine the rate implicit in the lease, a lessee is required to have at least the following information:

a. Unguaranteed residual value

b. Fair value of the underlying asset

c. Any initial direct costs to the lessor.

In the absence of such information, a lessee may be unable to determine the implicit rate in the lease and will have to use its incremental borrowing rate.

Due to the nature of the property in a real estate lease, the assets generally have a high significant residual value. Further, in case of leases of land, the lease term generally, tends to be long i.e. multiple decades or 99 years and so on. These characteristics make it difficult for lessees to determine an appropriate discount rate.

For leases of property, a property yield could be used as an input while determining the incremental borrowing rate. Property yields reflect the annual return expected on a property. They may be quoted before or after expenses (gross or net yield) and are a function of numerous factors, including but not limited to:

a. The market rental rates for the type of property

b. Expectations about growth (e.g. a low property yield is often associated with higher rental growth expectations)

c. Expectations about renovation costs and

d. Expectations about the risks associated with the property’s value.

These factors indicate that property yields are specific to a particular property. However, property yields do not consider company-specific features that would affect the lessee’s incremental borrowing rate. Therefore, certain adjustments to the property yield would be required to determine the lessee’s incremental borrowing rate. These are length of the lease, lessee’s credit rating vis-à-vis average market ratings of tenants, expectations about risks associated with the property’s value that are not related to the lessee’s performance and others.

• Lease payments including variable payments: Certain real estate leases, e.g. lease of retail premises comprise of a fixed lease rent, variable lease rent or a combination of both. In cases where the variability of the lease payments is subsequently resolved, then such payments will be considered as in-substance fixed payments and will be included in the initial measurement of right-of-use asset and lease liability.

Example: Entity R, an established retailer, leases space for a store in a mature retail development from entity Q. Under the terms of the lease, R is required operate the store during normal working hours. R is not permitted to leave the store vacant or to sub-let it.

The contract states that the annual rentals payable by R will be:

• INR100 if R makes no sales at the store or

• INR1 million if R makes any sales at the store during the term of the lease.

R concludes that the lease contains an in-substance fixed lease payments of INR1 million per annum. R notes that this amount is not a variable payment that depends on sales. This is because there is no realistic possibility that R will make no sales at the store.

Source: KPMG IFRG publication ‘Real estate leases - The tenant perspective’, October 2018

• Impact of the new leases standard on various laws and regulations: Certain lease contracts may be structured based on the applicable laws and regulations or the business practices followed. Due to the new standard, entities may revisit the transactions and contract terms, due to which departments beyond financial reporting such as tax, legal, etc. are likely to be impacted.


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Transport, logistics and leisure

The key sub-sectors in the transport, logistics and leisure sector are aviation, hotel and shipping with large lease portfolios.

Following are the key considerations for the transport, logistics and leisure sector:

• Identification of a lease: An entity’s evaluation of whether a supplier’s substitution right is substantive

should be based on facts and circumstances at the inception of the contract and should exclude consideration of future events that, at inception of the contract, are not considered likely to occur.

Example: An entity A, a logistics service provider enters into a two years contract with entity B (an e-commerce entity). As per the terms of the contract, entity B will use entity A’s space (2,500 square meters) as warehouse to store its products.

Entity A’s warehouse is spread over 30,000 square meters. It has the right to change the location of the space allocated to entity B at any point of time and the cost to shift is minimal.

AnalysisIn the present case, the space allocated to entity B is not identified and can be changed by entity A anytime. Therefore, entity A also has a substantive

right to substitute the space, because entity A has the practical ability to substitute the asset and would also benefit economically from exercising the said rights (as higher rentals could be obtained from other party). Therefore, the contract between entity A and entity B does not contain a lease.

On the other hand, if in the given case, the space allotted to entity B was fixed and identified for the term of the lease, then there would be an identified asset which needs to be evaluated further for any substantive substitution right with the lessor.

Example: Entity A is an aviation entity operating in domestic and international routes. They have taken certain identified aircrafts on lease from entity C (an aircraft lessor). The aircrafts can be operated anywhere - domestic and international. Also, entity A can sub-lease the aircrafts to any other airline.

Based on its route planning, entity A decides to sub-lease some of its aircrafts to entity B (another operating airline). The said sub-lease agreement contains certain restrictions, in terms of:

a. Additional cargo limit (only 20 kilograms per passenger) and no commercial cargo

b. Allowed to operate only on the specified routes between two tier city (as mentioned in the agreement)

c. No modification to the fleet (except painting of the logo on the outer body) and

d. Further sub-leasing of the agreement is restricted.

AnalysisIn the given example, there are two contracts. The first contract between entity A and C is likely to be classified as a lease contract, as entity A decides which passengers to be transported, which route the aircraft would be operated and it controls how the aircraft would be operated.

With regard to the second sub-lease contract between entity A and B, there are restrictions on free usage/operations of the fleet. Entity B would need to evaluate if the restrictions are protective in nature and the arrangement provides it decision making rights of ‘how and for what’ purpose regarding the usage of the fleet. If entity B has right to direct the use of the fleet and entity A’s rights are protective in nature, then the arrangement between entity A and B would be accounted as a lease.



a. Right to obtain economic benefits from use: While assessing whether a contract conveys a right to control the use of an identified asset, the lessee is required to determine whether it has a right to obtain substantially all of the economic benefits from the use of the asset throughout the period of use and also has a right to direct the use of the identified asset.

Such an economic benefit could be obtained from the use of an asset directly or indirectly, such as by using, holding or sub-leasing the asset. These economic benefits need to be defined in the scope of the lessee’s right to use an asset.


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b. Right to direct the use of an asset: The new standard lays emphasis on which party controls the use of an identified asset. While determining the right to use an asset, at times, it becomes imperative to read the contract for any protective rights. A contract may include certain terms and conditions designed to protect the lessor’s interest

in the identified asset, to protect its personnel or to ensure the lessor’s compliance with laws and regulations. Such protective rights typically define the scope of the lessee’s right to use an asset but do not, in isolation, prevent the lessee from having the right to direct the use of the asset within that scope.

• Determination of lease term: Determination of lease term involves considerable amount of judgement, therefore, an entity needs to reassess

its judgement and if required, need to re-measure the lease term, on occurrence of significant event or significant change in circumstances.

Example: A customer X enters into a four year contract with a shipping entity Y, for use of an identified ship. Subject to certain restrictions specified in the contract, X decides what shipment will be transported and to which ports the ship will sail throughout the four year period. The contract prohibits the ship from sailing into waters at a high risk of piracy or/and carrying explosive materials as cargo. Shipping entity Y operates and maintains the ship, and is responsible for safe sailing of cargo to destinations.

AnalysisIn the given case, customer X has the right to direct

the use of the ship. The aforementioned contractual restrictions are protective rights that protect company Y’s investment in the ship. In the scope of its right to use, customer X determines how and for what purpose the ship will be used throughout the term of four years, because it decides when, where and how much cargo will be transported through the use of ship. Customer X has the right to change these decisions throughout the period of use. Therefore, it can be concluded that the contract contains a lease.



Example: Hotel Alpha enters into a non-cancellable lease contract with landlord Beta to lease a building for construction of a hotel unit (beach property). The lease has been entered for 25 years initially, and Hotel Alpha has the option to extend the lease by another 25 years at the rental escalation of 7.5 per cent per annum. While determining the lease term, Hotel Alpha considers the following factors:

a. The location of the hotel unit is ideal for tourism given its proximity to beaches and upcoming airport (which is 10 kilometers)

b. Hotel Alpha has already incurred significant amount in construction of a luxurious property (including leasehold improvements) on the land

c. Market rentals for a comparable building unit in the same area are expected to increase by 10 per cent over the 50 years period covered by the lease. At inception of the lease, lease rentals are in accordance with the current market rents.

In view of the above, Hotel Alpha concludes that it has a significant economic incentive to extend the lease. Therefore, for the purpose of accounting of the lease, Hotel Alpha will use a lease term of 50 years.


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• Lease payments: A lessee may include the following payments in the measurement of lease liability:

a. Fixed payments less any lease incentives receivables

b. Variable lease payments (i.e. payments that depend on an index such as Consumer Price Index (CPI) or a rate)

c. Payments for early termination of the lease

d. Payments for non-lease components (if practical expedient to separate it from lease component has not been opted).

Determination of lease payments could be another area of concern in certain situations. The following example will help understand the application of new requirements in a given scenario:

AnalysisIn all the three cases, there is a specified asset i.e. hotel building and surrounding open land, whose right to use is conveyed to the lessee under the lease contract.

Lease I: The term of the lease is more than 12 months, hence, the lease contract would be eligible to be qualified as a lease under the new standard, in the books of lessee.

The entity considers a period of lease as 66 years since it has the option to renew the lease term for further period of 33 years and also, it is reasonably certain, at the inception of the lease, that it would exercise the option of extending the lease.

The lessee is required to compute the present value of the lease payments over 66 years using interest rate implicit in the lease or its incremental borrowing rate. Also, it will be required to recognise a right-of-use asset with a corresponding lease liability.

The future lease payments would change due to change in CPI. The initial measurement of the

lease liability is based on the value of the CPI on lease commencement. If during the first year, the lease liability increases (say 5 per cent), then at the end of the first year, the lease liability is recalculated assuming future annual rentals. The lessee would need to consider the resulting impact of change in CPI in the calculation of lease liability in the future periods.

Lease II: The entity measures the right-of-use asset at the minimum lease rental, i.e. INR4 lakh per month, over the period of the lease, i.e. 33 years. This is because the variable lease payments that depend on an index or a rate are included in the initial lease liability. Other variable payments – e.g. payments based on revenues or usage are recognised in the statement of profit and loss during the period in which event or condition (triggers those payments) occurs.

Lease III: Since the lease payments are variable and not based on any index, the lease liability is measured as zero. The lease payment would be recognised in the statement of profit and loss as lease rent as the revenue of each month is determined.


Facts Lease I Lease II Lease III

Asset Hotel building and surrounding open land

Hotel building and surrounding open land

Hotel building and surrounding open land

Date of lease agreement

1 April 2019 1 June 2019 1 September 2019

Term of lease 33 years extendable for another 33 years at the

option of lessee

33 years 99 years

Lease payment Monthly lease payments of INR5

lakh at the end of the month. The rent will be reviewed every year and increased by the change

in the CPI index.

2 per cent of the gross revenues per month or INR4 lakh, whichever is

higher.

2.5 per cent of the gross revenues per month.

Other terms No option to buy the assets at the end of

lease term.

No option to buy the assets at the end of

lease term.

No option to buy the assets at the end of lease term.

Example:


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• Separating the components of a contract - lease and non-lease component: In transport and logistics sector, separation of non-lease components from lease could pose significant challenge.

Example: An entity A, a logistics entity has entered into a five year lease contract with entity B (e-commerce operating company) for using the warehouse facility situated in Bhiwandi.

The contract includes provision of delivery of the products along with sorting by destination. Annual payment is INR100,000 (including INR15,000 for transportation/delivery service and INR500 for insurance costs). Entity B determines that provisions of similar services by third parties amounts to INR16,500 (delivery service) and INR500 (insurance), respectively. However, there is no observable stand-alone rental amount for lease of warehouse rentals, because it is not available for lease without related transportation services.

AnalysisIn the given case, entity A would be required to allocate INR83,000 (i.e. INR100,000 rental less INR16,500 transportation and 500 towards insurance) to the lease component on account of the following reasons:

a. The observable stand-alone price for transportation/delivery service is INR16,500

b. There is no observable stand-alone rent for the warehouse

c. The insurance cost does not transfer a good or service to the lessee and therefore, it is not a separate lease component.

Source: KPMG IFRG Limited ‘First Impressions: IFRS 16, Leases, January 2016

• Overhauling provision: Aviation entities may have an obligation to incur overhaul costs during the period of lease. The new standard requires that the estimated cost of overhaul of an aircraft should be measured in accordance with Ind AS 37 and capitalised as part of the right-of-use asset on the lease commencement date.

• Sale-and-leaseback: In a sale-and-leaseback transaction in the aviation sector, generally three parties are involved - the airline manufacturer, aviation entity and financing entity. The aviation entity generally sells its right to purchase (assignment right) the aircraft to the financing entity who in turn pays the airline manufacturer for the aircraft and leases back the aircraft to the aviation entity. Under Ind AS 17, these transactions resulted in a gain or loss in the books of the aviation entity, and were accounted as a lease (either operating or financing - depending on the facts of each case).

Under the new standard, the aviation entity would need to carefully evaluate its sale-and-leaseback arrangements for the aircrafts with the financing entity to assess whether sale of the assignment right meets the conditions of transfer of control under Ind AS 115.

In the situations where the sale of the assignment right does not meet the conditions of transfer of control under Ind AS 115, then the aviation entity would need to account for the aircraft as its property, plant and equipment under Ind AS 16 and its liability to pay to the financing entity under Ind AS 109.

If the sale does meet the conditions of Ind AS 115, then under the new lease standard the computation of gain/loss on sale-and-leaseback would require adjustment if the transaction is not at fair value or lease payments are off-market.

• Impact of foreign currency on re-measurement of lease liability: In the aviation sector, airlines rely heavily on leased aircrafts. Under the new standard, such aircrafts are likely to meet the lease criteria and would be recognised on the balance sheet of the airline entity along with the related lease liability. The lease liability of the aircraft that is denominated in foreign currency is a monetary item. This liability would need to be translated at the closing exchange rate at each reporting date as per Ind AS 21, The Effects of Changes in Foreign Exchange Rates. However, the right-of-use asset would not be restated. This will potentially create significant volatility in the statement of profit and loss.


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Automotive

The players in the automotive sector are generally the Original Equipment Manufacturers (OEMs) and component manufacturers/supplier units (who engage in production of components, parts and ancillary products used in vehicles and dealer network).

With leasing being one of the most common way for companies across industries, including the automotive industry to gain access to finance and to property, plant and equipment, the impact of applying the new leases standard is likely to be significant for certain players in the sector.

Following are the key considerations for the automotive sector:

• Leases of land: Many entities in the automotive industry in India, especially OEMs perform their operations such as manufacturing and assembling of products on leasehold lands provided by the respective state government/government agency. These agreements are, in general, for long duration (for instance, 99 years) and non-cancellable with significant up-front payment and little or no lease rentals throughout the lease term. Such agreements also typically carry renewal options at the end of the lease term. Currently, these arrangements are classified as operating leases or finance leases depending on the nature of the operations carried out and transfer of significant risks and rewards to the lessees.

Under the new standard, land is an identified asset which has to be further evaluated to determine as to who has the right to control it. For such a purpose, the OEM is required to determine whether it has the right to direct ‘how and for what’ purpose the asset is used throughout the period of use. If the OEM has the right to direct the use of the leasehold land, then it would be required to recognise land as a right-to-use asset with a corresponding lease liability in its balance sheet.

• Leases of real estate: Entities in the automotive sector also take real estates on lease such as office buildings, warehouses, etc. Such leases are generally for short duration (less than 10 years) with non-cancellable lease periods for initial few years. Therefore, many of these leases are classified as operating leases under Ind AS 17.

Under the new standard, such arrangements would qualify as a lease and would be on the balance sheet of the automobile entities.

• Leases of vehicles: Many automobile entities are located in the outskirts of main city, and they generally provide transportation facility to their employees. For this purpose, buses, cars, etc. are taken by entities on lease. Agreements with the transport provider are for short period and are generally non-cancellable. The terms of the agreements specifically identify the mode of transportation required (for instance, bus), the model of the bus and at times, requires the providers to carry the logos and name of the OEMs.

While assessing whether such arrangements meet the definition of a lease, the key area of interpretation would be to determine the lessor’s substantive substitution rights. Since the vehicles carry the logos and OEM’s name, etc., it can be reasonably concluded that there would not be a substantive substitution right as replacing one vehicle with another would not be economically feasible for the provider of these buses. Also, the OEMs determine how to run the vehicles and for what purposes. Therefore, it can be concluded that the OEMs have a right to direct the use of the asset in such circumstances. Accordingly, such arrangements would typically result in recognition of a right-to-use asset on the balance sheet with a corresponding liability, unlike the current accounting, where such leases are classified as operating leases.

Automotive entities also enter into agreements with logistic service providers to provide vehicles for transportation of the entity’s finished products. The agreements with such service providers require them to supply the automotive entity’s with vehicles of a particular make and specification as and when demanded by the OEMs, to transport specified quantity of goods. Unlike the buses in the above example, the logistic service providers generally have a practical ability to substitute the asset throughout the period of use, as they can provide an alternative vehicle of similar make and specifications from a fleet of similar vehicles available with them with no or minimal cost. Accordingly, in such cases, there will not be an identified asset. Therefore, such arrangements will not meet the definition of a lease, rather they would be accounted as a service contract.


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• Component manufacturers: In the automotive sector, the agreement between an OEM and a component manufacturer also have to be evaluated to consider whether it meets the definition of a lease under the new requirements. In such arrangements, the fulfilment of the contract is dependent on the use of the specified assets. Also, an OEM generally takes substantially all of the output produced by the component manufacturer. However, the key factor to evaluate is who has the right to direct the use of the identified asset i.e. the contract manufacturer or the OEM.

How and for what purpose decisions may include decisions regarding how much quantity to produce, when to produce the output and the mix of products to produce. The new standard lays focus on the party that controls the use of an identified asset. Under current guidance, an arrangement may be a lease when the customer obtains substantially all of the output or other utility of the asset even if the customer does not control the use of the asset. Under the new standard, a lease can exist if, and only if, the customer has the right to both control the use of an identified asset and obtain substantially all of the economic benefits from the use of that asset.

Therefore, an OEM and a contract manufacturer should evaluate their contract carefully.

• Tools and moulds: Component manufacturers also enter into agreements with OEMs to develop and manufacture tools/moulds that are used for

manufacturing parts that are supplied to the OEM. The tools/moulds so developed are specific to the OEM and cannot be used for other purposes.

Further, the terms of agreements generally provide that tooling can be purchased by the OEM at any point in time. In such arrangements, the tools/moulds represent the identified asset since they are custom built for the OEM and for use in production and supply of parts to the OEM. The OEM has the right to direct the use of such tools/moulds including deciding how and for what purpose they would be used. Also, the OEM obtains substantially all of the benefits from such tools and moulds. Therefore, such arrangements would constitute a lease under the new standard which would need to be recognised as a right-of-use asset in the OEM’s balance sheet.

• Determination of lease term: The definition of lease term largely remains the same between Ind AS 17 and the new standard. The key aspect that entities would need to evaluate in making an assessment of the lease term is whether the lease contract has an option to extend the lease term or option to terminate the lease term and whether it is reasonably certain to exercise such option to extend or not to exercise the option to terminate. In making this assessment entities must consider all facts and circumstances and also some of the additional considerations noted in the new standard.


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Telecom

The new standard would have a significant impact on telecom sector as the business is inherently asset intensive with capacity and asset sharing arrangements among the telecom operators. For example, there may be bilateral arrangements between telecom operators for towers, sites or network assets. Other typical arrangements include intra-group capacity sharing and sale-and-leaseback deals. Implementation of the new standard would require these companies to make significant judgements around identification of leases, lease term, discount rate, cash flows and segregation of lease and non-lease components and these aspects could have widespread business implications.

Following are the key considerations for the telecom sector:

• Lease term and asset retirement obligation for leased sites: Telecom entities enter into leasing arrangements with private land owners, governments and others to place tower and other telecom equipment on buildings, rooftops, bridges, etc. Such arrangements would usually meet the definition of lease under the new standard.

Generally, such arrangements are entered for short to medium-term which are renewed automatically unless cancelled by either party by giving a termination notice. In such cases, determination of lease term is a key judgement area considering the renewal and termination options and specific facts and circumstances of each lease. Entities may also consider the economic disincentives on non-renewal of leases, for example, cost of relocation, significance of sites from operational perspective, difficulty in finding the new tenant for lessor, etc. Such considerations may lead to the lease term being higher than the stated non-cancellable period. This would be the case even if

the lessor may have the right to walk away from the arrangement on the expiry of initial contract term. Termination options held by the lessor only are not considered when determining the lease term because, in this situation, the lessee has an unconditional obligation to pay for the right to use the asset for the period of the lease, unless the lessor decides to terminate the lease.

Some of these arrangements may obligate the telecom entities to restore the site in the original condition. Accordingly, they would be required to determine whether the requirement to restore the leased asset should be included in the right-of-use asset.

• Lease definition for site-sharing arrangements: Telecom operators generally enter into tower sharing arrangements with other operators and/or tower management entities to install their respective telecom and ancillary equipments on telecom towers. Independent base area is also provided to keep telecom equipment. One key element in identifying a lease as per the new standard would depend on whether the substitution rights held by the provider of tower space are substantive.

Many telecom entities consider the tower sharing arrangements as service arrangements and have not considered them as lease under Ind AS 17. However, the evaluation as per the new standard may bring these arrangements within the ambit of lease definition. This would be a key change for telecom entities since there will be a balance sheet recognition of such arrangements. Similar considerations would apply from the perspective of lessor. Although lessor accounting does not change under the new standard, there would be additional disclosure requirements to this effect.


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Source: IFRS 16 issued by the IASB - Illustrative example 3

• Capacity sharing contract: It is quite common for telecom entities to enter into capacity sharing arrangements. These arrangements could take place in various forms with rights and obligations of each party specifically defined in the agreement. It is important to analyse facts and circumstances of each such arrangement to decide whether the supplier has any substantive substitution rights,

customer’s right to substantially all of the economic benefits from the use of fibres, and customer’s ability to direct the use of the fibres. Analysis of these questions could be complex and may require detailed deliberation with business teams to evaluate whether the arrangement is or contain a lease.

Example: Operator A (customer) enters into a 20-year contract with Operator B (supplier) for use of three identified, physically distinct dark fibres within a larger cable. These cables provide a connection from Country X to Country Y. The arrangement allows the customer to make the decisions about the use of the fibres by connecting each end of the respective fibres to its electronic equipment, lighting the fibre and decisions relating to transport of data, etc. Supplier has the responsibility to fix the damaged fibres and ensure that fibres are in working condition. Supplier can also substitute the fibres in the event of repairs and maintenance.

Based on the above facts, it can be concluded that the contract contains a lease of dark fibres. Dark fibres are explicitly specified in the contract and physically distinct from other fibres within the

cable. Customer has the right to control the use of the fibres throughout the 20-year period of use because:

• Dark fibres are used exclusively by the customer throughout the period of 20 years.

• Customer takes all the decisions relating to the use of such fibres i.e. how and for what purpose fibres will be used. This is because the customer decides (i) when and whether to light the fibres and (ii) when and how much output the fibres will produce (i.e. what data, and how much data, those fibres will transport).

A supplier’s right or obligation to substitute the asset for repairs and maintenance, because the asset is not working properly – i.e. a ‘warranty-type’ obligation is not a substantive substitution right and therefore, ignored for the lease evaluation.

• Customer premise equipment: Telecom entities often deploy equipment such as routers, modems, etc. at the customer’s premise to provide various services (these arrangements may involve a higher level of ongoing decision-making due to increased functionality). If the how and for what purpose decisions are made by the customer, then the customer has the right to direct the use of the asset and a lease exist if the other criteria are met. By contrast if the arrangement does not contain a lease, it may fall entirely in the scope of Ind AS 115 for telecom entities.

• Segregation of lease and non-lease components: Segregation of lease and non-lease components is critical for both the parties in an asset sharing arrangement as there may be additional services like electricity, security, water, maintenance, etc. rendered by the provider. Segregation between lease and non-lease components is achieved basis respective stand-

alone selling prices of the services. In this case, although the lessee has a practical expedient to combine the lease and non-lease component and account for the whole arrangement as a lease component, lessor does not have any such practical expedient. Hence, operators who may be a lessee or a lessor on different arrangements will have to carefully consider the practical expedient based on the impact on financial statements.

• Determination of discount rate: Determination of incremental borrowing rate may pose challenges to telecom entities due to voluminous lease transactions with different lease terms. Incremental borrowing rate is required to be determined for each lease contract considering the credit worthiness of the entity, lease term, amount of funds borrowed, security i.e. the nature and quality of underlying asset and the economic environment on the lease commencement date.


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Media and Entertainment (M&E)

The M&E sector is fairly diverse and entities in this sector, generally, use diverse range of products for delivering the final content which implies that a single contract may often contain multiple components. Also, the contracts at times may involve use of third party assets, such as online servers, satellites or physical advertising space. Therefore, it becomes necessary to identify the contracts that would qualify for recognition of a lease arrangement under the new standard.

Following are the key considerations for the M&E sector:

• Identification of a lease arrangement: Entities in the M&E sector would need to evaluate each and every arrangement entered into by it so as to determine whether a contract constitutes a lease under the new framework and would have to be recognised in the financial statements. For instance, in an arrangement to hire sites for mounting an advertising billboard or to rent fiber optic cable for transmission, while evaluating which party has the right to direct the use of the underlying asset, the lessee would have to assess which party directs the use of a dedicated cable that is part of the larger network infrastructure. This is likely to involve considerable amount of judgement.

Example: Right-to-use advertising billboards on a structure (e.g., a side of building, side of bus stop shelter, pillars of bridge and floor of a sporting arena) for advertising

A Ltd. (customer) is a television broadcasting network that enters into an arrangement with B Ltd. (supplier), an out-of-home advertising entity, to advertise its new television show on billboards located in metro and non-metro cities across India.

The arrangement for metro cities is for digital billboard and locations are pre-approved by the operations team of A Ltd. including its display, design and other features for each location.

In case of non-metro cities, the customer selects 15 locations in each city of which B Ltd. will put traditional billboards on five such locations throughout the term of the arrangement.

The duration of arrangement for metro and non-metro cities is three months and 16 months respectively. B Ltd. is responsible for the operation and maintenance of the billboard and requires a week’s advance notice before the advertisement can be changed.

AnalysisIn many instances, specific space on the side of the structure is an identified asset as it can specifically be used to mount an advertising billboard. Further, economic benefits can be derived not only from an asset’s primary use (e.g. building) but also from ancillary use. Consequently, entities may reach different conclusions about whether there is an identified asset or not, depending on the facts and circumstances of each case.

In the given case, the arrangement for the traditional billboard would not be a lease if the supplier has substantive substitution rights i.e. if B Ltd. finds a higher bidder for a particular site in a non-metro city, it can relocate A Ltd.’s advertisement to one of the other approved sites within the city.


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On the other hand, in case of the arrangement for digital billboard, it would be likely to be concluded that the arrangement contains a lease on account of the following reasons: a. The customer will use digital billboard for

advertising its television show and may direct to change or modify the advertisement

b. The supplier lacks control to substitute the digital billboards

c. The billboard is explicitly identified as stated in the arrangement and

d. Locations are pre-approved by the customer and the supplier does not have the contractual ability to substitute the locations.

Further, the customer has the right to control the use of the advertising billboard throughout the period as:a. It has the right to obtain substantially all of the

economic benefits from use of digital billboard over the period of use (i.e. the economic benefit obtained from displaying advertisement at the site) and

b. It makes the relevant decisions on ‘how and for what purpose’ the billboard space is to be used by determining what content has to be displayed, when it is to be displayed and how often it needs to be changed.



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Example: Transmission service arrangement in a television industry

A Ltd. (customer) a multi-system operator, enters into a five-year contract with B Ltd., a satellite communications provider (supplier) to provide dedicated broadcast transmission capacity using five dedicated satellite transponders. B Ltd. is the owner of the satellite transponders and is responsible for its operation to enable transmission, including any required maintenance. Each transponder is capable of 35 to 54 channels. The arrangement specifies the transponder capacity of each transponder and provides the customer with the relevant technical details to access and operate its dedicated capacity (e.g., the microwave radio frequency range and specific orbital location to up-link customer’s broadcast signal to the transponder). The capacity on the dedicated transponder is assigned to the customer who has exclusive use of that capacity and the customer can choose during which hours and/or which signals it wants to broadcast via that transponder. Further, the supplier cannot substitute the transponder except for maintenance or in the event of malfunction.

B Ltd. receives channel signals from C Ltd., a broadcasting network, from its up-linking location. The content/television feed is transmitted to the up-linking facility through fiber optic cable hired from various telecom operators. Telecom operators offer similar services to other broadcasters and operators.

The term of the arrangement with C Ltd. is five years and the telecom operators are the legal owners of the fiber cable.

AnalysisThe arrangement between A Ltd. and B Ltd. contains a lease on account of the following reasons:

a. The transponder is physically distinct in nature and is dedicated for use by A Ltd., thus, it is an identified asset.

b. A Ltd. has the right to control the use of the transponder throughout the period of use because it has the right to:

i. Obtain substantially all of the economic benefits from the use of the transponder as the identified transponder’s capacity is dedicated to A Ltd. throughout the period of use and

ii. Make relevant decisions about when and how much data is to be transmitted because A Ltd. can elect at its sole discretion to go-off or on-air at any time during the period of use.

The arrangement between B Ltd. and C Ltd. will not be classified as a lease as the capacity portion of fiber cable does not seem to qualify as an identified asset as it is not capable of being distinct. Further, since it is being shared by several customers, therefore, it neither provides substantially all economic benefits to B Ltd., nor B Ltd. can direct the use of the cable.



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Example: Hire of projectors by exhibitors

DEF Ltd. (customer) is a film exhibitor having 300-plus cinema screens across locations. Out of these, 55 screens are exclusively used to exhibit technologically advanced 3D movies for which DEF Ltd. has installed high-end projectors specially designed for exhibition of such movies. Since, purchase of high-end projectors involve huge costs, DEF Ltd. has entered into an arrangement for hire of such projectors with STL Ltd. (supplier) for a period of five years in exchange for a consideration to be paid on a monthly basis. These projectors are physically distinct and explicitly specified in the contract. STL Ltd. is the legal owner of the projectors and performs regular maintenance services. Also, the projectors are annually verified by STL Ltd.

AnalysisThe arrangement between ABC Ltd. and STL Ltd. contains a lease as it relates to an identified asset i.e. a projector which is physically distinct and explicitly specified in the contract. Since, the primary use of the projector is to exhibit movies on the defined screens of ABC Ltd., therefore, substantially all economic benefits from the use of the projectors by exhibition activity (for instance, sale of tickets, advertisement revenue, etc.) will flow to ABC Ltd. Please note that, though STL Ltd. may have legal right of substitution, this right would not be considered substantive in nature, if significant costs are involved in substituting the projectors.

Further, ABC Ltd. has the right to control the projectors in terms of exclusive access during the contract period and in terms of the content to be exhibited and its timing. Moreover, supplier’s right for verification of projectors annually seems to be protective in nature.


• Identifying components of lease: In the M&E sector, Multiple System Operators (MSOs) and Direct-To-Home (DTH) players (i.e. lessors) have arrangements with a lease and a non-lease component i.e. set-top box (lease) and television broadcasting service (non-lease). If a contract contains a lease component and one or more additional lease or non-lease components, then the lessee is required to allocate the consideration in the contract to each lease component on the basis of the relative stand-alone price of each lease component and the non-lease components.


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Example: Bank B enters into a five-year lease of 4,000 ATM machines to be used across its branches/kiosks in Maharashtra, Gujarat and Karnataka. The lease payments are INR10,000 per month and the contract includes an additional maintenance charge and supply of consumables calculated as INR0.80 per transaction processed. Payments are due at the end of each month.

Identification of a lease

In this case, the specified asset is the ATM machine and bank B obtains the right-to-use it i.e. bank B directs how and what purpose the ATM machines would be used and also it

Financial services

The nature of leasing arrangements in financial services sector typically comprises of the following:

• Lease of branch premises, Automated Teller Machines (ATMs) and cash deposit machines

• Lease of IT assets including data centers, servers and photocopy devices, laptops and workstations

• Lease of vehicles for use of employees.

Following are the key considerations for the financial services sector:

• Identification of a lease: In the financial services sector, assets taken on lease by entities/banks are generally identifiable (such as branch premises, IT assets like data centers, computers, printers and photocopy devices) in the agreements.

However, even if an asset is specified, a lessee does not control the use of an identified asset if the lessor has a substantive right to substitute the asset for an alternative asset during the lease term.

Example: Bank B enters into a lease contract for five year lease of ATM machines to be used across its branches/kiosks in Maharashtra, Gujarat and Karnataka. Bank B would like ATM machines of a particular specification. Lessor A specialises in lease of ATM machines of the specification, and has a large pool of similar machines that can be used to fulfil the requirements of the contract. The ATM machines are stored at lessor A’s warehouses when they are not being used at branches/kiosks. These warehouses are located strategically at a central location for every region. Costs associated with substituting the machines are minimal for lessor A.

In this case, since the ATM machines are stored at lessor A’s premises, it has a large pool of similar machines and substitution costs are minimal, the benefits to lessor A of substituting the ATM machines would exceed the costs of substituting the same. Therefore, lessor A’s substitution rights are substantive and the arrangement does not contain a lease.


• Separating components of a contract: If a contract is, or contains, a lease, then an entity accounts for each lease component separately from non-lease components following a two-step approach as explained below:

Step 1: Identify the component

An entity considers the right to use an underlying asset as a separate lease component if it meets the following criteria:

a. The lessee can benefit from using that underlying asset either on its own or together with other resources that are readily available and

b. The asset is neither highly dependent on, nor highly inter-related with, the other assets in the contract.

Step 2: Accounting of the separate component

If a contract contains a lease component and one or more additional lease or non-lease components, then the lessee allocates the consideration in the contract to each lease component on the basis of:

a. The relative stand-alone price of each lease component and

b. The aggregate stand-alone price of the non-lease components

However, as a practical expedient a lessee can elect, by class of underlying asset, not to separate lease components from any associated non-lease components. A lessee that makes this election accounts for the lease component and the associated non-lease component(s) as a single lease component.


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Source: KPMG’s Insights into IFRS, 15th edition, 2018-19

• Assessment of lease term: Sometimes, the terms of a lease are enforceable only during a specified period. In this situation, the ‘lease term’ is the non-cancellable, i.e. enforceable period of the lease, together with:

- Optional renewable periods if the lessee is reasonably certain to extend and

- Periods after an optional termination date if the lessee is reasonably certain not to terminate early.

When determining the lease term, an entity considers all relevant facts and circumstances

Example: A Non-Banking Financial Company (NBFC) B enters into a non-cancellable lease contract with lessor L to lease a residential building to be used as its staff quarters. The building is located near an emerging upscale business complex area in Mumbai. The lease is for 20 years initially, and X has the option to extend the lease by another 10 years at the same rental.

To determine the lease term, B considers the following factors:

• Market rentals for a comparable residential building in the same area are expected to increase by 30 per cent over the 30-year period covered by the lease. At the inception of the lease, lease rentals are in accordance with current market rents.

• B intends to stay in business in the same area for at least 30 years.

• The location of the residential building is ideal for its employees to commute and has all the basic amenities.

Based on the above, B concludes that it has a significant economic incentive to extend the lease. Therefore, for the purpose of accounting for the lease, B uses a lease term of 30 years.

obtains substantially all the economic benefits from the use of such machines.

Additionally, there is no substantive right to substitute the ATM machines designated for bank B’s use. Therefore, in this case, the contract contains a lease.

Separating components of a lease

The contract includes lease of 4,000 ATM machines. Accordingly, bank B would need to evaluate whether each of these 4,000 ATM machines are separate lease components. In this case, bank B could benefit from the use of ATM machine on its own, as they can be used without the use of other machines. Also, it is not highly dependent on the other assets. Therefore, each ATM machine would be eligible to be recognised as a separate lease component.

Further, the contract also includes services for supply of consumable and maintenance services. Since the supply of consumables and maintenance services involves transfer of goods and service, for which bank B would have to pay, otherwise, separately (for instance, if ATM machine requires repairs, cartridge for printing receipts, etc.), therefore, they could be considered as non-lease components.

In order to account for charges towards consumables and maintenance services, bank B could either:

• Separate the amount from the lease payments, exclude it from the lease liability and expense it as incurred

• Apply the practical expedient and include it in lease liability.

that create an economic incentive for the lessee to exercise an option to renew or not to exercise an option to terminate early. When assessing whether a lessee is reasonably certain to exercise an option to extend, or not to exercise an option to terminate early, the economic reasons underlying the lessee’s past practice regarding the period over which it has typically used particular types of assets (whether leased or owned) may provide useful information.

The new standard provides examples of factors to consider when assessing whether it is ‘reasonably certain’ that a lessee would exercise an option to renew the lease. The assessment of the degree of certainty is based on the facts and circumstances at commencement of the lease, rather than on the lessee’s intentions.


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Consumer market and retail

Consumer markets typically comprise consumer products, food and beverage products, retail products and transportation products.

Following are the key considerations for the consumer market and retail sector:

• Leases with variable payments: In case of consumer market and retail sector, lease rentals comprise fixed lease payments as well as variable (with minimum fixed lease payments included).

If lease liability includes lease payments that vary based on an index or a rate, for instance, Consumer

Price Index (CPI) or open market rent reviews, then the lessee is required to re-measure the lease liability for changes arising from that index or rate.

The re-measurement of the lease liability will bring changes to the reported amount of assets and liabilities on the balance sheet.

However, variable payments that depend on sales or usage, for example, lease rentals dependent on a specified turnover, will continue to be expensed as incurred.

Example: Fixed payments made by a lessee

A lessee enters into a 20-year lease for a store in a mall. Lease payments are INR80,000 per year, all payable at the end of each year. To obtain the lease, the lessee incurred initial direct costs INR25,000. The interest rate implicit in the lease cannot be determined and incremental borrowing rate is 6 per cent per annum. The present value of the lease payments is INR917,600.

In this case, at the commencement date, the lessee incurs the initial direct costs and measures the lease liability at INR917,600.

The carrying amount of the right-of-use asset in lessee’s balance sheet is INR942,600 (i.e. INR917,600 + INR25,000) and the annual depreciation charged to the statement of profit and loss is INR47,130 (INR942,600/20).

Subsequently, the lease liability will be measured using amortised cost principles. Accordingly, for the two years, the computation of the lease liability would be as follows:

S.no. Opening balance(A)

Finance cost (6 per cent*(A))

(B)

Lease rental (C)

Closing balance(D = A + B - C)

1 INR917,600 INR55,056 INR80,000 INR892,656

2 INR892,656 INR53,559 INR80,000 INR866,215

At the end of year one, the carrying amount of the ROU asset will be INR895,470 (INR942,600 less INR47,130 depreciation).The interest cost of INR55,056 will be taken to the statement of profit and loss as a finance cost.

Variable payments made by a lessee

Modifying the above example, if the lessee had to pay rent on the basis of turnover of the store, say, 20 per cent subject to minimum fixed rentals of INR80,000. The turnover for year 1 has been estimated to be INR1,000,000.

In such a case, the lessee will charge INR120,000 {200,000 (20%*1,000,000)-80,000} as expense (being variable in nature) with annual depreciation of INR47,130 in the statement of profit and loss.

Lease rentals that are variable and not based on any index e.g. payments based on revenue or usage are recognised in the statement of profit and loss during the period in which event or condition (triggers those payments) occurs.



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• Determination of lease term: Assessment of lease term is a critical input in estimating the discount rate used to calculate the present value of the future lease payments. For example, the incremental borrowing rate estimated for a 10-year lease of a particular asset is likely to differ from the rate for a 20-year lease of the same asset.

The lease term is the non-cancellable period of the lease, together with:

- Optional renewable periods if the lessee is reasonably certain to extend and

- Periods after an optional termination date if the lessee is reasonably certain not to terminate early.

Therefore, entities in consumer market and retail sector should identify those lease agreements which have termination or renewal options and evaluate the lease term based on the new guidance.

Additionally, a lessee should identify leases for which the lease term is 12 months or less and decide whether to utilise the practical expedient of not recognising such short-term leases.

• Leases with provisions to restore a property: At the lease commencement, a lessee measures the right-of-use asset at cost and includes an estimate of costs to be incurred in dismantling and removing the underlying asset, restoring the site on which it is located or restoring the underlying asset to the conditions required by the terms and conditions of the lease, unless those costs are incurred to produce inventories. The obligation for these costs is recognised and measured in accordance with Ind AS 37.

Example: Lessee B is a retailer of high-end clothing. B enters into a five-year lease of a retail space that includes an outdoor courtyard.

The lease payments are INR10,000 per annum, paid at the end of each year. B’s incremental borrowing rate is five per cent.Under the lease agreement, B is required to restore the property to its original condition (e.g. removing any leasehold improvements, etc.) at the end of the lease.AnalysisAt commencement of the lease, B fits out the store by knocking down a wall and installing display shelves, lighting fixtures and a staircase. At this time, B’s suppliers estimate that it will

Source: KPMG IFRG publication ‘Real estate leases - The tenant perspective’, October 2018

• Contract manufacturing: It is extremely common for the consumer markets sector, especially the Fast Moving Consumer Goods (FMCG) industry, to enter into outsourcing arrangements for the manufacture of their products as part of their overall supply chain management strategy and attaining cost efficiencies.

Ind AS 17 provides guidance on embedded leases. A job work arrangement which is captive in nature and requires the purchaser to make payments (that are not fixed or at market price for each unit of output) irrespective of whether the purchaser takes delivery of the contracted products or not, was typically covered under Ind AS 17 as a lease. Such a lease was evaluated either as a finance lease or an operating lease.

Under the new standard, such an arrangement would only be a lease if the customer controls the use of the identified asset and obtains substantially all of the economic benefits from the use of the asset. Therefore, if the FMCG is able to make decisions about ‘how and for what’ purpose regarding the assets of the job worker, then the arrangement could be considered as a lease after taking into consideration other facts and circumstances of the arrangement.

cost INR5,000 to remove the fit-outs and rebuild the wall, to restore the property to its original condition at the end of lease. The nominal risk-free rate is four per cent.Accordingly, B records the following at lease commencement:• A lease liability of INR43,295 (measured at

the present value of five annual payments of INR10,000, using B’s incremental borrowing rate).

• A provision for restoration costs of INR4,110 (measured as the estimated restoration costs of INR5,000 at the end of year 5, discounted using a risk-free rate).

• A total of INR47,405 (INR43,295+INR4,110) as an asset at lease commencement.


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Information Technology (IT)

Entities in the IT sector, generally, enter into lease arrangements (as lessees) for lease of property, equipment, etc. Accordingly, the entities in this sector would need to evaluate the impact of such transactions on their financial statements.

Following are the key considerations for the IT sector:

• Determination of right-to-use an asset in a supply arrangement: IT entities enter into a variety of supply arrangements that will need to be evaluated to determine whether they involve the use of an identified asset. For example, some contract arrangements require the use of an explicitly or implicitly specified asset (e.g. supply of hardware, installation, networking, commissioning, dedicated facilities, etc.). Even if the arrangement specifies an asset, entities will need to carefully evaluate whether the supplier has substantive substitution rights (i.e., whether, throughout the period of use, it can practically use another asset and economically benefit from doing so) to determine if there is an identified asset subject to lease accounting.

• Right to direct use of the asset: It is important to assess whether the assets specified in the contracts, provide the right-of-use of those specified assets. One would need to understand all facts and circumstances and whether the objective of providing the assets to the customer is to aid the maintenance services to the customer. A lessor may have a right to substitute the assets with customer’s approval but one should evaluate if approval for substitution is a protective right.

Example: An entity, ABC enters into a five-year service contract with a customer. Under the contract, ABC is required to provide support and maintenance services for customer’s IT infrastructure.

As per the agreement, the services delivered are from a specified customer premise, for which ABC is required to pay fixed monthly rentals to the customer for use of these premises.

Rent paid to the customer is at arm’s length price.

AnalysisServices delivered by ABC are from an identified location for a fixed rent, which is at arm’s length. Since, the rent paid to the customer is at fair value and towards distinct service obtained from the customer, ABC accounts for it in the same way as it accounts for other purchases from suppliers.

Accordingly, ABC recognises right-of-use the asset and accrue lease liability for its obligation towards lease payments in relation to lease of customer premises in its books of accounts.



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• Leases of vehicles: Entities may provide car facilities to employees, generally senior management for a fixed tenure. The master agreement would generally lay down the general terms and conditions and individual purchase orders that would indicate the employee names, car model, monthly fixed amounts that the company needs to pay and the duration of the arrangement.

Ownership of the vehicle remains with the lessor at all times but responsibility of maintaining the vehicles in good working condition belongs to the entity. One would need to understand all facts and the substance of the arrangement, whether the vehicle is implicitly or explicitly identified in the arrangement and if substitution rights of lessor are substantive.


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Healthcare

The healthcare sector in India is one of the most capital intensive businesses with several lease transactions, including infrastructure and equipment lease arrangements. Recently, some of the entities in this sector have moved to an ‘asset light’ model for their infrastructure development. This has been achieved by entering into an ‘operation and management agreement’ with the infrastructure

owners or into a long-term operating lease under Ind AS 17.

Following are the key considerations for the healthcare sector:

• Identification of a lease arrangement: One of the critical condition to identify a lease is the right to direct the use of an identified asset - in a typical supply or service contract.

Example: Evaluation of an operation and management agreement

Health Ltd. (operator), entered into a 20-year Operation and Management (O&M) agreement with a supplier who is the owner of a building in respect of a floor in the building. As per the terms of the agreement:

a. The supplier has engaged Health Ltd. to upgrade, operate, maintain and manage the hospital in a building and carry out other related health care activities.

b. Revenue from patient services and all direct and indirect expenses accrues to Health Ltd. Health Ltd., pays ‘revenue share’ with a minimum fixed payment, in consideration of the right-to-use the building.

c. The supplier agrees that it will not, directly or indirectly, engage or appoint any person other than the operator.

d. The operation and management of the hospital is under the supervision and control of the operator. Further, Health Ltd. has complete discretion and control on all matters relating to the management and operation of the hospital.

Analysis

The O&M agreement, in the given case, will be recognised as a lease if it meets the given criteria:

• Identified asset and substitution rights: A contract contains a lease only if it relates to an identified asset. In the given case, the O&M agreement identifies a floor of a building running as hospital for which the supplier has appointed Health Ltd. as the operator. The supplier does not have any alternative assets which are readily available for substitution (since it needs time and cost to convert a floor of a building into hospital). Therefore, it can be concluded that the supplier does not have any substantive substitution rights.

• Right to obtain economic benefits: If the terms of the agreement specifically provide that the supplier will not engage or appoint any person other than the operator for the service, then, it can be construed that Health Ltd. has the exclusive use of the asset throughout the lease period.

The operator has exclusive rights for 20 years to use the floor as hospital and all the economic benefits will flow to the operator. This is because the cash flows arising from patient services (revenue) are considered to be economic benefits that Health Ltd. obtains from use of the floor in that building, a portion of which it then pays to the supplier as a consideration for the right to use of that space.

Therefore, Health Ltd. has the right to obtain economic benefits from the use of the asset throughout the period of use.

• Right to direct the use of an asset: As per the terms of the agreement, the relevant decisions relating to how and for what purpose the asset is used are predetermined in the given case and also Health Ltd. has the right to operate the hospital in a manner that it determines. Therefore, it has the right to direct the use of an asset.

Hence, it can be concluded that the O&M agreement between Health Ltd. and the supplier is a lease arrangement in accordance with the new standard.

Evaluation of ‘right to direct the use’ of an asset will be critical and is likely to involve significant amount of judgement. Suppose, in the above example, if the supplier (owner of building) is a ‘trust’ with a permission/obligation to set up a hospital. In such a case, the trust would be required to have some control over the assets as per the trust’s obligation to set up a hospital and hence, would not be accounted as a lease.



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Life sciences

Life sciences sector comprises various sub-sectors i.e. pharmaceuticals, biotechnology, Research and Development (R&D) and medical devices. Each of these sub-sectors enter into a variety of arrangements which may meet the definition of lease under the new lease standard. Some typical arrangements include Contract Manufacturing Operation (CMO) in which a life sciences entity utilises its manufacturing facility to produce specific drugs for the specific customer, arrangement in which a company provides a medical device to the customer along with supply of consumables and dedicated warehousing arrangement with a Carrying and Forwarding Agent (CFA).

Following are the key considerations for the life sciences sector:

• Identification of a lease: A life sciences entity can be either a customer or a supplier in a CMO arrangement. In both the cases, unit of account for the assessment of such an arrangement for a lease would be the manufacturing facility (or a portion of its total capacity) used to supply drugs.

In case of a CMO arrangement, evaluation would be required as to whether the manufacturing facility has been identified as an asset either at the inception of the arrangement or commencement of production. Even if it is specified in the arrangement, further evaluation would be required to assess whether the supplier has a substantive right to use an alternate facility i.e. right to substitute the facility throughout the tenure of the arrangement. This would involve a high degree of

judgement including consideration of certain factors such as regulatory approvals, for instance U.S. Food and Drug Administration (USFDA), geographical location, potential downtime penalty, technology and legal right to substitute.

Additionally, an assessment would be required to evaluate whether the economic benefits arising to the supplier from substituting the asset exceeds the associated costs. Generally, costs of substitution are expected to be higher when such facility is located on customer’s premises. It is important to note that a mere legal right and practical feasibility to substitute is not sufficient.

Once the manufacturing facility or portion is concluded to be an identified asset, it needs to be assessed if the customer obtains substantially all the associated economic benefits from the use of such an asset e.g. primary output and the by-products.

As a next step, the life sciences entities need to determine who controls the use of asset in terms of taking decisions with respect to how the manufacturing facility is to be used and for what purpose. If the ‘how and what purpose’ decisions are predetermined, then the assessment of whether an arrangement contains a lease may depend on which party has the right to operate the asset. That is, relatively minor day-to-day operational decisions may determine the assessment. However, this area requires careful evaluation and understanding the nature of the asset and the terms and conditions of the contract.


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Example: An entity A enters into a five-year agreement with Contract Manufacturing Organisation (CMO) for a dedicated production line to manufacture Product 1. The contract states that entity A has the exclusive use of the production line (i.e., CMO cannot use the manufacturing equipment for any other customer).

The manufacturing qualifications of Product 1 are specified in the contract. Entity A issues instructions to CMO about the quantity and timing of products to be delivered. If the production line is not producing Product 1 for entity A, the production line will not operate. CMO operates and maintains the production line on a daily basis.

AnalysisEntity A has the right to use the dedicated production line for five years. The dedicated production line is an implicitly identified asset because CMO has only one line that can fulfil the contract, and CMO does not have the right to substitute the specified production line.

Entity A has the right to control the use of the dedicated production line (i.e., the identified asset) throughout the five-year period of use because:

• Entity A has the right to substantially all of the economic benefits from the exclusive use of the

dedicated production line. It has right to all the quantities of Product 1 produced throughout the five-year period of use.

• Entity A has the right to direct the use of the dedicated production line. Entity A makes the relevant decisions about how and for what purpose the production line is used because it has the right to determine whether, when, and how much the production line will produce (i.e., the timing and quantity, if any, of Product 1 produced) throughout the period of use. Because CMO is prevented from using the production line for another purpose, entity A has decision-making rights about the timing and quantity of Product 1 produced, in effect, the operation of the production line. Although the operation and maintenance of the production line are essential to its efficient use, CMO’s decisions are dependent on entity A’s decisions about how and for what purpose the production line is used.

Based on the above, it can be concluded that agreement in the given case, is a lease agreement to be accounted for in accordance with the new standard by entity A.

Similarly, arrangement for providing medical equipment and future supply of consumables would need to be evaluated based on the same principles. These arrangements are expected to meet the definition of lease under the new standard as the underlying medical equipment is identified and the

supplier does not have right to substitute except in case of breakdown. Further, the customers are entitled to all the associated economic benefits and have right to use the equipment exclusively as generally, they are located on customers’ premises.



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Education

Education service providers require a fleet of vehicles, computers and e-learning equipments, residential facilities etc. for their operations. Such providers will now have to make a strategic decision of whether to buy such facilities or to take them on lease considering the new requirements.

Following are the key considerations for the education sector:

• Determining whether an arrangement contains a lease: Education entities enter into a variety of arrangements that will need to be evaluated

to determine whether they involve the use of an identified asset. For example, certain arrangements specify explicitly or implicitly an asset (e.g. fleet of vehicles, learning aid equipment, etc.). Even if the arrangement explicitly specifies an asset, education institutes will need to carefully evaluate whether the supplier has substantive substitution rights (i.e., whether, throughout the period of use, it can practically substitute another asset and economically benefits from doing so) to determine if there is an identified asset subject to lease accounting.

Example: ABC School (customer) enters into a three year contract with a bus owner (supplier) for use of its specified buses. The buses are explicitly specified in the contract and bus owner does not have substitution rights. Customer decides which all passengers will be transported and whether, when and to which locations the bus will go throughout the three year period of use, subject to restrictions specified in the contract. Those restrictions prevent customer from operating buses in high risk areas or adverse conditions. Bus owner operates and maintains the bus and is responsible for the safe passage of the passenger on board a bus. Customer is prohibited from hiring another operator for the bus or operating the bus itself during the term of the contract.

AnalysisThe contract contains a lease in the given case as there is an identified asset (i.e. bus) and the customer has the right to use the bus for three years. Also, the bus owner does not have the right to substitute the specified bus.

Customer has the right to control the use of the bus throughout the three year period of use because:

• Customer has the right to obtain substantially all of the economic benefits from use of the

bus over the three-year period of use. Customer has exclusive use of the bus throughout the period of use.

• Customer has the right to direct the use of the bus. The contractual restrictions about where the bus can go, limit the scope of customer’s right to use the bus. However, they are protective rights that protect bus owner’s investment in the bus and bus owner’s personnel. Within the scope of its right of use, customer makes the relevant decisions about how and for what purpose the bus is used throughout the three year period of use, because it decides where and when the bus will travel. Customer has the right to change these decisions throughout the three-year period of use.

Although the operation and maintenance of the bus are essential to its efficient use, bus owner’s decisions in this regard do not give it the right to direct how and for what purpose the bus is used. Instead, bus owner’s decisions are dependent on customer’s decisions about how and for what purpose the bus is used.



• Determination of lease term: When determining the lease term, lessees need to consider all relevant facts and circumstances that create an economic incentive to exercise or forfeit options to renew and terminate early. For instance, level

of rentals in any secondary period compared with market rates, availability of suitable alternatives, costs relating to termination of the lease and the signing of a new replacement lease and restoration costs of the underlying asset.

• Lease of IT and office equipment: Education institutes hire various IT equipments such as laptops, desktop computers and other ancillary office equipments such as printers, photo-copiers, etc. Under Ind AS 17, while most of the the IT equipments are generally classified as finance leases, if significant risks and rewards gets transferred. Other office equipments such as

printers, etc. are recognised as operating leases as such leases are generally capable of being terminated by the parties at a short notice.

Under the new standard, an educational institute should evaluate if an exemption from recognition could be taken as short-term lease or of low value, depending on the terms of the arrangement.

Example: An institute of learning (X) enters into a non-cancellable lease contract with lessor L to lease a building. The lease is for four years initially, and X has the option to extend the lease by another four years at the same rental expense.

To determine the lease term, X considers the following factors:

• Market rentals for a comparable building in the same area are expected to increase by 10 per cent over the eight-year period covered by the lease. At inception of the lease, lease rentals are in accordance with current market rents

• X intends to stay in business in the same area for at least 10 years

• The location of the building is ideal for relationships with suppliers and students.

In the given case, since X has a significant economic incentive to extend the lease, therefore, for the purpose of accounting for the lease, X will use a lease term of eight years.


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Matters to consider• Identification of all lease agreements

and extracting lease data: Substantial effort would be required to identify all lease agreements and extract all relevant lease data necessary to apply the standard.

• Changes in systems and processes: Systems and process changes may be required to capture the data necessary to comply with the new requirements. Certain leases may be very old and could extend to periods in multiple decades. Entities will need to institute processes to capture data systematically and perform calculations including review mechanism to monitor the changes regularly.

• Changes in contract terms and business practices: The application of new standard may require entities to reconsider their contract terms and business practices such as changes in the restructuring/pricing of a transaction including lease length and renewal options. Therefore, the standard is most likely to affect departments other than financial reporting such as legal, tax, sales, budgeting, IT, etc.

• New estimates and judgements: New judgements, assumptions and estimates would be applied to determine a lease identification, classification and measurement of lease transactions.

• Transition considerations: Entities will need to decide upon the transition options available under the new standard i.e. whether to apply the standard retrospectively to all leases or to use a modified retrospective approach. The extent of information required will depend on the transition approach chosen. For instance, a modified retrospective approach could be applied using only current period information

i.e. the lessee’s incremental borrowing rate at the beginning of the current and lessee’s remaining lease payments. On the other hand, an entity would require extensive information about its leasing transactions to apply the standard retrospectively. This will include historical information about lease payments and discount rates. The information will be required as at lease commencement and also as at each date on which an entity would have been required to recalculate lease assets and liabilities or modification of the lease.

• Changes in key financial metrics: The new standard is expected to impact the Key Performance Indicators (KPIs), profitability ratios and compensation linked to such KPIs.

Many entities measure performance based on EBITDA, debt-equity ratio, and current ratio. EBITDA would improve due to elimination of rent expense, which is replaced by interest and depreciation costs. Debt-equity ratio will reduce due to increase in debt due to addition of lease liability, compensated by adjustments to equity on transition and subsequent measurements and current ratio will also reduce due to the increase in the current portion of lease liability.

• Inter-company leases: Inter-company lease arrangements that were previously classified as operating leases by both the lessee and the lessor may no longer attract equal and opposite accounting in each group entity’s accounts i.e. the lessor will continue operating lease accounting but the lessee will recognise a right-of-use asset and a lease liability.

This could significantly increase the complexity of internal reporting and consolidation systems and processes.


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IN OUR ABILITY TO TRIUMPH OVER ANYTHING IN OUR SPIRIT OF

UNDYING ENTHUSIASM OUR DRIVE TO ACHIEVE THE EXTRAORDINARY

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The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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This document is meant for e-communications only. (061_THL0219_RU)

Sai VenkateshwaranPartner and Head CFO Advisory T: +91 22 3090 2020E: [email protected]

Ruchi RastogiPartner Assurance T: +91 124 334 5205E: [email protected]

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