Leases

Before Ind AS 116, a lease was either a finance lease on the balance sheet or an operating lease that was merely an annual rent expense with a note. A company could control billions of rupees of assets, be committed to paying for them for a decade, and report neither.

That is the problem the standard was written to fix.

What makes a contract a lease

A contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for consideration.

ICAI sets out the test: throughout the period of use, the customer must have both

• the right to obtain substantially all of the economic benefits from use of the identified asset; and
• the right to direct the use of the identified asset.

Both. A contract for capacity on a pipeline where the customer's share is less than substantially all of the capacity fails the first limb and is not a lease — it is a service contract.

This matters because it is a substance test, not a label test. What the document is called decides nothing.

What a lessee now recognises

For a lease in scope, the lessee recognises on the balance sheet:

• a lease liability — the present value of the future lease payments over the lease term; and
• a right-of-use asset — its right to use the underlying asset for that term.

The liability is discounted, which is chapter 1 of the Quantitative methods subject doing the work: a stream of future payments becomes one present value.

Then the income statement changes shape. Rent — a single operating expense — is replaced by:

• depreciation of the right-of-use asset, and
• interest on the lease liability.

What that does to the numbers

Work the retailer. 400 leased stores, nothing about the business changes, and:

Measure	Effect	Why
Total assets	Up	Right-of-use assets appear
Reported debt	Up	Lease liabilities appear
EBITDA	Up	Rent left operating expenses; depreciation and interest are both below EBITDA
Net profit, early years	Slightly down	Interest is front-loaded as the liability unwinds
Operating cash flow	Up	Lease payments reclassify toward financing
Cash	Unchanged	Nothing about the payments changed

None of this reflects a change in the business. The retailer has the same stores, the same obligations and the same bank balance. What changed is that the obligations are now visible.

Two consequences follow, and both are practical:

Leverage ratios jumped across lease-heavy industries — retail, airlines, hotels — on adoption. Comparing a pre-adoption year to a post-adoption year without adjusting is comparing two different measurement systems.

EBITDA became less comparable, not more. A company that leases and one that owns now look more alike on EBITDA than they are, because the lessee's rent has moved below the line. Chapter 18 of the Company analysis subject's caution about EV/EBITDA applies with force here.

The two exemptions

A lessee may elect not to apply the recognition requirements to:

1. short-term leases, and
2. leases for which the underlying asset is of low value.

Where the exemption is taken, the payments are recognised as an expense on a straight-line basis over the lease term, or another systematic basis if more representative.

These are genuine simplifications. They are also the place to check whether a company's lease disclosures are smaller than its footprint suggests.

What to read

The lease note gives the right-of-use asset by class, the lease liability split into current and non-current, the maturity profile of the payments, and the amounts recognised in profit. For a lease-heavy business that note describes a large part of the real capital structure.

The point

A contract is a lease if it conveys the right to control an identified asset — meaning substantially all the economic benefits and the right to direct its use. Lessees recognise a lease liability at the present value of the payments and a corresponding right-of-use asset, replacing rent with depreciation plus interest. Adopting it raised assets, reported debt and EBITDA across lease-heavy industries while changing no contract and no cash, which makes pre- and post-adoption years non-comparable.