CA Tasnim Tankiwala

Tasnim Tankiwala

Ind AS 116- Leases, is effective from annual period beginning on or after 1 April 2019. Ind AS 116 Supersedes Ind AS 17 – Leases from the date of its applicability.

Under Ind AS 17, lease rentals under an operating lease were recognised as an expense/income on a straight line basis over the lease term unless:

1. Another systematic basis is more representative of the time pattern of the user’s benefit even if the payments of the lessors are not on that basis.

2. Lease rentals are structures to increase in line with expected general inflation to compensate for the lessor’s expected inflationary cost increases. If payments to the lessor vary because of factors other than general inflation, then this condition is not met.

Hence, Ind AS 17 does not mandate straight lining of lease escalation, if they are in line with the expected general inflation compensating the lessor for expected inflationary cost.

Pursuant to this requirement, many companies where the increase in rent was greater than the general inflation would have created rent equalisation reserve for accounting of rent on a straight line basis.

The issue under discussion is what happens to this rent equalisation reserve which is existing in the books of the lessee for a long term operating lease as on the date of application of Ind AS 116.

The treatment and the adjusting entries to be passed depends on the what method the entity chooses to apply under Ind AS 116:

Method A

Apply Ind AS 116 retrospectively to each prior reporting period assuming that the same was applicable to all the leases (other than short term and low value leases) from day one of the lease agreements. When the lessee exercises this option then the previous year figures are restated and the impact of application of the standard is given in the opening balance of each effected component of equity for the earliest prior period presented.

For e.g.: if entity A chooses to apply Ind AS 116 as per this option it will recognise

i. for each lease, the amount of the lease liability and the related right‑of‑use as at the beginning of the preceding period i.e. 1 April 2018 and the same would be calculated as if Ind AS 116 had always been applied.

ii. The difference, as at the beginning of the preceding period i.e., 1 April 2018, between

    • the amount at which right‑of‑use is measured, together with the rent equalisation reserve (standing in the books), and
    • the amount at which lease liability is measured

would be recognised in retained earnings (or other component of equity, as appropriate).

For example, assume that retrospective application of Ind AS 116 results in the entity recognising a lease liability of Rs 100 and right‑of‑use asset of Rs 85 in respect of a lease as at the beginning of the preceding period, i.e., 1 April 2018. Assume further that the entity’s balance sheet as at 31 March 2018 has a ‘rent equalisation reserve’ of Rs 10 in respect of the lease. In such a case, it would give effect to the transition as of 1 April 2018 as follows.

Right‑of‑use – Dr 85
Rent Equalisation Reserve – Dr 10
Retained Earnings (or other component of equity) – Dr 5
Lease Liability – Cr 100

(thus at the beginning of the preceding period the entity recognises the Right‑of‑use and lease liability, reverses the rent equalisation reserve existing in the books as on that date and the difference of Rs. 6 is debited to equity)

iii. The comparative amounts presented in the financial statements for the year ended March 31, 2020 would be restated (i.e. amount for year ended 31 March 2019).

Method B

Applies Ind AS 116 retrospectively with the cumulative effect of initially applying the standard recognised on the date of initial application i.e. on 1 April 2019.

If a lessee elects to apply this Standard in accordance with method B, the lessee shall:

1. recognise a lease liability at the date of initial application for leases previously classified as an operating lease applying Ind AS 17. The lessee shall measure that lease liability at the present value of the remaining lease payments, discounted using the lessee’s incremental borrowing rate at the date of initial application i.e. as at 1 April 2019.

2. recognise a right-of-use asset at the date of initial application for leases previously classified as an operating lease applying Ind AS 17. The lessee shall choose, on a lease-by-lease basis, to measure that right-of-use asset at either:

a. its carrying amount as if the Standard had been applied since the commencement date, but discounted using the lessee’s incremental borrowing rate at the date of initial application; or

b. an amount equal to the lease liability, adjusted by the amount of any prepaid or accrued lease payments relating to that lease recognised in the balance sheet immediately before the date of initial application.

√ Treatment of lease equalisation reserve if the entity recognises right‑of‑use using option 2 (a) stated above:

In this case, the difference, as at the date of initial application of Ind AS 116 i.e. 1 April 2019, between

i. the amount at which right‑of‑use is measured, together with the amount of rent equalisation reserve, and

ii. the amount at which lease liability is measured

would be recognised in retained earnings (or other component of equity, as appropriate).

For example, assume that the entity recognises lease liability of Rs 100 and right‑of‑use asset of Rs 85 in respect of a lease as at 1 April 2019. Assume further that the entity’s balance sheet as at 31 March 2019 has a ‘rent equalisation reserve’ of Rs 10 in respect of the lease. In such a case, it would give effect to the transition by passing the following journal entry as at 1 April 2019:

Right‑of‑use – Dr 85
Rent Equalisation Reserve – Dr 10
Retained Earnings (or other component of equity) – Dr 5
Lease Liability – Cr 100

Comparatives would not be restated, nor would there be any adjustment entry as at the beginning of the preceding period i.e. 1 April 2018.

√ Treatment of lease equalisation reserve if the entity recognises right‑of‑use using option 2 (b) stated above:

In this case, the rent equalisation reserve would be regarded as ‘accrued lease payments’ and the amount of right‑of‑use would be determined by deducting the said liability from the amount of ‘lease liability’ determined in accordance with method B (1).

For example, assume that an entity recognises lease liability of Rs 100 in respect of a lease as at 1 April 2019. Assume further that the entity’s balance sheet as at 31 March 2019 has a ‘rent equalisation reserve’ of Rs 10 in respect of the lease. In this case, the right‑of‑use would be measured at Rs 90 (Rs 100 minus Rs 10 of accrued lease payments already existing on the date of initial application) as at 1 April 2019. Accordingly, the entity would give effect to the transition by passing the following journal entry as at 1 April 2019.

Right‑of‑use – Dr 90
Rent Equalisation Reserve – Dr 10
Lease Liability – Cr 100

Comparatives would not be restated, nor would there be any adjustment entry as at the beginning of the preceding period i.e. 1 April 2018.

Treatment for increase in rent income by the lessor

As per the requirement of Ind AS 17, the lessor was also not mandated to account for lease rental on a straight line basis (or on any other systematic basis) if the increase in the lease rentals was in line with expected general inflation to compensate the lessor’s inflationary cost increases. Instead, Ind AS 17 required such increases to be recognised in the respective period of increase only.

Ind AS 116, which has replaced Ind AS 17 in respect of accounting years commencing on or after April 1, 2019, states the following in respect of accounting for operating leases by a lessor:

> A lessor shall recognise lease payments from operating leases as income on either a straight-line basis or another systematic basis. The lessor shall apply another systematic basis if that basis is more representative of the pattern in which benefit from the use of the underlying asset is diminished.”

It should be noted that Ind AS 116 does not carry forward the carve out that Ind AS 17 made from IAS 17 and requires operating lease rentals to be recognised on a straight-line basis (or on another systematic basis if such other basis is more representative of the pattern in which benefit from the use of the underlying asset is diminished).

In view of the above, under Ind AS 116, the lessor would be required to recognise operating lease rentals income on a straight-line basis over the lease term, notwithstanding that the lease rentals are structured to increase in line with expected general inflation to compensate for its expected inflationary cost increases.

The resultant change in manner of recognition of operating lease rentals by the lessor represents a change in an accounting policy which will need to be accounted for as per Ind AS 8, Accounting Policies, Changes in Accounting Estimates and Errors, in the absence of specific transitional provisions in Ind AS 116 dealing with the change.

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