Before Ind AS 116, a company that leased its factory, its offices, its vehicles and its equipment showed none of these obligations on its balance sheet. The lease payments appeared as rent expense in the P&L. The balance sheet was clean. The leverage ratios were flattering. And the economic reality, that the company had committed to years of fixed payments for the use of assets it depended on, was invisible.
Ind AS 116 changed the accounting. It did not change the economics. But it made the economics visible: every lease with a term of more than 12 months and a value above the low-value threshold now creates a right-of-use (ROU) asset and a lease liability on the balance sheet. The P&L now shows depreciation of the ROU asset and interest on the lease liability, rather than a single rent expense line.
The visibility is an improvement. The judgments embedded in the implementation are where the blind spots remain.
The Judgment Points
Lease identification
Not every contract that involves the use of an asset is a lease under Ind AS 116. A lease exists when the contract conveys the right to control the use of an identified asset for a period of time, in exchange for consideration.
The judgment: does the customer control the asset, or does the supplier? A managed-services contract where the supplier provides equipment but retains operational control over how it is used may not be a lease. A contract where the customer directs the use of specific identified equipment is a lease.
The classification determines whether the arrangement appears on the balance sheet (lease: ROU asset and liability) or off it (service: expense in the P&L). A company that classifies arrangements as services rather than leases keeps them off the balance sheet, reducing reported leverage.
Lease term
The lease term under Ind AS 116 includes the non-cancellable period plus any periods covered by renewal options that the lessee is “reasonably certain” to exercise, and any termination options that the lessee is “reasonably certain” not to exercise.
The judgment: what is “reasonably certain”? A company with a five-year lease and a five-year renewal option must determine whether it is reasonably certain to renew. If it includes the renewal, the lease term is 10 years, and the ROU asset and liability are calculated on 10 years of payments. If it excludes the renewal, the term is five years, and the balance sheet items are roughly halved.
Management controls this judgment, and it directly affects reported leverage. A company that systematically excludes renewal options (shorter lease terms, lower liabilities) presents a less leveraged balance sheet than one that includes them.
Discount rate
The lease liability is the present value of future lease payments, discounted at the rate implicit in the lease (if determinable) or the lessee’s incremental borrowing rate (IBR).
The IBR involves judgment: what rate would the company pay to borrow a similar amount, for a similar term, with similar security? A higher IBR produces a lower lease liability (future payments are discounted more heavily). A lower IBR produces a higher liability.
A company that estimates its IBR at 10% produces a materially different lease liability than one that estimates 7%, for the same lease payments. The difference flows directly to the balance sheet and, through interest expense, to the P&L.
Variable lease payments
Payments that depend on an index, a rate or the lessee’s performance (revenue-linked rent, inflation-adjusted payments, percentage-of-sales rent) require judgment about inclusion in the lease liability measurement.
Variable payments linked to an index or rate are included in the initial measurement and remeasured when the index or rate changes. Variable payments linked to the lessee’s performance or use (percentage of sales, per-unit charges) are excluded from the liability and recognised as expense when incurred.
The classification affects the balance sheet: payments classified as performance-linked stay off it. Payments classified as index-linked go on it.
Lease modifications
When a lease is modified (scope change, term extension, payment adjustment), the company must determine whether the modification is a separate lease or a remeasurement of the existing lease. The treatment affects both the ROU asset and the lease liability.
The Economic Consequence
The accounting change did not alter the company’s cash flows. The lease payments are the same. The operational dependency on the leased asset is the same. The risk of losing the asset if payments are not made is the same.
What changed is the visibility: the balance sheet now shows the economic commitment, the P&L shows the financing component and the leverage ratios reflect the obligation.
But the judgments embedded in the implementation, lease identification, term, discount rate, variable payment classification and modification treatment, determine how much of the economic reality the financial statements actually show. A company that applies every judgment in the direction that minimises the balance sheet impact is using the standard’s judgment provisions to partially restore the off-balance-sheet treatment that Ind AS 116 was designed to eliminate.
In Northrop Management Private Limited’s financial reporting advisory and due diligence work, lease accounting is examined as a judgment exercise.
Step 1: Identify all arrangements involving the use of assets. Not just formal lease contracts. Managed services, outsourcing arrangements, equipment provisions within larger contracts: each must be evaluated for lease identification.
Step 2: Test the lease term judgments. For leases with renewal or termination options, assess whether the “reasonably certain” determination is supported by evidence (economic incentives to renew, significant leasehold improvements, location dependency, lack of alternatives) or by a preference for shorter terms.
Step 3: Benchmark the discount rate. Compare the IBR to the company’s actual borrowing rate for similar terms and security. An IBR materially above the actual borrowing rate may be inflating the discount and deflating the liability.
Step 4: Quantify the off-balance-sheet exposure. Calculate the total future payments for arrangements classified as services rather than leases, and for variable payments excluded from the lease liability. This is the lease-related obligation that the balance sheet does not show.
Ashish Chaudhary, frames the analytical challenge directly: “The hardest lease judgments are often not mathematical. They concern what the contract economically represents. A company that systematically classifies arrangements as services, excludes renewal options, applies high discount rates and treats variable payments as performance-linked is using the standard’s judgment provisions to minimise the balance sheet impact. The economics have not changed. The visibility has been managed.”
Questions for the Boardroom
- How many arrangements involving the use of assets has the company classified as services rather than leases, and what is the annual payment?
- For leases with renewal options, have we included or excluded the renewal period, and what evidence supports the determination?
- What IBR have we used, and how does it compare to our actual borrowing rate for similar tenors?
- What is the total off-balance-sheet lease-related commitment (service arrangements, excluded variable payments, short-term and low-value exemptions)?
- If we re-applied every lease judgment at the most conservative reasonable estimate, how would our ROU assets, lease liabilities and leverage ratios change?
Closing Implication
Ind AS 116 made lease obligations visible on the balance sheet. The judgments embedded in its implementation determine how visible. A company that applies every judgment toward minimising the balance sheet impact has partially reversed the standard’s intent, keeping economic obligations in the notes rather than on the face of the financial statements. The board that understands which judgments have been made, and how they compare to the conservative alternative, governs with full visibility into the company’s lease-related economic commitments.