Accounting of Perpetual Lease - Ind AS 116 / IFRS 16

Ind AS 116 (IFRS 16) Leases,?which is in supersession to its predecessor?Ind AS 17 (IAS 17),?have significantly revised the accounting treatment of leases particularly in the books of the lessee. The earlier standards recognised leases in the statement of the profit and loss on straight line basis, over the period of lease. However, Ind AS 116 requires lessees to put most of the leases on their balance sheets.

The Impact

How the new standard works

The new accounting principle for lease (operating lease in the books of lessee) requires the lessee to recognise a right-of-use asset and corresponding?lease liability at the commencement date of a lease agreement.

Lease liability is the present value of lease payments to be made by the lessee in accordance with the lease agreements entered. The below calculation will clear how lease liabilities are computed and recognised along with right-of-use assets.

Factors that measure lease liability

The computation of lease liability and corresponding right-of-use assets is based on certain internal and external factors viz.,

?- lease rentals / payments which are required to be made during the course of lease;

?- implicit discount rate;

?- incremental borrowing rate (in case implicit discount rate is not available);

?- lease term.

Lease term

Lease term = non-cancellable period + extension period + termination period?        

Non-cancellable period is the period where lessee has the right to use an underlying asset. Period where an option to extend the lease has been stipulated, shall be included in lease term if lessee is reasonably certain to exercise such option. Further, the period covered by an option to terminate the lease shall also be included in lease term where lessee is reasonably certain not to exercise such option.

Significance of Lease term

Measurement of lease liability and corresponding right-of-use assets would require assessment of lease term by the lessee. Any incorrect evaluation of lease term would mean that lease liability and right-of-use assets have been measured wrongly. The lessee need to first determine lease term and rentals pertaining to such lease term and then calculate present value.

Further, leases where lease term is 12 months or less are classified as short-term lease and such leases are exempted from complying with the recognition principle. Consequently, there is no requirement to measure lease liability and right-of-use assets in case of short-term leases.?

The Concern

Perpetual lease

Perpetual leases are generally used where underlying asset is land. Many entities (specifically public sector entity) entered into perpetual lease agreement, for which one-time upfront premium is paid at the time of commencement and rent is paid on periodic basis. The terms of lease in most of the cases are such that any default in payment of periodic basis may lead to cancellation of lease agreement.

The problem with perpetual lease is evident (from the name itself) that the lease term cannot be determined by the lessee. A long-term lease of land (say 99-years) is sometimes regarded as being economically similar to purchase of the land. IFRS 16 does not specifically exclude such leases from its scope as:

?- conceptually, both long-term lease of land and long-term lease for assets other than land are not different. If the contract does not transfer control of the underlying asset to lessee, but gives only the right to control the use of the asset, the contract should be accounted as such;

?- present value of lease payments under long-term lease is likely to represent substantially all of the fair value of the underlying asset.?

ASC-842, which is US GAAP equivalent of IFRS 16 / Ind AS 116, includes very long-term lease (999-years) in its scope.

My Assessment of Perpetual Lease

In sum, in case of long-term leases, an important aspect to be examined is whether the agreement transfers control of underlying asset or only right to control the use of such underlying asset. If former is the case, the same should be accounted for as per Ind AS 16 / IAS 16, 'Property, plant and equipment'. However, Ind AS 16 does not provide guidance as to how "control" should be established. In general, control is established where future economic benefits from that resource (underlying asset) must flow to entity in question (lessee). If terms of the long-term lease agreements are such that the lessee can only sell the underlying asset with prior consent of the lessor or that sale proceeds shall be shared between lessee and lessor or that in the event of sell, lessor may impose such terms and condition as he thinks fit, it cannot be said that future economic benefits from underlying asset will flow to the entity entirely. Therefore, it cannot be said that lessee has obtained the control of the underlying asset. Accordingly, such underlying asset cannot be recognised under Ind AS 16.

In case of long-term lease (where it is established that the lessee have not obtained control of underlying asset),? the entity shall, at commencement date, recognise right-of-use asset and lease liability considering lease payments over perpetuity. So far as depreciation of right-of-use is concerned, if the underlying asset is land, no depreciation should be charged as land is a non depreciable asset and also the fact that the lease term is perpetual. For underlying assets other than land, depreciation should be charged on straight line basis over its useful life. It is also to be noted that the right-of-use asset is required an impairment test and entities should account for any impairment loss.