Notes by: Sweta Kothari www.linkedin.

com/in/swko/

Date : 12th Oct 2024

Short Notes on
By CA Sweta Kothari
LEASES : Follow on LinkedIn :
www.linkedin.com/in/swko/

Meaning, Types &

Accounting treatment

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Notes by: Sweta Kothari www.linkedin.com/in/swko/

LEASES
A lease is a legal, binding contract outlining the terms where one party grants a right to use
a property or land to another party in return for consideration (periodic payment) and for a
specific period of time. Both the parties enter into a lease agreement specifying the terms
and conditions of the agreement.
It guarantees the tenant or lessee – the use of the property and guarantees the property
owner or landlord – regular payments for a specified period in exchange.

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

Lessee vs. Lessor

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

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

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

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Notes by: Sweta Kothari www.linkedin.com/in/swko/

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

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

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

Features of Financial Lease:

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

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

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Notes by: Sweta Kothari www.linkedin.com/in/swko/

Features of Operating Lease:

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

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

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

 Sales-type: If a lease meets any one of the five criteria, it is a sales-type lease for the
lessor and a finance lease for the lessee.

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

 Operating lease: If a lease does not meet any of the criteria, it is an operating lease
for both the lessor and the lessee.

 Operating lease vs capital lease: Evaluating whether a lease was operating or

capital, a classic test question for accounting 101 students, is now outdated since the
new standards no longer include capital leases, which have been replaced by finance
leases.

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Notes by: Sweta Kothari www.linkedin.com/in/swko/

Difference between Finance and Operating Lease

Basis Financial Lease Operating Lease

A financial lease is a rent agreement

An operating lease is like renting an asset
where a business leases an asset for a
Meaning for a short period without the commitment
significant portion of its useful life,
of ownership.
almost like buying it.

In a financial lease, the renter takes on In an operating lease, the owner keeps the
Ownership most ownership duties and risks during asset’s ownership rights, so renters have
the lease. fewer duties.

Operating leases are often short, covering

Financial leases usually last a long time,
Duration only part of the asset’s life, giving more
covering most of the asset’s life.
flexibility.

Renters in financial leases must look

Maintenance Owners in operating leases usually handle
after maintenance, insurance, and other
& Insurance maintenance, insurance, and other costs.
costs.

Operating leases usually don’t allow

Purchase Financial leases sometimes let renters
renters to buy the asset at the end of the
Option buy the asset when the lease ends.
lease.

Operating leases are just rental expenses

Accounting Financial leases show up as assets and
on the renter’s financial records, with no
Treatment debts on the renter’s financial records.
big impact on assets and debts.

Payments in financial leases stay the Payments in operating leases might

Payments same for the whole lease, so renters know change, giving renters more flexibility
what to expect. based on how much they use the asset.

Financial leases are perfect for

Operating leases are better for businesses
Use and businesses that need to have an asset for
with short-term needs or those that want
Flexibility a long time and desire to own it
more flexibility with assets.
eventually.

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Notes by: Sweta Kothari www.linkedin.com/in/swko/

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

Lease accounting is a complex area of accounting that requires an understanding of

GAAP. Under GAAP, leases are classified as either finance leases or operating leases

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

These changes to lease accounting rules are particularly extensive for lessees, even
though the core principle of classifying leases based on how much they’re like an
outright sale remains intact. The changes include big philosophical shifts along with
many small adjustments, with the primary change being that lessees are now required
to carry the operating leases on their balance sheets if they last more than 12 months
— the design is to give investors a better understanding of a company’s long-term
liability. Complying with the new rules has proven to be more difficult than
anticipated, especially for companies without the right accounting systems in place.

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

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

1) Proper recognition of lease liability on a lessee’s balance sheet.

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

Lessee vs. Lessor Accounting:

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

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Notes by: Sweta Kothari www.linkedin.com/in/swko/

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

 For sales-type leases, which are, as you might guess, most like an outright sale,
lessors ―derecognize‖ the underlying asset — which simply means they remove it
from their balance sheet — and add a new asset to their balance sheet in its
place: an investment in the lease. Also, at this point, the lessor would recognize
any profit or loss on the asset. Over the duration of a sales-type lease, the lessor
records interest income and reduces the balance of the lease investment as they
receive payments from the lessee. Sales-type leases are found often in the
entertainment business, where movie theater technology is leased to
independently owned theaters. Once the technology is installed in the theater, the
lessor effectively transfers total control and responsibility for it to the lessee,
usually for a 10- to 20-year lease term. At the end of the lease, the technology is
likely to be obsolete, and therefore of no remaining value to the lessor. In reality,
the lease is very much like a sale, which is why the movie-theater technology
asset is removed from the balance sheet and replaced by the lease investment
asset.

 For operating leases, which are the least sales-like, lessors retain the asset and
related depreciation on their books and simply record lease payments. A
straightforward example is a lease for office space in a high-rise building with
multiple occupants. Since this is more like a rental than a sale, the lessor retains
the building and related accounts, like a depreciation account, on its balance
sheet.

 Direct financing leases can be thought of as in between sales-type leases and

operating leases, although much closer to sales-type. With this type of lease, the
lessor’s accounting works similarly to a sales-type lease but defers any profit or
loss on the asset because it’s not quite an outright sale. This is the type of lease
used by most financial institutions that acquire assets simply to make money
from leasing them to customers.

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

 In the case of finance leases, where the relationship is more like ownership —
meaning, the risks and control of the asset lies mostly with the lessee. An open-
ended vehicle lease, where there is an obligation to purchase the car at the end of
the lease, is an example of a finance lease.

 In an operating lease, the lessee records a ―right-of-use asset‖ and a lease

liability on their balance sheet. A right-of-use asset designation distinguishes
leased assets from a company-owned assets, which is especially relevant for
financial reporting purposes. As lessees make payments over the lease term, they
amortize the asset, reduce the lease liability and recognize interest expense on

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Notes by: Sweta Kothari www.linkedin.com/in/swko/

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

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

1) Does ownership transfer at the end of the lease?

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

Example of Lease Accounting

Here is a simplified example to illustrate lease accounting:

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

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

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

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

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

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Notes by: Sweta Kothari www.linkedin.com/in/swko/

Operating Lease Accounting:

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

 Debit: Operating Lease Expense $10,000

 Credit: Cash $10,000

Finance Lease Accounting:

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

Assuming the present value of the lease payments at an appropriate discount rate is
$40,000, the initial lease accounting entry would be:

 Debit: Right-of-Use Asset (Office Space) $40,000

 Credit: Lease Liability $40,000

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

 Debit: Depreciation Expense (Office Space) $8,000

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

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

Scenario 2

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

Step-by-Step Calculation:

1. Calculate the present value of lease payments:

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

2. Recognize right-of-use asset and lease liability:

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

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

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

Illustration of the first year's entries:

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

 Balance Sheet:
o Right-of-use asset: $33,317 ($41,646 - $8,329)
o Lease liability: $38,314 ($41,646 - $3,332)

Key points to remember:

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

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

Why is Lease Accounting important?

 Transparency and Accuracy: Proper lease accounting enhances the

transparency and accuracy of financial statements. By recording lease obligations
on the balance sheet, it provides a more complete and accurate representation of
a company's assets, liabilities, and financial position. This information is vital for
investors, creditors, and other stakeholders in making informed decisions.

 Financial Statement Analysis: Lease accounting allows for more accurate

financial statement analysis. Investors and analysts can better evaluate a
company's financial health, liquidity, leverage, and profitability when lease
obligations are properly recorded and disclosed.

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 Comparability: Lease accounting standards provide a consistent framework for

companies to record and report leases. This improves the comparability of
financial statements across different companies and industries, allowing
stakeholders to make meaningful comparisons and assessments.

 Risk Assessment: Lease accounting enables a more comprehensive assessment

of a company's risk exposure. By recognizing lease liabilities on the balance
sheet, stakeholders can evaluate the financial impact of lease obligations, such as
debt covenants, repayment obligations, and future cash flow requirements.

 Contract Management: Accurate lease accounting facilitates effective contract

management. It helps companies monitor lease terms, payment schedules,
renewal options, and other critical aspects of lease agreements. This allows
businesses to better plan for lease expirations, negotiate favorable terms, and
optimize lease portfolios.

 Regulatory Compliance: Lease accounting standards, such as IFRS 16 and ASC

842, are recognized by regulatory bodies and accounting standard-setters.
Compliance with these standards ensures that companies meet the requirements
set forth by the respective governing bodies, avoiding potential penalties, legal
issues, or reputational risks.

 Decision Making: Lease accounting information assists in making strategic

decisions. Companies can evaluate the costs and benefits of leasing versus
buying assets, assess the financial implications of lease modifications, and
consider the impact of leases on profitability and cash flow.

Overall, lease accounting is essential for accurate financial reporting, informed

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

Advantages and Disadvantages of Lease Financing

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

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

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Notes by: Sweta Kothari www.linkedin.com/in/swko/

Advantages of Lease Financing

A. To Lessor:
The following are the benefits of lease financing from the perspective of the lessor:

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

B. To Lessee:
The following are the benefits of lease financing from the perspective of the lessee:

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

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Disadvantages of Lease Financing

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

B. To Lessee:
The following are the disadvantages of lease financing from the perspective of the
lessee:

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

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Difference between Hire purchase and Leasing

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

Basis Hire Purchasing Leasing

Hire Purchasing involves acquiring an Leasing involves renting an asset from the
Meaning asset through a series of installment owner (lessor) for a specified period in
payments over a specified period. exchange for periodic payments.

Duration of hire purchasing are longer Duration of leasing are shorter and
Duration
months to years. customizable.

In hire purchasing, the buyer gets

Ownership In leasing, the owner remains the same
ownership of the asset after completing
Transfer throughout the lease period.
paying installments.

Payment With hire purchasing, the buyer pays In leasing, the lessee makes regular
Structure installments until they own the asset. payments to use the asset for a set time.

Maintenance In hire purchasing, the buyer is In leasing, the owner usually handles
and Insurance responsible for maintenance & insurance maintenance and upkeep.

Hire purchasing terms are often fixed

Leasing is more flexible; lessees can often
Flexibility once agreed upon, offering less
change terms or upgrade assets.
flexibility.

Interest portion of hire purchase Lease payments may be treated as

Tax Treatment payments may be eligible for tax operating expenses and deducted from
deductions as a business expense. taxable income.

End of Term With hire purchasing, ownership is Leasing allows options like buying,
Options gained, & no more payments are needed. returning, or renewing the lease at the end.

In hire purchasing, the buyer takes on In leasing, the owner retains ownership
Risk Exposure
the risk of asset depreciation or damage. and risk.

Contract Hirer purchase can terminate before Breaking a lease can have legal
Termination ownership (subject to fees). consequences.

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IFRS 16/IND AS 116 ‘Leases’ -- snapshot

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

Right of Use Asset

Accounting for Leases

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

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

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

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

"An asset is a present economic resource controlled by the entity as a result of

past events. An economic resource is a right that has the potential to produce
economic benefits."

Based on IASB's Conceptual Framework for Financial Reporting (2019) , it would be

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

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

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

Process of Identifying Lease

IFRIC4 Determining whether an arrangement contains a lease which contained two

primary criteria for classifying an arrangement as a lease i.e. specific asset test and
right to use test.

Specific asset test - the arrangement to be satisfied by explicitly or implicitly

identified asset.

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

i. the lessee has the ability or right to use the asset or direct others to use the
asset and controls more than significant amount output /other utility arising
out of the asset , or

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

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

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

i. An asset is typically identified by being explicitly specified in a contract or

impliedly identified;
ii. In addition, the lessee has the right to use the specified asset. This condition is
not satisfied if the lessor has the substantive right to substitute the asset
through out the period of use or the lessor will economically benefit by
substitution of the asset.
iii. Thus if the supplier has a right or an obligation to substitute the asset only on
or after either a particular date or the occurrence of a specified event, the
supplier's substitution right is not substantive.
iv. Of course, the supplier's right or obligation to substitute the asset for repairs
and maintenance, if the asset is not operating properly or if a technical upgrade
becomes available does not preclude the customer from having the right to use
an identified asset.
v. The lessee shall be able to obtain substantially all of the economic
benefits from use of an asset. For this purpose an entity shall consider the
economic benefits that result from use of the asset within the defined scope of a
customer's right to use the asset.
vi. A customer has the right to direct the use of an identified asset throughout
the period of use. A lessee has the decision making right to direct how and for
what purpose the asset is used if, within the scope of its right of use defined in
the contract, it can change how and for what purpose the asset is used
throughout the period of use.

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vii. The lessor may enjoy protective right – the terms and conditions to protect its
interest in the asset or other assets, to protect its personnel, or to ensure the
supplier's compliance with laws or regulations. Such protective right does not
negate the existence of lease.

In contrast to restrictive requirements of IFRIC 4 regarding usage and pricing policy of

the output as indictors of right to use, IFRS 16/ Ind AS 116 sets out two modified
conditions –

 Right to obtain economic benefit from use ;and

 Right to direct the use of the identified asset.

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

Outsourcing arrangements as lease transaction

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

However, in outsourcing arrangement when the nature of product, quantity to be

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

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

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

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

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

Thus conditions for identifying a lease transaction is no longer subjected to the

condition pricing but still it remains an issue whether 'substantially all of the economic
benefits from use of the asset' flow to the customer.

Traditional Power Purchase Agreements

In traditional power purchase agreements, production is carried out by the power plant as
per its own production schedule and the buyer does neither has the right to direct

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

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

Measurement principle and reassessment of lease liability

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

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

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

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

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

Paragraph BC 192 of Basis of Conclusion , IFRS 16 clarifies reasons for adopting

adjustment of gain or loss arising out of reassessment to Right of Use asset:

a. A change in the assessment of extension, termination or purchase options reflects

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

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

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

Exclusions

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

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

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

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

However, an intangible asset under Paragraphs 15-19 of IFRIC 12 cannot be

recognized unless it there is an underlying right :

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

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

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Concluding remarks

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

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

Difference between IFRS-16 and INDAs 116

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

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

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

2. Terminology
 IFRS 16: Uses the term "right-of-use asset."
 IndAS 116: Uses the term "lease asset."

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3. Scope and Applicability

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

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

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

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

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

8. Interpretation of Certain Provisions:

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

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

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